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   ARTICLE   |   From Scotsman Guide Residential Edition   |   July 2011

How to Keep State Taxes from Giving You a F.I.T.

Financial institutions often face targeted excise schemes — are you subject to them?

Many states impose a special tax, usually a franchise tax, on regulated financial corporations, bank holding companies, savings and loan associations, and similar entities. In recent years, these state franchise taxes, commonly called financial institutions taxes (F.I.T.s) often have been drafted broadly. Because of this, they frequently subject nonregulated entities to the tax — including those that engage in making, acquiring, selling or servicing loans.

All businesses in the financial sector must be aware of their state F.I.T. exposure. In some cases, a business may be subject to tax even if it has no physical presence in a state.

State F.I.T.s come in many variations. In some states, the F.I.T. replaces corporate-tax liability. In other states, such as Missouri, the F.I.T. is an additional tax that financial institutions pay above and beyond the corporate income tax, although credits may be allowed for other taxes paid.

Most states base their F.I.T. on income. Some states, including Virginia and Michigan, base the tax on net capital. No matter what, every state that imposes a F.I.T. also defines what it considers a financial institution. The states, however, are anything but consistent in their definition.

"For mortgage brokers who only act as the agent of a borrower and who have no relationship with a financial institution, avoiding the tax in some states may be as straightforward as avoiding ownership of mortgages."

The Multistate Tax Commission (MTC), which promotes uniform state-tax laws, suggests a definition. It includes typical financial institutions — such as bank holding companies, national banks, thrifts and credit unions — but also includes any corporation more than 50 percent owned by a typical financial institution and any business earning more than 50 percent of its income from finance leases.

Few states rely on the tax commission’s definition, instead preferring to institute local variations. For example, some states, such as Hawaii, specifically include mortgage-loan companies in the definition of a financial institution. Several states don’t give clear guidance about whether mortgage brokers are specifically exempt.

A constant theme

One constant theme is the inclusion of entities that “carry on the business of a financial institution” or do “banking activities.” For example, in Indiana, a company that derives 80 percent or more of its gross income from making, acquiring, selling or servicing loans — including mortgages — is taxable under the Indiana F.I.T.

In New York, “banking business” refers to any activities substantially similar to those a bank would be authorized to do under the state’s banking law. In California, a business performing activities that compete with some parts of the business of national banks is considered a financial institution.

For mortgage brokers who only act as the agent of a borrower and who have no relationship with a financial institution, avoiding the tax in some states may be as straightforward as avoiding ownership of mortgages. As long as a brokerage isn’t owned by

Then again, as many mortgage brokers consider transitioning into the lending side of the business, they may face new tax liability. Evaluation of state F.I.T. exposure becomes critical when you:

  • Become a branch of a federally chartered bank;
  • Start or buy a bank;
  • Apply for a Federal Housing Administration direct-lender license; or
  • Merge with a direct lender.

Depending on the state, your taxes may be substantially greater than they were during your broker days. In addition, a state’s definition of “financial institution” may be modified through regulation, statute or case law. Further, an entity may become a financial institution under a state’s rules merely by growing its income or pursuing a new business model.

Because there is no single test for determining whether an entity is a financial institution, awareness is important for every broker.

Multistate worries

In some cases, a business may be subject to a state’s F.I.T. even if the business isn’t located in the state. For example, a mortgage broker or lender may be licensed in a particular state or maintain an office in a particular state but have loan receivables or property interests — or otherwise derive income — from a different state that considers the business a financial institution because of that interest or income.

In recent years, limitations on interstate tax connections for F.I.T. purposes have been weakened. In many states, an entity doesn’t need a physical presence in a state to be subject to its F.I.T. One modern theory of economic nexus holds that an entity’s mere economic presence in a state — collecting income from state residents, for example — qualifies it for taxation in the state.

Several cases have challenged these rules. State courts, including those in Indiana and West Virginia, held that a financial institution’s economic presence was enough to let the state charge it F.I.T.s.

States vary on how they measure an entity’s presence within their boundaries. Connecticut and New Jersey subject corporations to tax if they derive income from sources within the state. A corporation will have nexus with California if $500,000 in sales comes from California sources. In Indiana, a corporation is presumed to be doing business in the state if it has 20 or more Indiana customers during the taxable year.

As states adopt increasingly expansive nexus standards, all businesses in the financial sector, including brokers, must be aware of the risks of taking on new business in a state.

Although some states haven’t dealt specifically with nexus issues, businesses should be cautious as states seek new sources of revenue. Seemingly minor activities may be enough to expose a business to tax liability. When examining state laws, consider every state in which you have an economic presence.

Divvying up income

Suppose you determine you qualify as a financial institution in two states. Clearly, you don’t owe taxes to both states on your entire income. So how do you determine exactly how much of your income is taxable in each state?

This process of apportionment varies among states, and some states have adopted special apportionment rules in their F.I.T.s.

Many states have variations on the MTC’s model-apportionment statute. That three-factor formula weighs receipts, property and payroll equally. To determine what percent of an entity’s income is taxable in a state under the tax commission’s formula, you would first determine what percent of your receipts, property and payroll reside in — or are derived from — sources within each state. Then you would divide the sum of those percentages by three.

Similar apportionment formulas are used to determine corporate income tax liability, but the MTC model statute includes definitions specific to financial institutions. This includes the value of loan receivables for inclusion in the property factor, and loan-servicing fees and investment interest for inclusion in the receipts factor.

Further, the tax commission includes sourcing rules, which indicate whether a particular value should be included in the in-state portion or the out-of-state portion. For example, when a financial institution collects interest from mortgages, the state in which the mortgaged property is located will be allocated the value of the interest, as well as fees and penalties earned from those mortgages.

In theory, if every state implemented the rules as proposed by the MTC, 100 percent of an entity’s income would be taxed. Many states, however, implement their own variations of the apportionment formula. Some states, like Indiana and Connecticut, rely on a single-factor formula based solely on receipts. New York uses a three-factor formula based on receipts, payroll and deposits.

Because states will sometimes use a different apportionment formula for their F.I.T. than for their corporate income tax, the application of the F.I.T. to a business could substantially change the amount of tax the business will pay.

Given the variations between states, a multistate business must be especially diligent in determining the apportionment method, factors and sourcing rules applicable for each state with which the business has nexus.

•  •  •

State F.I.T.s can place significant burden on taxpayers in the financial sector. When considering your options — including whether to become a banker or branch operator or to grow your business — pay attention to how any such change could alter your tax liability or tax status. The more you know ahead of time, the less likely you’ll be surprised later on.  

Disclaimer: This article is for informational purposes only and does not constitute tax or legal advice.


 


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