Editor’s note: Mike has been following published materials on Gov. Sundquist’s proposed state income tax, and it is his observation that Jerry Adams, CPA, with Joseph Decosimo & Company, CPAs, has issued the most comprehensive, thought-provoking memorandum on the proposed tax plan. The following is the Mar. 19, 1999 version of Adam’s memo, authorized by Adams for publication here. The DECOSIMO CPA firm is a large, Tennessee-based CPA firm. Most of the firm’s clients are families and family businesses. DECOSIMO clients have expressed many of the views stated here.

At press time, the governor was about to announce revisions to his plan. For current and on-going updates, please consult the DECOSIMO CPA firm’s web page.

The front door is locked, so to speak, on a Tennessee personal income tax, so Gov. Don Sundquist is trying to get in through the back door. The irony is that Sundquist, a Republican, campaigned that he would never let a state income tax become law.

“This is not an income tax,” the governor says, “It is a tax on income.”

In just a matter of weeks, before the people of Tennessee realize what is happening, the governor could have his way. There was no advance notice from the governor that he would propose a tax on compensation. Now, Finance Commissioner John Ferguson is pushing the tax plan in the legislature and accusing business of wanting more time to organize opposition.

“Sock it to business” is the madness of the governor’s proposed tax plan. Adding compensation to the tax base is the way he will get big new tax dollars, most of which (72.4 percent by his own computation) will be paid by corporations already subject to state taxes. Many corporations would pay 10 times as much or more in state taxes than they now pay.

Once the back door is open for “taxes on income,” it is likely to be a short time until Tennessee has a full-blown income tax to fund the bottomless pit of spending for TennCare and other state programs.

Sundquist proposes $900 million tax increase on business

Sundquist has proposed to replace the Tennessee franchise and excise taxes on corporations with new taxes on all businesses. The governor’s proposed tax plan would tax:

1) All compensation paid above a $50,000 total exemption at 2.5 percent and
2) Business profits above $50,000 at 2.5 percent

The current franchise tax is levied at $0.25 per $100 value of the greater of:
1) a corporation’s net worth or
2) the value of the property owned and used in Tennessee

The current excise tax is levied at a rate of 6 percent of a corporation’s net annual earnings derived from business done in Tennessee.

The governor’s proposed tax plan represents a big tax increase for most businesses located or doing business in Tennessee — mainly for corporations currently subject to Tennessee franchise and excise taxes. The change is too abrupt.

TennCare spending is out of control

No one in authority seems to know how to “control the TennCare monster.” TennCare is a program begun five years ago to replace Tennessee’s Medicaid program. Costs have grown rapidly to $4 billion annually and could soon reach $5 billion. Tennessee’s total annual budget is about $16 billion. The state of Georgia’s annual budget is $12 billion. Gov. Sundquist proposes to increase TennCare spending next year by $142 million.

Not only is the TennCare program putting unbridled pressure on the Tennessee state budget, it is causing financial havoc with health care providers.

If there is to be more TennCare spending, the money received from the tobacco industry should be used for this purpose.

Corporate franchise and excise taxes underestimated

Tennessee’s corporate franchise and excise tax collections totaled $880.5 million for the fiscal year ended June 30, 1997 and $918 million for the fiscal year ended June 30, 1998. A projection of $800 million for the fiscal year ending June 30, 1999 seems to be underestimated. About 25 percent of annual franchise and excise tax collections are made in April of each year, so it will be after April before an accurate projection can be made.

Many corporations would pay 10 times as much or more in Tennessee taxes under the governor’s proposed tax plan as they currently pay in franchise and excise taxes. It appears that the administration’s estimate of $900 million in new business taxes is a gross underestimate. It seems to us that the governor’s proposed tax plan would cost businesses more than $2 billion.

The so-called loopholes for limited liability companies and limited liability partnerships could be closed simply by making them subject to franchise and excise taxes that corporations pay. However, many limited liability entities are vehicles for managing and controlling investments and are not operating businesses. Imposing taxes on family investment entities would represent overreach and result in unfair double taxation by the state.

Most other states exempt limited liability entities from state business taxes for good reasons. The state of Florida has tried taxing limited liability entities and professional services, but has or is in the process of removing the taxes because of adverse results.

Moreover, very few corporations have restructures as limited liability entities to escape franchise and excise taxes because such restructures trigger federal and state taxes as corporate liquidations. It is true that there have been some corporate restructures but not to the exaggerated extent that reports have suggested.

It seems clear and simple to most people that a tax on earnings of proprietors and partners is a personal income tax not authorized by Tennessee’s constitution. Most proprietorships and partnerships that adopted limited liability status, including the DECOSIMO CPA FIRM, did so not to avoid state taxes, but to limit open-ended business liability exposure — especially from one partner to another.

Here are some factual illustrations of business tax increases that would result from the governor’s proposed tax plan:

A) A corporation pays $1,050,000 of compensation and has no profits. Last year, the corporation paid $1,250 of franchise tax. Under the governor’s proposed tax plan, the corporation would pay $25,000 in state taxes, calculated as 2.5 percent of $1 million of compensation paid. The tax increase for this corporation would be $23,750.

B) A corporation pays $10,050,000 of compensation and has profits of $1,050,000. Last year, the corporation paid $12,500 of franchise tax and $63,000 of excise tax for a total of $75,000. Under the governor’s proposed tax plan, the corporation would pay $275,000 in state taxes, calculated as 2.5 percent of $10 million of compensation plus 2.5 percent of $1 million of profits. The tax increase for this corporation would be $199,500.

C) Two Tennessee corporations have identical sales and profits. One corporation employs 500 workers and pays compensation totaling $14 million. The other corporation employs 50 workers and pays compensation totaling $2 million. Under the governor’s proposed tax plan, the corporation that employs more workers would pay $300,000 more in state taxes than the corporation that employs fewer workers. (This illustrates how the governor’s proposed tax plan would impose a penalty on businesses for employing workers in Tennessee.)

D) An architect owns and operates a professional corporation. He earns $120,000 and has four employees — a staff architect who is paid $57,000, a secretary who is paid $32,000 and two part-time assistants who are each paid $8,000 for total compensation paid of $225,000. The PC has profits of $5,000. Last year, the PC paid $200 in franchise tax and $300 in excise tax for a total of $500. Under the governor’s proposed tax plan, the PC would pay $4,375 in state taxes, calculated as 2.5 percent of $175,000 of compensation paid. The tax increase for this PC would be $3,875.

E) Two architects combine their identical PC businesses and pay compensation totaling $450,000. Under the governor’s proposed tax plan, the combined PC would pay $10,000 in state taxes, a $1,250 penalty for combining two businesses.

F) A staffing business pays compensation totaling $8,050,000. Under the governor’s proposed tax plan, the business would pay $200,000 in new state taxes, calculated as 2.5 percent of $8 million of compensation paid.

G) A proprietor pays employees $105,000 and makes $75,000 for operating the business. Last year, the proprietor was not subject to franchise and excise taxes. Under the governor’s proposed tax plan, the proprietor would pay $3,125 in new state taxes, calculated as 2.5 percent of $100,000 of compensation paid plus 2.5 percent of $25,000 of profits.

H) John Doe earns $100,000 working for the government. Jane Doe earns $100,000 in her own business. Under the governor’s proposed tax plan, Jane would pay $1,250 in state taxes, calculated as 2.5 percent of $50,000, because her income is from a business.

I) An accounting practice partnership pays compensation of $1,050,000, and the partners earn a total of $750,000. Under the governor’s proposed tax plan, the partnership would pay $42,500 in new state taxes, calculated as 2.5 percent of $1 million of compensation paid plus 2.5 percent of $700,000 of partner profits.

J) A law practice is a professional corporation subject to Tennessee franchise and excise taxes with facts similar to the preceding accounting practice. Last year, the PC paid state taxes of $750. Under the governor’s proposed tax plan, the PC would pay $43,750 in state taxes, calculated as 2.5 percent of $1.75 million of compensation paid. The tax increase for the PC would be $43,000.

K) A big corporation has a highly-automated Tennessee plant representing an investment of $150 million and pays 40 people a total of $2 million to operate the plant. Last year, the corporation had profits of $6 million and paid $735,000 in state taxes — $375,000 in franchise tax and $360,000 in excise tax. Under the governor’s proposed tax plan, the big corporation would pay only $197,500 in state taxes, calculated as 2.5 percent of $1.95 million of compensation paid plus 2.5 percent of $5.95 million of profits. The tax decrease for the big corporation would be $537,500. (This illustration shows how the governor’s proposed tax plan would help big businesses that do not employ many Tennessee workers.)

Most other states have business tax structures similar to Tennessee’s franchise and excise taxes. Only Michigan imposes a tax on compensation paid. A tax on compensation paid would be at variance with the tax structure of Tennessee’s surrounding states. When state tax structures vary, businesses take advantage of the tax differences, and that could cause businesses to locate operations and employees in other states.

An unfair situation for multi-state businesses is that each state allows credit only for other state taxes calculated on income. Many taxpayers would pay state taxes to two states since no tax credit is allowed by states for taxes calculated on compensation paid.

Big corporations with high profits, large capital investments and few employees would pay less than they now pay in state taxes under the governor’s proposed tax. Most businesses would pay whopping state tax increases.

Insurance companies are exempted from the tax increase.

Startup businesses and businesses that incur losses would be hit especially hard with taxes on compensation paid although they have no profits. Not even the IRS does this.

It’s an income tax! Most people feel that the governor’s proposed tax plan is a disguised or “back door” income tax. Gov. Sundquist declared in his re-election campaign that he would never allow a personal income tax to become law. The constitutional issue of whether a tax on compensation paid by employers is a personal income tax not authorized by the Tennessee Constitution will have to be determined by the Tennessee attorney general of the Tennessee Supreme Court.

Linked to the governor’s proposed business tax plan is elimination of state and local sales taxes on groceries. (Georgia and Kentucky, two of Tennessee’s bordering states, have no state sales tax on groceries.) Annual sales tax on groceries has totaled $549 million, which equals about $100 per person per year. What benefit will there be to a Tennessee worker who saves some sales tax on groceries but loses his or her job?

With the economy booming, state tax revenues are now at the highest level ever, so why does Tennessee have a $380 million projected budget shortfall? TennCare is a big part of the cause. TennCare spending now totals $4 billion and is 25 percent of the Tennessee budget.

As Tennessee’s businesses face this substantial tax increase, Georgia businesses were told recently that Georgia employers will likely enjoy a $1 billion tax cut over the next four years. This will provide double incentive for businesses to locate their operations and employees in Georgia rather than in Tennessee. Tennessee residents whose employers move into bordering states will have to pay personal income taxes on their earnings to the state where they work.

While the initial cost of the governor’s proposed tax plan will be borne by business, the ultimate cost will be the loss of jobs and job opportunities in Tennessee that will result from a declining state economy.

Many business owners have said that they would have to deduct the compensation tax from their employees or reduce the compensation of their employees.

Because the Tennessee franchise and excise tax system has been in existence since 1923, there is a well-established body of regulations, court cases and administrative positions related to the law. If that law were to be repealed and replaced by new tax laws, it would take years and years for state government officials and taxpayers to reestablish administrative application of the new tax law.

While the elimination of sales tax on groceries is a happy thought for everyone, it has the risk of costing many Tennessee workers their jobs. Then more people would need TennCare, the cost of which is now one-fourth of Tennessee’s total budget.

Directors of the Tennessee Association of Business are opposed to the business payroll tax, and the Nashville Area Chamber of Commerce board has voted to oppose the governor’s proposed tax plan. A Nashville study has concluded that the tax plan would put Tennessee at a business disadvantage. Businesses now pay more than a third of all taxes collected by the state of Tennessee.

DECOSIMO suggestions:

There is criticism that business only opposes tax increases without providing constructive ideas for Tennessee’s budget dilemma. So, here are some DECOSIMO suggestions:

Suggestion: Retain capital and income as bases for Tennessee’s business taxes. These are the bases for business taxes in almost every other state. Differences cause serious economic development and multi-state problems. For example, a Georgia resident owner of a Tennessee business would pay state taxes to both states. A Tennessee resident owner of a Georgia business would pay only Georgia taxes.

Suggestion: If the Tennessee franchise and excise tax is applied to all businesses, then exclude self-employment income and investment income from the excise tax. This prevents a personal income tax and double taxation of interest and dividends.

Suggestion: Exempt specific food categories such as milk, fresh fruits and vegetables and other nutritionally-essential foods from sales tax without removing the tax from all groceries. Many food products are not essentials.

Suggestion: Phase out the sales tax on groceries over three to six years rather than eliminating the tax in total at one date.

Suggestion: If the governor’s proposed tax plan is adopted, then protect businesses from outrageous tax increases and grossly unfair situations by placing a cap on the amount of tax increase each business would have to pay during a 10-year transition period. During that period, each business would calculate its taxes (1) under the new tax law and (2) under the existing franchise and excise tax law. No business would be required to pay more under the new tax law than 150 percent of the franchise and excise tax for any year. Regulations and administrative positions could be developed during that time, and the new tax law could be fine-tuned as to rates, structure and application.

Suggestion: A good prospect is that Tennessee’s inheritance tax collections will reach record high levels during the next 20 years. If Tennessee would eliminate the additional inheritance tax that Tennessee imposes over and above the federal state tax credit, wealthy Tennessee residents would not be encouraged to change their state of domicile as many now do Please address your questions or comments on these subjects to Mr. Costello at:

Costello, Strain & Company, P.C., Certified Public Accountants
510 Republic Centre, 633 Chestnut Street
Chattanooga, Tennessee 37450,

or by phone at (423) 266-4466.