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State Mandatory Combined Reporting: Complex Formula or 'Loophole' Closer?

State Mandatory Combined Reporting! You're probably wondering what this obscure state tax concept means and whether it impacts your company's state corporate taxes. Before jumping into today's discussion, here are a few questions to consider.

Is your company a subsidiary or affiliate within a "controlled group" of corporations? Do any of the "controlled group" corporations do business in multiple states? Are you considering selling a majority interest in your company to another corporation which does business or in multiple states or has subsidiaries with multi-state operations? Is the prospective buyer a vendor, supplier or otherwise integrated with your corporation? Have you been advised to reorganize your corporate structure and create new legal entities? Will this reorganization involve transferring intangible assets, such as technology, trademarks or patents; to a new legal entity and having related corporations compensate each other for the use of those assets? 

If you answered yes to any of these questions, understanding state mandatory combined reporting is important as this filing method, employed by many states, could have a significant impact on your company's state corporate tax liability. 

A few years ago, mandatory combined reporting became a "hot button" issue when it was discovered that many large corporations were significantly reducing their state tax bills by exploiting "creative" restructuring techniques. More on that in a bit!

What the Heck IS State Mandatory Combined Reporting Anyway?

Unless you're a tax or legal professional, there's a good chance you've never even heard of state mandatory combined reporting. Actually, unless they frequently deal with state tax issues, many CPAs and tax attorneys don't completely understand it. 

In a nutshell, it's a filing method required in many states, in which multiple related corporations are taxed as a single corporate taxpayer. (Technically, it's an apportionment methodology....blah, blah - but let's keep it simple!) 

In states that require or "mandate" combined reporting, the taxable income of a group of related corporations which meet certain criteria is aggregated and this total combined group income is subject to the state's corporate income or equivalent business tax. While this may sound benign, the impact of combined reporting may seem harsher when you consider that only one corporation in the related group with "nexus" to the taxing state pulls in all the other related corporations even if those corporation do not engage in business in the combined reporting state. In some combined reporting states, even non-U.S. (foreign) corporations that meet certain thresholds are required to file as part of the combined group.  

What are some of the criteria that could cause a group of related corporations to have to file on a "combined basis"? Though every state has its own requirements, in general, corporations that are related by ownership (e.g., a common parent owns more than 50% of the voting control or value of its subsidiaries) and are interrelated or interdependent with each other would meet the criteria for mandatory combined filing. This connection and interdependence between the related corporations is referred to as a "unitary" business relationship. For this reason, mandatory combined reporting is often referred as "unitary" reporting or the filing a "unitary" return. In general, if a controlled group of corporations are functionally integrated, have centralized management, and enjoy economies of scale, the controlled group is deemed to be "unitary". 

An example might include a group of commonly owned corporations in which the management team is employed by the parent corporation and the subsidiaries perform various "steps" in a process. (e.g., one corporation designs and manufacturers a component part which is used in the product of a related corporation who then sells the finished product to yet another related corporation who then distributes the final product to end users.)

Why Have State's Shown an Interest in Enacting State Combined Reporting Laws in Recent Years?

Here's an interesting note - between 1985 and 2004, not a single state enacted a mandatory combined reporting law. That's right, for almost 20 years, combined reporting wasn't a hot state issue! So what happened? Beginning in the 1990's and into the beginning of this millennium, large corporate taxpayers got aggressive in their tax planning and began taking advantage of "loopholes" that allowed them to greatly reduce their state corporate taxes. 

Though several variations of these "tax planning" strategies evolved, the general idea involved splitting up a single corporation into multiple corporations. Along with this "reorganization", various assets were transferred to new corporations and "inter-company agreements" were created that required the related corporations to pay one another for use of the assets. Because state corporate rates vary from state to state, the overall corporate group could ensure, by dictating the flow of income and expenses between the corporate group members, that the corporations that earned the highest income filed mostly in states with low rates or no corporate tax, while the corporations with the lowest income filed elsewhere. Because each of these corporations were separate legal entities, only the activity of that specific entity would be taxed in "separate reporting" states - those that tax only the activity of the specific legal entity doing business in, or having "nexus" to, their state.

It wasn't long before these "strategies", and the large corporations abusing them, were exposed. In 2007, The Wall Street Journal published a scathing report which revealed how Wal-Mart avoided approximately $350 million in state taxes over four years by transferring all of its real estate (stores) to a Real Estate Investment Trust (REIT), an entity which often pays little to no tax. By having the stores pay rent to the REIT, Wal-Mart was able to create huge deductions which reduced its overall state taxes, while paying little to no tax on the rent income earned by the REIT. (See "Wal-Mart Cuts Taxes By Paying Rent to Itself", WSJ, 2/1/07)

A similar strategy involved transferring trademarks or trade-names to a newly created entity that would in turn charge an inter-company fee for use of those intangibles. These royalty or intangible holding companies (IHCs) were often incorporated in low or no corporate tax states, such as Delaware or Nevada. Like the Wal-Mart REIT strategy, the stores received huge royalty expense deductions which in turn greatly reduced their state taxable income, while the royalty or IHC paid little to no tax. Name just about any mega retail chain - Toys "R" Us, The Gap, Home Depot, Wal-Mart - and it's was good bet they had (or still have) one of these tax planning "strategies" in place.

Eventually states realized these arrangements were draining state revenues and attempted to apply "band-aid" approaches, such as enacting laws that disallowed these "tax planning" deductions. When these approaches were less than effective, more and more states began to realize that enacting mandatory combined reporting was the best approach to closing this "loophole". With combined reporting, those questionable tax-planning deductions that reduced state taxes in separate reporting states were eliminated, as collapsing the combined group members into one reporting entity meant that the income and expense deductions would now offset each other. 

Sylvia's Summation

Although mandatory combined reporting has proven to be an effective approach to closing certain state tax abuses, it is not without criticism. For one, combined reporting laws are extremely complex!! They require analysis of which entities must be included in the combined group, a determination of what proportion of the group's total combined income should be taxed in that state ("apportionment"), how to treat corporations that become or cease to become combined group members (such as through an acquisition or divestiture), and how losses and credits generated by individual group members are shared (See Note A). And although these laws were intended to target the mega-corporate abusers, any controlled group, regardless of its size, that meets the requirements to file combined basis must do so in mandatory states.

So which states have mandatory combined reporting laws? As of the beginning of 2011, they are...(drumroll please!):  Alaska, Arizona, California, Colorado, Hawaii, Idaho, Illinois, Kansas, Maine, Massachusetts, Michigan, Minnesota, Missouri, Nebraska, New Hampshire, New York, North Dakota, Ohio, Oregon, Texas, Utah, Vermont,  Wisconsin, and the District of Columbia.

State mandatory combined reporting. Complex! And I've only touched on the basics! So if you're concerned about its impact on your business, seek guidance from a CPA, attorney or consultant that specializes in state taxes (such as your author here, wink!).

(Note A: Want to a little more sense of just how complex mandatory combined reporting can be? See my prior "Buzz" post, "Massachusetts Department of  Revenue Offers an Opportunity to Withdraw 'Binding' 2009 Worldwide or Affiliated Group Election".)


The above post was authored by me, Sylvia Dion, for, and was published on on 9/29/11. It has been reproduced here at The State and Local Tax "Buzz" for the benefit of the "Buzz" readers. See my "Contributions to Other Blogs" webpage for a full listing of all of my contributions.