Apportionment apoplexy: throwback, throwout, or just throw up your hands.

• Author: Wilson, Margaret C.

Apportioning corporate taxable income for state tax purposes may, at first blush, appear analogous to a will contest over a decedent's estate, with multiple parties each vying for a piece of the pie. Each party fighting over an estate wants as much as he or she can get, often caring little--if at all--for the needs or rights of the others involved. Each has his or her own idea of what the rules should be for determining how large a piece of the pie is deserved.

But there is an important difference between this situation and that involving state tax apportionment: Unlike the will contest scenario, in multistate corporate income taxation it is possible for each of the states to win. In a will contest, ultimately one arbiter will decide the law to be applied to the corpus of the estate, and all the slices of the "pie" will add up to the exact size of decedent's estate. In multistate corporate income taxation, that is not necessarily the case inasmuch as the Supreme Court has determined that, in the absence of a congressional requirement of uniformity, the states have a great deal of discretion in selecting and applying apportionment formulae. Each state may, by and large, use its own formula to determine its share. As a consequence, the states--in the aggregate--may tax more than 100 percent of the income of a corporation or corporate group. This state of affairs has not only been acknowledged by the Court, it has been--with certain limitations--condoned.

Fortunately, corporate taxpayers are not wholly without recourse. First, the Constitution does place real limitations on state apportionment of corporate income. In addition, the statutory language prescribing a state's formula may be open to interpretation, and may not support the state taxing authority's interpretation or application of the formula. Many states have specific statutory provisions that allow deviations from standard apportionment formulae (constitutional or statutory interpretation arguments can, if nothing else, be a powerful buttress when seeking such deviation). Finally, the states cannot simply make up the rules as they go. State law may prevent a state taxing authority from applying a particular interpretation or aspect of an apportionment law to the extent that the state taxing authority has not followed administrative law requirements for promulgating rules or regulations.

These issues converge in different ways in the context of the battery of apportionment formulae that corporate taxpayers face. Throwback rules, throwout rules, and even single-factor apportionment formulae can raise any or all of these bases for challenge, and the corporate taxpayer must be prepared to identify which base, or bases, can be helpful.

This article first explores the reasons formulary apportionment is used, and then discusses the constitutional limitations on the apportionment methods that states may use. Then, certain specific apportionment approaches are analyzed: single factor apportionment, throwback rules, and throwout rules. Finally, this article summarizes the weapons a taxpayer needs (and should be aware of) when attacking a taxing authority's apportionment position.

1. Why Apportionment? Slicing a Shadow.

   1. What Is the Right Way to Carve Up the Income of a Multistate Business?

      Before delving into the nitty gritty of apportionment law "quirks" such as throwout or throwback, it is worthwhile to explore why states use formulary apportionment in the first place. After all, apportionment is not found in nature--it is just an arbitrary but generally reasonable and efficient way to determine the share of a corporate tax base that a state is entitled to tax.

      1. Separate Accounting

         Historically, separate accounting was often employed in state tax systems to attribute to each relevant state the portion of the taxpayer's income that was generated there. "Early state income tax laws permitted corporations to treat separately the income earned in each state as long as they maintained separate geographic accounting records that enabled them to ascertain that income with reasonable accuracy." (1)

         Separate accounting, however, has lost its luster over the years, at least with the governmental bodies that select apportionment formulae. Some have questioned whether attempting to carve up an enterprise into 50 different income generating components, for example, is ever feasible. Of course, beyond the issue whether separate accounting is an acceptable (or should be the default) means of carving up a corporate tax base, maintaining separate geographic records may be impractical from the taxpayer's perspective.

         "[A]pportionability often has been challenged by the contention that ... the source of [particular] income may be ascertained by separate geographical accounting. The Court has rejected that contention so long as the intrastate and extrastate activities formed part of a single unitary business. Butler Bros. v. McColgan, 315 U.S. 501, 506-508 (1942); Ford Motor Co. v. Beauchamp, 308 U.S. 331, 336 (1939); cf. Moorman Mfg. Co. v. Bair, 437 U.S., at 272. In these circumstances, the Court has noted that separate accounting, while it purports to isolate portions of income received in various States, may fail to account for contributions to income resulting from functional integration, centralization of management, and economies of scale. Butler Bros. v. McColgan, 315 U.S., at 508-509. Because these factors of profitability arise from the operation of the business as a whole, it becomes misleading to characterize the income of the business as having a single identifiable 'source.'" (2)

         In essence, the Supreme Court has concluded that even though formulary apportionment is necessarily artificial, separate accounting may be also to the extent it fails to take into account the synergies among business operations in different states. This reasoning led the Court to conclude in 1991 that "[a]lthough separate geographical accounting may be useful for internal auditing, for purposes of state taxation it is not constitutionally required." (3)

      2. Formulary Apportionment

         In contrast to separate accounting, formulary apportionment applies a percentage-based formula to the total tax base in order to determine the share attributable to the state in question. While certain items may be removed from the tax base as non-business or non-operational income, (4) in most states for most types of corporations the balance of taxable income is apportioned using a statutory formula. The product of formulary apportionment has become--generally--accepted as a reasonable proxy for the real amount of income (or other base) attributable to a particular state.

         States use a wide variety of different formulae to apportion the income or franchise tax base that is computed under their tax laws. The baseline approach is the "three-factor" formula with fractions comparing a taxpayer's in-state property, payroll, and receipts to the respective total amounts of these items everywhere. Other variations include three-factor formulae with disproportionate weight given to certain factors, such as double-weighting the receipts fraction, and even certain single-factor formulae, such as a single-factor formula based only on the fraction of the taxpayer's in-state to its total receipts.

         The Supreme Court has largely accepted these variations in methods of formulary apportionment because of "the difficulty of identifying the geographic source of the income earned by a multistate enterprise." (5) Because formulary apportionment is a synthetic means of determining the portion of corporate income, receipts, or other value that may properly be assigned to one state, there seemingly can be no single, perfect approach to formulary apportionment. Indeed, as the Court acknowledged, "[a]llocating income among various taxing jurisdictions bears some resemblance ... to slicing a shadow." (6)

   2. State Variations In Apportionment Formulae Are Allowed

      When the Supreme Court contemplated invalidating the Iowa single-factor receipts formula in 1978, the Court determined that the Commerce Clause did not flatly prohibit "any overlap in the computation of taxable income by the States." (7) The Court acknowledged that unless all of the states in which a corporation did business followed identical apportionment rules, there would always be some risk of duplicative taxation.

      Nonetheless, the Court found that if the freedom of each state to choose its own, independent apportionment formula rules was ever to have to yield to "an overriding national interest in uniformity," the determination of which approach to apportionment should govern all states "should be determined only after due consideration is given to the interests of all affected States." (8) The Court refused to make a "policy" decision of which of the many different approaches to formulary apportionment should be the single, uniform rule across the country. Instead, it concluded such a determination was the sole province of Congress as part of its power under the Commerce Clause. To date, Congress has declined to exercise that power to address this issue.

2. Constitutional Requirements

   Just what are the constitutional limitations on the apportionment methods that states employ? They include the Commerce Clause fair apportionment requirements, the Due Process Clause preclusion of disproportionate taxation, and finally the Commerce Clause and Equal Protection Clause discrimination prohibitions.

   1. Fair Apportionment

      The Supreme Court has identified four requirements for any state tax to pass muster under dormant Commerce Clause jurisprudence, and one of those four requirements is that the tax scheme fairly apportion the base that it taxes. (9) ("Dormant Commerce Clause jurisprudence" refers to the body of common law developed by the Supreme Court in the absence of specific congressional action.) That fair apportionment requirement has been further developed by...