On May 25, 2011, Michigan Governor Rick Snyder signed into law a series of bills1 enacting a Michigan corporation income tax (CIT), eliminating the Michigan Business Tax (MBT) except in limited situations, and making significant changes to the individual income tax provisions. The CIT will be imposed at a 6% tax rate on apportioned business income of C corporations and will take effect January 1, 2012. The freeze of the individual income tax rate at 4.35% is effective October 1, 2011, and accordingly, the original 0.1% scheduled reduction in the tax rate will not occur on October 1, 2011.

Summary

The CIT is a more straightforward tax than its predecessors, the Single Business Tax (SBT) and the MBT. Highlights of the CIT include the following:

  • Filing obligation for businesses with $350,000 or more of apportioned gross receipts2 sourced to Michigan;
  • Unitary return requirements (applying a Finnigan3 approach for sourcing);
  • The tax base, which consists of business income, defined as federal taxable income without taking into effect bonus depreciation under Internal Revenue Code (IRC) Sec. 168(k) or the domestic production activities deduction under IRC Sec. 199;4
  • Apportionment via a single sales factor, with carryover MBT sales definitions and sourcing provisions; and
  • Practically no credits for the general taxpayer, though there is an elective regime available for taxpayers holding credits under the MBT.

Nexus5

Unless taxation is prohibited under Public Law 86-272, a taxpayer will be subject to the CIT if the taxpayer has a physical presence in Michigan for more than one day during the tax year, if gross receipts sourced to Michigan are at least $350,000 or the taxpayer has a direct or indirect ownership or beneficial interest in one or more flow-through entities that have substantial nexus in Michigan. Physical presence can be established by a taxpayer or a taxpayer's employee, agent or independent contractor acting in a representative capacity. Physical presence is not established from professionals providing services if the activity is not associated with the taxpayer's ability to establish and maintain a market in Michigan. The new law requires the Department to define the term "actively solicits" through written guidance that will be applied prospectively.

Income Tax Base and Adjustments

The CIT is a 6% tax on apportioned and allocated business income of C corporations.6 In contrast to the MBT, sole proprietorships and flow-through entities will not be subject to the CIT. However, flow-through entities, whether owned by corporations or individuals, will need to comply with withholding requirements.7 Flow-through entities not owned by corporations will pay tax on apportioned business income based on a single sales factor under the individual income tax. Entities that elect to be treated as corporations for federal income tax purposes will be subject to the CIT and will be required to file as part of the unitary group or individually if not a member of a unitary group.8 The taxation of insurance companies and financial institutions will not fundamentally change from the MBT regime. Insurance companies will continue to be subject to tax on direct premiums written9 and financial institutions will continue to be subject to franchise tax on net capital.10

Adjustments to Federal Taxable Income11

In addition to Michigan's nonconformity to bonus depreciation under IRC Sec. 168(k) and the domestic production activities deduction under IRC Sec. 199,12 the state-specific adjustments to federal taxable income to arrive at income subject to apportionment are the following:

  • Additions to Michigan taxable income to the extent deducted for federal purposes:
  • Interest and dividends from obligations or securities of states other than Michigan less related expenses;
  • State taxes imposed on net income;
  • Royalties paid to a related person not included in the taxpayer's unitary group for use of intangible property;13 and
  • Federal net operating loss;
  • Subtractions from Michigan taxable income to the extent included in federal taxable income:
    • Dividends and royalties received from persons other than United States persons;14
    • Interest from U.S. obligations; and
    • Income from producing oil and gas, less related expenses.15

In addition, a ten-year net operating loss carryforward is available for losses created under the CIT.16

Apportionment and Sourcing17

The CIT will use single sales factor apportionment. Following the Finnigan rule, unitary business groups will include all sales in Michigan in the sales factor, whether or not the person has nexus with Michigan. Sales between members of a unitary group will be eliminated in the calculation of the sales factor. A taxpayer with a direct or indirect ownership or beneficial interest in a flow-through entity would apportion the business income that is directly attributable to the business activity of the flow-through entity by using an apportionment formula based on the business activity of the flow-through entity.

For CIT purposes, Michigan will generally source sales from services based on where the benefit of the service is received. The sourcing provisions for the CIT are identical to those of the MBT. Special sourcing rules are provided for financial, transportation, telecommunications and media broadcasting services. It should be noted that a comprehensive technical correction bill for the MBT is pending and could have implications for sourcing and other areas of the new CIT structure.

Reduced Tax Rate for Small Businesses18

Businesses other than insurance companies and financial institutions with less than $20 million in gross receipts and business income less than $1.3 million after any loss adjustment will be eligible for a credit that effectively reduces the tax rate from 6% to as low as 1.8%. The provisions for this credit are substantially similar to the small business credit provided for under the modified gross receipts portion of the MBT. For fiscal year taxpayers for 2012, and short year returns, the gross receipts and compensation phaseout amounts must be prorated when determining eligibility for the credit.

Optional MBT Filing and Certificated Credits

Corporations can elect to continue filing the MBT return if they have unused "certificated" credits or credit carryforwards.19 Certificated credits are credits granted before January 1, 2012 under the MBT Act and include the Michigan Economic Growth Authority (MEGA), Renaissance Zone, Brownfield Redevelopment, Film Production and Battery credits, among others.

Taxpayers not subject to the CIT that have certificated credits or credit carryforwards may elect to continue filing the MBT return in order to receive the credits or use the credit carryforwards.20 The election to file an MBT return will apply to the entire unitary group, not just the taxpayer with the certificated credit.21

In order to continue filing an MBT return and receive the certificated credits or use certificated credit carryforwards, taxpayers must elect to file an MBT return for the first tax year ending after December 31, 2011.22 Taxpayers that elect to file an MBT return will not file a CIT return. Notably, taxpayers making this election must continue to file an MBT return until the credit and any credit carryforward is exhausted.23 Taxpayers with a Historic Preservation or Brownfield credit may elect to receive those credits in a lump sum, less an applicable statutory percentage.24 While an MBT return is filed, taxpayers must still pay the greater amount of tax due under the MBT or the CIT, after taking into effect the credits.25

MTC Three-Factor Apportionment

As part of the tax reform legislation, effective January 1, 2011, taxpayers are no longer permitted to use the MTC three-factor apportionment provision for the MBT and such provision extends to the CIT as well.26

ASC 740 Implications

The financial accounting implications of the adoption of the CIT will depend on the particular facts and circumstances of each taxpayer. However, the following items are likely to have common application in practice:

  • Elimination of modified gross receipts deferrals for reversal periods ending after December 31, 2011;
  • Enactment of the legislation and reporting period will vary, but for entities following a quarterly approach, such entities will report the changes in the quarter or period end that includes May 2011;
  • Entities that have recorded deferred tax assets relating to the tax credit established as part of the 2007 enactment of the MBT for companies incurring deferred liabilities from the enactment generally will have to make offsetting adjustments derecognizing this deferred tax asset. The tax credit was available beginning in MBT tax year 2015 which for nearly all taxpayers will not exist (except for those opting into the MBT provision for current users of MEGA and other credits above). Legislation is being considered that would find a method to compensate companies relying on this credit to avoid adverse financial statement implications;
  • Changes in deferred tax balances as a result of effective tax rate changes. For companies that included non-refundable and refundable credits in their rate computations, the new CIT rate likely will be higher for most companies, which could be favorable or unfavorable;
  • Change in taxable entity status for pass-through entities such as partnerships and S corporations. Pass-through entities are generally not subject to the CIT and this may have significant implications on separate entity financial statements; and
  • Tax-sharing agreements will be need to be reconsidered, particularly for partnerships and joint ventures owned by corporate taxpayers. The mechanics associated with corporate partners may change the structure of tax-sharing agreements with the partnership, including the underlying liabilities compared to the MBT.

1099-MISC Reporting27

A person required to file form 1099-MISC under the IRC will be required to file the 1099- MISC with the Department by January 31 of each year, or the date required to be filed under the IRC, whichever is later. Any person failing to file form 1099-MISC with the Department by the due date will be subject to a $50.00 penalty for each form 1099-MISC the taxpayer fails to timely file.

Individual Income Tax Changes28

In addition to the comprehensive changes to the Michigan corporate tax system, the following changes have been made to the state's individual income tax:

  • Elimination of the phased reduction of the rate to 3.9%, replaced with a reduction to 4.25% beginning January 1, 2013;
  • Elimination of the public pension exclusion for taxpayers born on or after Jan. 1, 1946;
  • Elimination of the pension exemption amount for private pensions and annuities;
  • Creation of an exclusion from all types of income ($20,000 for single filers, $40,000 for joint filers), for taxpayers 67 and older
    • This exclusion may also be used by taxpayers born between 1946 to 1952 before reaching age 67 for public or private pension income, and
    • The phaseout for the exclusion begins at $75,000 of household resources for single filers and $150,000 for joint filers;
  • Creation of a phaseout for the personal exemption beginning at $75,000 of household resources for single filers and $150,000 for joint filers;
  • Limited eligibility for the homestead property tax credit, and a reduction of the amount of credit available;
  • Reduction of the earned income tax credit ("EITC") from 20% to 6% of the federal EITC for low-income working taxpayers;
  • Elimination of the dependent child deduction; and
  • Elimination of several non-refundable credits, including:
    • City income tax credit;
    • Public contributions credit;
    • Community foundations credit;
    • Homeless shelter/food bank credit;
    • Historic preservation credit;
    • College tuition and fees credit;
    • Vehicle donation credit;
    • Individual or family development credit;
    • Adoption credit; and
    • Stillbirth credit.

Commentary

Governor Snyder has said that the new CIT is simple, fair, and efficient. The changes will reduce Michigan business tax revenues by almost 80% by eliminating the taxation of all business entities other than C corporations, and also eliminating the modified gross receipts tax component of the MBT while retaining a business income tax similar to the current income tax base of the MBT.

The legislation eliminates virtually all of the credits and incentives which are elements of the MBT, with the exception of a small business credit for entities with less than $20 million in sales. The CIT takes effect on January 1, 2012, regardless of the year-end used by the taxpayer. The Governor stated that the goal of the legislation was to create jobs by lowering the corporate cost structure.

Individual income taxes statewide will rise significantly under the plan, causing some political concerns about the burden that such increases will have on the state in the long term.

The new CIT, the transition of the SBT to the MBT, the elimination of the MBT, and a host of technical corrections to the MBT and SBT will make Snyder's short-term goal of creating a "simple, fair, and efficient" structure difficult. Perhaps in the long term, this goal is achievable, but initially there will be a significant amount of education on the CIT that is necessary clean-up for older years under the MBT and the SBT, and a host of related issues to manage, including but limited to financial statement accounting.

Some have said that the SBT was the most hated tax in the United States until the MBT was enacted. While the goals of the Governor can be admired, there is still a significant amount of technical matters to deal with for the SBT, MBT, and the new replacement tax. Taxpayers will need to consider their specific facts and circumstances as we move to yet another "replacement" tax in a very short time frame.

Will this be the "final" replacement tax for a while? Only time will tell.

Footnotes

1 Enrolled House Bills 4361 (2011 PA 38), 4362 (2011 PA 39), 4479 (2011 PA 40), 4480 (2011 PA 41), 4481 (2011 PA 42), 4482 (2011 PA 43), 4483 (2011 PA 44) and 4484 (2011 PA 45) were all signed by the Governor enacting the new Michigan corporate and individual income tax regime. 2011 PA 38 and PA 39 address the corporate and individual income tax provisions, as well as the optional MBT filing and certificated credits. 2011 PA 40 amends the Multistate Tax Commission (MTC) three-factor apportionment option to specifically exclude the MBT and the CIT from such provision, and 2011 PA 41 through 45 enact legislation that affects public pensions.

2 The definition of gross receipts for the CIT is substantially similar to the definition in the MBT. The CIT definition does not include phased-in provisions for certain receipts.

3 Under the approach followed in Appeal of Finnigan Corp., No. 88-SBE-022-A, Cal. State Bd. of Equalization, Jan. 24, 1990, a member of a unitary group has nexus with a state if any members of the group have nexus with the state. Many states follow the opposite ("Joyce") approach, under which a member of a unitary group does not have nexus with a state by reason of other members of the group having nexus with the state. See Appeal of Huffy Corp., No. 99- SBE-005, Cal. State Bd. of Equalization, April 22, 1999.

4 2011 PA 38 §§ 603(2), 607(1).

5 2011 PA 38 §§ 621.

6 2011 PA 38 § 623(1).

7 2011 PA 38 § 703(3)-(5).

8 2011 PA 38 § 605(1).

9 2011 PA 38 § 635(2).

10 2011 PA 38 § 653(1).

11 Generally contained in 2011 PA 38 § 623(2).

12 2011 PA 38 §§ 603(2), 607(1). 13 2011 PA 38 § 623(2)(e) allows for royalty, interest or other expense payments to be excluded from Michigan taxable income if the taxpayer can demonstrate that the transaction meets one of three requirements: (i) the transaction has a nontax business purpose; (ii) the transaction is conducted with arm's-length terms pricing, rates and terms; and (iii) the transaction is (a) a pass-through of another transaction between a third party and the related person, (b) the addition would result in double taxation, (c) the addition would be unreasonable as determined by the State Treasurer, or (d) the transaction is with a foreign related person and is protected by a tax treaty.

14 2011 PA 38 § 611(6) conforms the definition of United States person to the definition used by the IRC.

15 Oil and gas production is subject to severance tax.

16 2011 PA 38 §§ 623(4).

17 2011 PA 38 §§ 661, 663.

18 2011 PA 38 §§ 671.

19 2011 PA 39 § 500(1).

20 2011 PA 39 § 117(5)(A).

21 2011 PA 39 §§ 117(5)(A), (B), see also § 500(1).

22 The Department has not yet issued guidance on the specific method for electing to file the MBT.

23 2011 PA 39 § 500(1).

24 2011 PA 39 §§ 510(1),(2).

25 2011 PA 39 §§ 500(4)(b).

26 2011 PA 40 Art. III, § (1).

27 2011 PA 38 §§ 707.

28 2011 PA 38 §§ 30(9); 51(1); credit eliminations and limitations contained in several discrete tax provisions.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.