Question

M Corporation reported 2019 book net income of $185,000. The following items were included in book income for 2018:

State A income tax expense $ 15,000

State B income tax expense $ 5,000

Federal income tax expense $49,000

Book depreciation expense $ 18,000

Municipal bond interest income $ 10,000

US government obligation interest income $ 12,000

Dividends received from 5% owned US co. $ 8,000

Separately, M Corporation computed federal tax depreciation of $26,000.

A) Based on the above, compute M’s 2019 federal taxable income.

B) M Corporation computed state tax depreciation of $23,000. M is only taxable in States A and B. All investment income, including interest and dividend income is earned in State A. State A allows exclusion for interest earned on federal obligations, taxes all municipal interest and disallows all deductions for state income taxes .State A has not adopted federal depreciation methods and does not recognize the dividends received deduction. State A apportions taxable income based on the average of three factors- payroll, property, and sales. M Corporation has 60% of its payroll, 40% of its property, and 20 % of its sales in State A. Based on the above information; compute M’s state 2018 taxable income in State A.

C) M Corporation is looking to expand online sales activities into various states. What advice would you give M Corporation before they begin this expansion?

Answer 1

A. Based on the above, compute M’s 2019 federal taxable income

	2019 book net income	185,000.00
Add	Federal income tax expense	49,000.00
Add	Book depreciation expense	18,000.00
Less	federal tax depreciation	(26,000.00)
Less	Municipal bond interest income	(10,000.00)
Less	Dividend Received deduction (8,000*70%)	(5,600.00)
	Taxable Income	210,400.00

Notes :

a. The interest on municipal bonds -- which are issued by state and local governments -- is nontaxable to corporations, as well as to individuals and other business structures. Since this is already included in book income it needs to be deducted for working out taxable Income

b. Interest earned on all U.S. Government obligation, including Treasury bills, is exempt from taxation at the state and local level but is fully taxable at the federal level. Since it is already included in income no adjustment is required to derive taxable income from book income.

c. The dividends received deduction allows a company receiving dividend from another company to deduct that dividend from its income and reduce its income tax accordingly. When holding is less than 20% the dividend received deduction is 70% of dividend received

d. For corporation all state income tax is allowable as deduction, since book income already have deducted this amount hence no adjustment required.

e. Federal Income tax is not allowable as deduction for tax purpose hence it needs to be added to book income to derive taxable income

f. Book depreciation is not allowable for taxable income hence it needs to be added while tax depreciation is allowed as deduction hence federal tax depreciation needs to be deducted.

B. compute M’s state 2018 taxable income in State A.

Answer : 91,800

Working Notes :

1. State Aid allocation :

	State A	State B	Total
Real Estate	40%	60%	100%
Payroll	60%	40%	100%
Sales	20%	80%	100%
Total	120.000%	180.000%
Divide by 3	40%	60%

Calculation of Income before Allocation
	2019 book net income	185,000.00
Add	Federal income tax expense	49,000.00
Add	Book depreciation expense	18,000.00
Add	State A income tax expense $ 15,000	15,000.00
Add	State B income tax expense $ 5,000	5,000.00
	State A Specific Income
Less	Municipal bond interest income	(10,000.00)
Less	US government obligation interest	(12,000.00)
Less	Dividends received from 5% owned US co	(8,000.00)
	Income before Allocations	242,000.00

	Income after State A Allocation	96,800.00
Add :	State A Specific Income which are taxable
	Municipal bond interest income	10,000.00
	Dividends received from 5% owned US co	8,000.00
Less :	state tax depreciation	-23,000.00
	State A Taxable Income	91,800.00

Note : For working out state income before allocation we need to add to book income federal income tax and state income tax as no deduction of federal tax is allowed by state and it is also specifically provided that State A doesn't allow other state income tax deduction. Further book depreciation needs to be added back. All interest income and dividend have direct nexus with State A hence it will be reduced from book income so that it is not part of allocation and it will be added directly to state A's taxable income.

Once allocated state A income is derived let us add taxable direct income i.e. Dividend and municipal interest. Interest of federal obligation will not be added since as provided it is not taxable in state.

C. M Corporation is looking to expand online sales activities into various states. What advice would you give M Corporation before they begin this expansion

The online sales activities can create nexus for sales & income tax hence M corporation should consider nexus study of all state laws to establish their obligation either to collect sales tax or pay the income tax.

A nexus for state sales tax purposes has, earlier considered physical presence of the taxing business in that state.

A growing concern has driven states to consider online businesses and non-payment of sales taxes.

Through the years , the states have come up with several ways to determine nexus:

• Click-through Nexus. "An out-of-state business establishes click-through nexus in a state when an in-state business receives a commission for referring a certain amount of sales to the out-of-state seller, as through a website link (“clicking through”).
• Affiliate Nexus. Affiliates are independent businesses selling through another business. example is the Amazon Affiliates program.
• Economic Nexus. The easiest way of determining sales tax nexus is economic nexus, which is actually just sales. A business might have an economic nexus in a state if they have sales over a specific amount. e.g. Idaho has established $100,000 in annual sales as the minimum for sales tax nexus.