Tennessee made significant strides in improving its tax structure when it completed the phase-out of the Hall tax, the state income tax, which was levied only on income from businesses. interest and dividends. This change lasted for many years, making Tennessee the eighth state with no personal income tax. But while Tennessee no longer claims personal income taxes, there is still work for businesses to do – Tennessee is well positioned to get the job done.
Tennessee General Fund Revenue grown up 8% in fiscal year 2021 and the Department of Revenue expects this growth to continue in fiscal year 2023, albeit at a slower pace. Using this recurring growth to improve the tax code would put the state on track for continued success.
Tennessee corporations face three distinct levels of taxation: something akin to a typical corporate income tax, but also applies to S corporations and most LLCs (the excise tax), a capital stock tax on the net worth of businesses (the franchise tax), and a tax on gross receipts (the business tax). If the voluntary state is looking to build on its momentum and make the state more attractive to business, these three taxes are ripe for improvement. Sole proprietors and partnerships are exempt from franchise and excise taxes, but apply to other intermediary businesses that would generally be subject to personal income tax in other states. Therefore, intermediary companies do not receive the same benefits as if they operated in other states without personal income tax.
Tennessee’s flat corporate income tax rate of 6.5% is in the middle of the road compared to other states. Even so, there are areas where the voluntary state could improve its structure, namely its apportionment formula and the treatment of capital investments.
When C corporations do business in more than one state, they must allocate their income to each state in which they have a connection for tax purposes. Currently, states can use three factors in their apportionment formulas: the share of total ownership, payroll, and sales that a business has located in each state. Historically, most states have weighted these factors equally, but there is a pronounced tendency to give greater, if not exclusive, weight to the sales factor. This generally benefits businesses in the state while exporting some of the tax burden to businesses with sales, but less physical presence, in the state.
Tennessee currently has a three-factor split, with the sales factor given double weight. This is a perfectly legitimate way to allocate corporate income, but in a landscape where states increasingly favor in-state operations, maintaining a three-factor allocation formula could make the Tennessee less competitive in the long run.
Less competitive than the pay-as-you-go formula is the government’s treatment of capital investment. Eighteen states allow immediate depreciation of all business investments, following federal treatment, while Tennessee requires businesses to deduct capital expenditures according to predefined depreciation schedules. In other words, instead of immediately deducting the capital expenditure in the year the investment took place, it could take 15 years old before Tennessee recognizes the full cost of an investment to a business.
This creates a problem. Due to inflation and the time value of money, a dollar in the future is always worth less than a dollar today. Delaying deductions for the cost of business investments means that the real value of the deductions will always be less than the original cost. Ultimately, this treatment means that corporation tax is skewed away from capital investment because other business expenses (e.g. labor, advertising, and supplies) can be amortized in the first year. This is particularly detrimental to companies in equipment-intensive manufacturing industries.
It should be mentioned that the creation of the net interest deduction limitation – found in section 163(j) – at the federal level was intended to help defray the costs of implementing the full expense. . Notably, although Tennessee does not comply with the spending provisions of the pro-business section, the state does comply with Section 163(j) on revenue collection.
Federal spending provisions are set to expire in 2023; no state has acted to extend this deadline. At the same time, the federal interest limitation becomes stricter. This creates an opportunity for the voluntary state: complying with federal spending provisions would bring Tennessee up to par with its peers, while permanently integrating comprehensive spending into its corporate tax code would set Tennessee apart. State.
the Franchise tax
Tennessee is one of 16 states to levy a franchise (or capital stock) tax on businesses. Among those states, it levies the fourth-highest rate of 0.26% and does not cap payments.
Unlike corporate income taxes, which are levied on a company’s net income (or profit), franchise taxes (or capital stock taxes) are levied on a company’s net worth. As a form of corporate wealth taxation, the franchise tax exhibits many of the inefficient characteristics of a personal wealth tax, but with additional implications for the economy.
“Share capital”, targeted by this tax, includes the value of all the physical components a company uses to generate its goods or services, less the company’s debt. Franchise taxes are levied regardless of whether a business is making a profit, which makes them especially onerous for new businesses that have not yet made a profit and for all businesses in an economic downturn.
Over the past 10 years, legislators have become aware of the problems with franchise taxes. As a result, four states have completely repealed their franchise taxes and two more are in the process of phasing them out.
Tennessee would do well to follow suit in any way possible. Since the franchise tax represents a significant portion of the state’s business revenue (the tax brought in $1.07 billion to the state in FISCAL YEAR 2021), a full repeal in the near future would likely be difficult. However, lawmakers should pursue creating a payment cap and lowering rates to reduce the state’s reliance on the franchise tax.
Tennessee also levies a low-rate gross receipts tax on all businesses that have a connection to the state. The rates vary from 0.02% to 0.3%, depending on the classifications of the companies. Unlike corporate income taxes, which target actual profits, gross receipts taxes are applied to a company’s gross sales, with no deductions for business expenses such as compensation and cost of goods sold. Seven states currently levy gross receipts taxes.
Even with rates as low as Tennessee’s, gross receipts taxes can cause economic damage. Business-to-business transactions are not exempt, so the same economic value is taxed in every transaction in the production process. This compounds the effect of the tax, which can lead to higher prices for customers, lower wages for workers, or more limited job opportunities. The companies concerned are encouraged to integrate vertically, to change sectors or to leave the tax jurisdiction.
Firms and industries with lower profit margins or more stages in the production process – each taxed separately – are hit harder by gross receipts taxes than high-margin firms that are vertically integrated. Differential rates attempt to adjust for these industry-to-industry differences, but do so imperfectly. As with franchise taxes, gross receipts taxes can be particularly severe for start-ups and entrepreneurs, who typically incur losses in the first few years while still having to pay gross receipts.
The State relies less on this tax than on the franchise tax, the gross receipts reported $264 million for the state in fiscal year 2021. The local portion of business tax makes complete elimination a difficult conversation. However, since Tennessee’s gross revenue rates are already relatively low, lawmakers can work to further reduce reliance on such an economically harmful tax at the state level.
At a time when businesses and workers are increasingly mobile, state tax competition becomes more important than ever. Tennessee has already taken important steps in the right direction, and the legislature seems interested in continuing that progress. If lawmakers want to make the state as competitive as possible, they should take this opportunity to improve the state’s corporate tax structure and reduce the state’s reliance on its franchises and most economically damaging gross receipts taxes.
As they begin another legislative session, lawmakers can celebrate past successes while pushing to make the voluntary state a more attractive business destination.