Legal Tax Avoidance Trips State Collection

Arkansas collected less in corporate income taxes in 2002 than in any year since 1993, and 2003 isn’t expected to be much better.

Gov. Mike Huckabee and officials of the state Department of Finance and Administration have blamed the decline on general economic malaise and on widespread “legal tax avoidance” — sophisticated strategies used primarily by large, out-of-state public companies to shift income to states that don’t collect corporate income taxes.

As a result, the share of the state’s net general revenue that has come from corporate income taxes has declined from 7.7 percent in 1996 to an estimated 4.8 percent in the current fiscal year. The net corporate income receipt for 2002, $176.9 million, was 30 percent below the high-water mark of $252.9 million collected in 1998.

But a third factor is also involved, one that state officials say they cannot quantify and which may exaggerate the appearance of a declining tax burden on businesses. That is the growing popularity of business organizational structures that are not subject to corporate income taxes.

“Pass-through entities” — the catch-all phrase for subchapter S corporations, limited liability partnerships, limited liability companies and similar business organizations — generate taxes, but those dollars show up on the owners’ personal income tax returns rather than on corporate income tax filings.

“You can’t look at one type of tax in a vacuum,” said Mike Parker, a tax lawyer with the Dover Dixon & Horne firm in Little Rock who advises the tax committee of the Arkansas State Chamber of Commerce. “I hardly ever form a corporation anymore for a taxpayer starting a business. If I form a corporation, it will be an S corporation.”

And many — neither DF&A nor the Secretary of State’s office seems to know how many — businesses that were previously corporations and were required to pay corporate income taxes have converted to LLPs and LLCs, thus dropping off the corporate income tax rolls completely. The number of corporate income tax filers ranged from 29,492 in 1993 to 32,772 in 2001. Last year, 31,594 corporate income tax returns were filed.

Nationally, corporate profits declined by 8 percent between 1999 and the middle of 2002, according to the Council for State Taxation, a Washington, D.C., think-tank associated with the Council of State Chambers of Commerce. An Arkansas-specific figure is not available.

COST also reported that, nationally, business income reported on individual income tax returns grew from $6.2 billion in 1980 to $41.8 billion in 1999. Again, no specific information on the trend in Arkansas is available, according to David Foster, administrator of DF&A’s income tax division.

“But I would think we would see most of that in the past five years or so,” Foster said — a time frame that corresponds with the decline in corporate income tax receipts.

Avoiding Taxes

Tax avoidance strategies, which have become a business product in themselves, is a revenue issue for all states and the federal government.

Nationwide, an estimated mid-point figure of $11 billion was lost by states in 2001 to various tax shelter strategies, said Dan Bucks, director of the Washington, D.C.-based Multi-State Tax Commission. About $5.7 billion of that came from income-shifting within U.S borders, with the balance being accomplished by offshore income shifting, such as to Caribbean islands and tiny European principalities.

Arkansas is participating in a new MTC survey that will break down dollar figures for income tax avoidance by state. The complete survey won’t be released until mid-April, but John Theis, assistant revenue commissioner for DF&A, said he submitted data to MTC indicating that Arkansas could be losing as much as $94 million annually based on fiscal 2001 data for private and public companies.

“It’s still a work in progress. I’d present this as a preliminary estimate,” Theis said. “It’s our first effort to get a handle on on it. No one really knows the true scope.”

About $34 million of that was through offshore income transfers, Theis said. The rest is domestic, with a high-end estimate of $60 million, a mid-point estimate of $44 million, and a low-end estimate of $28 million.

DF&A has developed four “housekeeping” bills that would recapture something above $1 million a year in corporate income taxes now lost to tax avoidance strategies. That would increase corporate income tax receipts by a less than 1 percent compared with 2002.

The DF&A bills have been introduced by Sen. Paul Miller, D-Melbourne, Sen. John Paul Capps, D-Searcy, and Rep. Roger Smith, R-Hot Springs Village. They would broaden existing restrictions on the shifting of income to out-of-state subsidiaries and add more specifics to the definition of taxable business income. One would have “pass-through” entities such as subchapter S corporations and LLCs file composite tax returns on behalf investors, who are personally responsible for paying income taxes on the business’ profits.

“These are just plugging the holes. There’s no big revenue change,” said Tim Leathers, commissioner of revenue for DF&A.

The state is not attempting a total overhaul of its corporate tax structure such as the one proposed by Gov. Paul Patton of Kentucky, who wants to scrap corporate income taxes in favor of a “business activity tax” on gross receipts. Such an approach can stabilize tax revenue — after all, companies make sales even in years when they don’t make profits — but it is “not a silver bullet and can be just as complicated,” Leathers said.

Nor is there any legislative attempt to adopt “combined reporting,” an approach currently used by 16 states. Because it treats corporations and any subsidiaries as a single taxpaying entity, some tax experts consider it the most effective tool for short-circuiting gamesmanship between related companies.

“Combined reporting shuts down in one fell swoop the major ways corporations can shift income out of states to states where it isn’t taxed,” said Michael Mazerov, a tax analyst with the Washington, D.C.-based Center on Budget and Policy Priorities.

Arkansas isn’t considering that approach, Leathers said, because business lobby groups made clear 20 years ago that they wouldn’t accept that structure. In a case brought by Jacuzzi Inc. of Little Rock, which wanted to use combined reporting so that losses in one subsidiary could offset taxable income in a sister company, the Arkansas Supreme Court ruled in 1996 that the state was not required to allow the combined reporting method.

Leathers also said combined reporting might not have much positive effect for Arkansas because companies could decrease taxable income by counting losses from other operations.

Mazerov dismissed that argument, saying corporations already transfer losses for tax benefits.

“That’s an exaggerated problem,” Mazerov said. “I still think it would be an advantage for the state. It’s not a two-sided coin.”

Bucks, with the MTC, said combined reporting is “one very effective method” to help ensure income earned stays within a state.

“But combined reporting isn’t a panacea,” Bucks said. “It’s not the only measure needed to ensure proper accountability. (The DF&A bills) will help to better ensure income earned within Arkansas is reported as income for tax purposes.”

Parker noted that even states with combined reporting have experienced similar declines in corporate income tax receipts.

Awaiting Action

DF&A-backed bills that would close some corporate income tax loopholes include:

• SB-336 (Miller) — This bill would have the greatest revenue impact at about $1 million a year by doing away with what Leathers and Theis called “nowhere sales.”

It refines existing legislation called the “throwback rule,” which allows Arkansas to tax sales made to another state if that state isn’t going to collect a tax on those sales. For instance, an Arkansas manufacturer might sell merchandise to a warehouse in a state where the manufacturer has no operations. Those sales would have to be included in the taxable income formula when the manufacturer files its corporate income tax return in Arkansas.

• SB-334 (Miller) — This legislation would generate about $50,000 annually, according to DF&A impact statements, by strengthening existing rules on transferring income to tax haven states by setting up subsidiaries that do nothing but license nontangible assets such as copyrights, patents and trademarks to related companies.

The bill’s language calls for allowing such arrangements only if the income received by the subsidiary is subject to income tax in its home state or country.

• SB-430 (Capps) — This proposal would generate $50,000 or less in most years, according to DF&A, by redefining business income. Basically, this bill expands the definition of business income to include anything that the U.S. Supreme Court has found to be constitutional — a definition that is always subject to change. And that is problematic for taxpayers, Parker said.

The chamber would prefer to see the state wait for the results of a Multi-State Tax Commission study on appropriate definitions of business and non-business income.

• HB-1989 (Smith) — This bill would generate $10,000 or less annually — primarily from non-residents of Arkansas — by tightening collection of personal income tax from shareholders in “pass-through” entities such as subchapter S corporations, general partnerships, LPs, LLPs and LLCs.