You Win $ome, You Lose $ome

If you own or operate a business in Georgia, you may have cause to thank the state General Assembly and shake your fist at it all at the same time. In its 2005 session, the General Assembly passed several bills, which Governor Sonny Perdue subsequently signed into law, that significantly reshape the landscape of Georgia business taxation. Some of the changes will be of benefit to your company, while others will be viewed as detrimental.

If you own or operate a business in Georgia, you may have cause to thank the state General Assembly and shake your fist at it all at the same time. In its 2005 session, the General Assembly passed several bills, which Governor Sonny Perdue subsequently signed into law, that significantly reshape the landscape of Georgia business taxation. Some of the changes will be of benefit to your company, while others will be viewed as detrimental.

Major features and effects of the new legislation include:

  • Significant revamping of the taxation of multi-state
    business operations based in Georgia;
  • The death of Delaware Holding Companies, or at
    least a very serious blow to their health; and
  • Relaxation of rules regarding like-kind exchanges under
    Section 1031 of the Internal Revenue Code.

Multi-State Operations

A company that transacts business in only one state is subject to state income tax only in that one state. If you only transact business in Georgia, your corporate taxable net income is subject to Georgia corporate income tax at a rate of six percent. However, if your business corporation transacts business in multiple states, each state in which you transact business can levy an income tax based upon the amount of business you conduct within that state’s borders. To determine how much business you transact in a particular state, most state revenue codes traditionally have looked at three different types of activity in their state: your personnel located in their state as measured by your payroll to persons in that state; the amount of real and personal property you have located in that state; and the level of sales to, or gross receipts from, customers located within that state.

For many years, Georgia law provided that Georgia corporate income tax at a rate of six percent could be levied against Georgia taxable income. Georgia taxable income was determined by taking federal taxable income, with certain adjustments, and multiplying that number by a fraction determined as follows:

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This placed an equal weight on Georgia payroll, Georgia property and Georgia gross receipts in determining the amount of taxable income subject to tax in Georgia. This formula was the law in Georgia for many years and was quite similar to the approach taken by most other states.

In recent years, many states, including Georgia, have taken steps to try to entice businesses to relocate into their state by easing the tax burden on businesses with a significant in-state presence. One way that Georgia tried to ease the burden on its corporate taxpayers was to modify the above apportionment formula in 1996 to place 25 percent weight on payroll, 25 percent weight on property and 50 percent weight on gross receipts. The effect of this change was to reduce the amount of taxable income subject to Georgia corporate income tax by reducing the resulting apportionment percentage number. For Georgia businesses that had a large majority of their plant and payroll located in-state but sales in many states, the Georgia tax burden was lessened merely by this revised mathematical formula.

In recent years, many states, including Georgia, have taken steps to try to entice businesses to relocate into their state by easing the tax burden on businesses with a significant in-state presence.

Let’s look at an example using a fictional company. NightSky, Inc. is based in Georgia. Ninety percent of its property is located in Georgia, and 90 percent of its payroll goes to employees who are located in Georgia. Because NightSky has sales throughout the Southeast, only 20 percent of its sales are to Georgia customers.

Assuming NightSky had federal taxable income equal to $1 million and no Georgia adjustments, the 1996 change in the apportionment formula without any other change in facts would reduce NightSky’s Georgia income tax by $7,000. Here is how:

Under the original formula, .9+.9+.2 divided by 3 produced an apportionment factor of .6666. Taxable income of $1,000,000 times the apportionment factor of .6666 resulted in $666,666 in Georgia taxable income. This amount times a six percent tax rate produced a Georgia income tax liability under the old equal-weighted formula in the amount of $40,000.

Under the double-weighted gross receipts formula enacted in 1996, the computation is as follows: .9+.9+.2+.2 divided by 4 = .55. Taxable income of $1,000,000 times the apportionment factor of .55 produces $550,000 in Georgia taxable income. This amount times the six percent Georgia income tax rate results in tax of $33,000. The Legislature thus provided this fictional corporation tax savings of $7,000 without any change in business operation facts.

Wait until you see what the Legislature has done for you now.

House Bill 191, which was passed by the General Assembly during the 2005 Session and signed into law on April 6, 2005, takes us to an entirely new level. For 2006, property will represent 10 percent, payroll will represent 10 percent and gross receipts will represent 80 percent of the apportionment formula. In 2007, property will represent five percent, payroll will represent five percent and gross receipts will represent 90 percent of the apportionment formula. Beginning in 2008, gross receipts will make up a full 100 percent of the Georgia apportionment factor.

Let’s fast forward to calendar year 2008. Assume our same business facts given above for NightSky. A 100 percent gross receipts factor means that only 20 percent of NightSky’s $1 million taxable income will be subject to Georgia tax, even though 90 percent of its property and 90 percent of its payroll are located here. Georgia taxable income of $200,000 (20 percent of gross receipts in Georgia times $1,000,000 taxable income) times a six percent corporate tax rate produces a tax of $12,000–a savings of $28,000 from the original equal-weighted apportionment formula that was the law for many years, with no corresponding change in facts. This is a tremendous incentive for businesses to expand personnel and property located in Georgia with no resulting increase in corporate income tax.

Delaware Holding Companies

In the past, when assisting clients in establishing a Delaware Holding Company (DHC), we advised them that any state income tax savings resulting from the creation of a DHC could well be short lived, as most states, including Georgia, were doing everything they could to neutralize the effect of this corporate structure. The Georgia Legislature has succeeded in dealing this tax-planning arrangement a serious, if not fatal, blow.

By way of background, the State of Delaware has a corporate income tax, but corporations that derive their incomes exclusively from intangibles are exempt from that tax. As a result, many businesses will form a Delaware corporation as a subsidiary or affiliate and transfer to that Delaware entity certain valuable intangible assets such as patents and trademarks. The newly formed DHC then grants a license to the original owner to allow that operating company to use the patent or trademark in exchange for the payment of a fee or royalty. The fee paid by the operating company to the affiliated DHC is a legitimate business expense, which reduces the amount of income of the operating company that is subject to state income tax. For its part, the DHC will have income only from the license fees or royalties, which represents income from intangibles, and therefore pays no state income tax to Delaware. The DHC also takes the position that it is not doing business in the states where its licensed property is being used.

In addition to the major change in the apportionment formula computation discussed above, Georgia House Bill 191 also sought to stop the loss of revenue brought about by DHCs by requiring companies to add back otherwise allow-able deductions for interest expenses and intangible expenses directly and indirectly paid to related persons. As a consequence, patent, trademark and copyright royalty fees and license fees paid to affiliated DHCs are no longer deductible in computing Georgia taxable income. Interest expenses paid to affiliated DHCs in connection with intangible assets likewise are no longer deductible. In other words, this legislative action basically negates the benefits of having a DHC in place insofar as Georgia corporate income tax benefits are concerned. (Note that while this article discusses the effect of HB191 on DHCs, the new law disallows the deductions for these types of payments to any related person, not just DHCs.)

IRC § 1031 Like-Kind Exchanges

Section 1031 of the Internal Revenue Code (IRC) allows a taxpayer to defer otherwise taxable gain in certain circumstances. In its simplest form, if you paid $100,000 for a piece of property (Parcel A) that you later sell for $200,000, you have taxable gain of $100,000, which is determined by subtracting your basis in the property (the $100,000 that you originally paid) from your selling price of $200,000. Suppose your purchaser owned a second piece of property, Parcel B, which interested you and was worth $200,000. IRC § 1031 would allow the two of you to exchange the two parcels of property–a “like-kind” exchange–without triggering any income tax. The gain would be deferred; your $100,000 basis in Parcel A would transfer and become your basis in Parcel B. You would not pay tax until you actually sold Parcel B.

Such an arrangement works fine for federal income tax purposes and for Georgia income tax purposes so long as Parcel A and Parcel B are both located within the State of Georgia. Any gain deferred on the sale of Parcel A will be captured when Parcel B is sold.

What if Parcel B is located in Florida or Alabama or Tennessee? Parcel A, located in Georgia, would generate taxable income in Georgia upon its sale. If Parcel A is exchanged for property in Tennessee, then Georgia may not be in a position to capture that gain when the Tennessee property is ultimately sold, and the deferred gain on the sale of Parcel A would, from the State’s perspective, be lost.

As a consequence, for many years in Georgia, a like-kind exchange deferral was allowed only if Georgia property was exchanged for other Georgia property. An exchange for non-Georgia property triggered Georgia income tax.

Not anymore.

Sections 9 and 14 of House Bill 488, passed by the 2005 Legislature and signed into law by Governor Perdue, repeal for both individuals and corporations the requirement that Georgia property must be exchanged for Georgia property for tax to be deferred in a like-kind exchange. Under the new law, if the Section 1031 exchange is valid at the federal level, it is valid at the state level, and Georgia never gets to tax the gain deferred on the sale of the Georgia parcel if it is exchanged for non-Georgia property.

In a very rare move for the Georgia Legislature, these two sections–and only these two sections out of 28 sections in the bill–were made retroactive to include the 2004 tax year (obviously someone with some significant political clout had such a sale in 2004!). You may be the beneficiary of this retroactive application. If you had such a disallowed transaction in 2004 and paid tax on the Georgia property portion of the like-kind exchange, give us a call. We can assist you in filing a state income tax refund to take advantage of this revision to the Georgia Code.

THIS COMMUNICATION HAS NOT BEEN WRITTEN AS A FORMAL LEGAL OPINION. ACCORDINGLY, IRS REGULATIONS REQUIRE US TO ADVISE YOU THAT ANY TAX ADVICE CONTAINED IN THIS COMMUNICATION WAS NOT INTENDED OR WRITTEN TO BE USED AND CANNOT BE USED FOR THE PURPOSE OF AVOIDING FEDERAL TAX PENALTIES.