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September 2, 2008
The Loophole of Labeling a Tax Provision a Loophole
by Jeffrey A. Friedman, Michele Borens, and Charles C. Kearns

Full Text Published by Tax Analysts®

Document originally published in State Tax Notes
on September 2, 2008.

Welcome to the first installment of A Pinch of SALT. We hope to share with you our monthly observations of interesting and perhaps thought-provoking (or sometimes irritating) trends and developments that occur in the state and local tax world. We hope to have some fun with this column — please share your thoughts on it whether you agree with us or not.

The state tax area continues to evolve at a staggering pace. States are more frequently revamping their tax systems. There are several reasons for these changes, including budget shortfalls, inefficient or outdated tax systems, the desire to create incentives to attract or appease segments of the business community, and the elimination of tax loopholes. This month we will focus on this last purported rationale for altering state tax systems — the eradication of tax loopholes.

What is a loophole? Is it something obscene — like when income escapes taxation (and you know it when you see it)? Or is it just a "bad" tax provision — one that produces a result that is unwanted or deemed unfair? We think it is something different. This article is devoted to the use, and overuse, of the label "loophole," and it suggests some ground rules for its continued use.

Loophole Defined

A loophole is defined as:

    An ambiguity, omission, or exception (as in a law or other legal document) that provides a way to avoid a rule without violating its literal requirements; esp., a tax-code provision that allows a taxpayer to legally avoid or reduce income taxes.

    Black's Law Dictionary, 764 (Abridged 7th ed. 2004).

We believe that in the state tax world, a loophole is essentially an omission or ambiguity that allows an interpretation of a tax provision that may be different from what was intended by the drafter of the provision. For instance, a loophole exists if a state legislature drafted and enacted a tax provision that was intended to grant a tax deduction to individuals, but in doing so it (through less than precise language) left open the possibility that a corporation could also benefit from the deduction. Also, if a department of revenue promulgated procedures for perfecting a refund claim but unintentionally allowed otherwise nonperfected claims to be granted, one could argue that the department created a loophole. However, we distinguish those situations from ones in which a tax provision produces an intended result (regardless of whether that intended result is viewed positively or negatively). The mortgage interest deduction that many of us enjoy on our federal (and state) tax returns is not a loophole, even though many economists view it unfavorably. The same is true of a whole host of tax rules that favor various types of transactions, taxpayers, and structures. If, however, one of these tax rules is applied by a taxpayer or a tax administrator to produce an unintended result, we may have a tax loophole. We recognize, however, that some observers characterize as loopholes the intended exceptions that they believe run counter to the overall perceived intent of a statute.1 Nevertheless, we think the better view is to limit the definition of a loophole to a provision that produces unintended results. So hang in there with us while we examine some tax provisions that have been labeled or referred to as loopholes and decide whether they have been unfairly accused.

Federal Tax Conformity: Loophole or Just Misunderstood?

Most states have largely adopted the Internal Revenue Code as the starting point for determining state taxable income. The benefits to states and taxpayers of conformity are obvious — conforming to the IRC provides taxpayers a robust set of provisions with which they are familiar and provides states with a robust set of rules with interpretative guidance. However, conforming to the IRC may produce unforeseen results. For instance, many states found themselves in a difficult situation when they adopted the federal dividends received deduction. The federal dividends received deduction generally does not apply to dividends paid by non-U.S. companies, and that makes economic sense (the underlying income ordinarily has not yet been taxed in the United States, thus undermining the rationale of preventing multiple instances of U.S. tax on the same income). Insofar as the income has been taxed in foreign countries, the IRC in some circumstances offers a tax credit to reduce double taxation of the same income by different countries.2 However, this limitation of the dividend received deduction ran headlong into the foreign commerce clause of the U.S. Constitution (which limits the states', but not the federal government's, ability to tax foreign commerce). In Kraft Gen. Foods, Inc. v. Iowa Dep't of Rev., 505 U.S. 71 (1992), the U.S. Supreme Court rejected Iowa's attempt to justify the constitutional violation as an unintended consequence, and it went on to strike down the limitation to non-U.S. dividend payers as applied at the state level. Here the discrimination appeared to be unintended. Thus, a tax administrator upset with this result could justifiably argue that her state had created a tax loophole by conforming to the IRC.

States have run into other instances of loopholes associated with federal tax conformity. U.S. Treas. reg. section 301.7701-3, entity election provisions — known as the check-the-box rules — permit entities that are not organized as corporations to elect their filing status. Some states conform to these federal check-the-box rules for some or all types of entities and taxes. For example, Massachusetts's treatment of business trusts (corporate trusts) and some partnerships differed for state and federal tax purposes. Thus, some types of businesses could be treated as a corporation for federal income tax purposes but as a partnership (or a disregarded entity) for Massachusetts excise (income) tax purposes. Massachusetts recently addressed this discrepancy in treatment by enacting legislation that provides that the filing status for business entities in Massachusetts must conform to their filing status for federal tax purposes.3 Previously, taxpayers could benefit from that discrepancy by creating entities that are disregarded for state income tax purposes but are recognized for federal income tax purposes. For instance, a business that established itself as a corporate trust (any partnership, association, or trust the beneficial interest in which is represented by transferable shares4) generally was not subject to Massachusetts corporate income tax, but was subject to Massachusetts personal income tax even if it elected to be taxed as a corporation for federal income tax purposes.

Is the Massachusetts partial conformity with the federal check-the-box regulations a loophole? Arguably, it is not, because for years Massachusetts adopted the check-the-box rules for most types of entities. Only a few different types of entities continued to be potentially subject to differing federal and state income tax treatment. Because Massachusetts continued to allow nonconformity for specific entities, the limited nonconformity with the check-the-box regulations appears to be the intended tax consequence of the law. Unlike with a loophole, which produces an unintended result, that nonconformity may have been intended.

Another interesting aspect of loopholes is that they do not always favor taxpayers. A state (or a department of revenue) can also be the beneficiary of a tax loophole. For instance, in New Jersey Natural Gas Co., v. Director, Div. of Taxation (N.J. Tax Ct. Nos. 000240-2005 and 007284-2005, Apr. 17, 2008), the New Jersey Tax Court held that the taxpayer had to pay New Jersey tax on nearly all of its income (that is, the taxpayer did not have the right to apportion its income) even though the taxpayer was engaged in business (and paying tax) in other states. New Jersey Stat. Ann. section 54:10A-6 requires that a taxpayer maintain a regular place of business outside the state as a prerequisite to apportioning its income. New Jersey Reg. section 18:7-7.2(a) provides that a regular place of business is any bona fide office (other than a statutory office), factory, warehouse, or other space of the taxpayer that is regularly maintained, occupied, and used by the taxpayer in carrying on its business and in which one or more regular employees are in attendance.

In New Jersey Natural Gas, New Jersey benefited from that rule by imposing its tax on most of the taxpayer's multistate income. Although the taxpayer was subject to tax, and paid tax, in other states — New Jersey, Maryland, Pennsylvania, West Virginia, and New York — the court held that the taxpayer did not satisfy the prerequisite to formulary apportionment. Rather, the taxpayer was relegated to receiving a credit for taxes it paid to other states. The credit mechanism ensures that all of a taxpayer's income — even income with little connection to the taxing state — is subject to tax at a rate that is at least no lower than New Jersey's. While the court found that this credit insulated the tax regime from a constitutional attack, the decision resulted in a far higher tax burden than if the taxpayer had been permitted to apportion its income. Essentially, the taxpayer was punished by New Jersey because it lacked a substantial out-of-state physical presence. Ironically, New Jersey has been one of the most aggressive states in asserting its tax jurisdiction over companies that have a thin (that is, nonphysical) presence in the state.5

Certainly it could be argued that neither the New Jersey Division of Taxation nor the Legislature intended to subject multistate taxpayers to tax based on unfavorable apportionment regimes. Nevertheless, in an age of states asserting economic nexus, it is unlikely that a state like New Jersey would expect taxpayers to pay tax in only those states where it has a "superoffice." The loophole in this instance benefits New Jersey.

Do Old and Cold Loopholes Lose Their Reputation?

Some loopholes have been known to state revenue administrators and legislators — and even acknowledged and accepted by them — for years. Thus an interesting question arises: Do famous (or infamous) loopholes eventually lose their status as loopholes? For instance, under the old Texas franchise tax (that is, before the tax was amended and turned into a "margins tax" measured in large part by gross receipts), corporations that limited their in-state activity to the ownership of a limited partnership interest were deemed not to be subject to the Texas tax. That result was acknowledged by the state for years.6 As a result, many taxpayers were able to nearly eliminate their Texas tax. (See Issues Facing the 79th Texas Legislature as prepared by the Texas Senate, January 2005, in which the Senate acknowledged the Texas limited partnership taxation issue, and "Delaware Loophole Faces Closure," Dallas Business Journal, Apr. 11, 2003, in which Texas Gov. Rick Perry (R) addressed the revenue loss created by the lack of taxation of Texas limited partnership limited partners and stated his intention to close the loophole.) Although Texas ultimately eliminated this treatment, a question of timing arises. It is possible, perhaps even likely, that the Texas Legislature never intended to allow companies to eliminate their Texas tax via this provision. Therefore, it is fair to say that the Texas limited partnership treatment originated as a loophole (at least based on the large-scale benefit that it achieved for mostly out-of-state companies). Nevertheless, the provision became so well- known and understood that its status as a loophole faded over time. After many years of its existence having been acknowledged, and after the Texas limited partnership structure had been widely adopted, one could not seriously argue that the continued treatment was unintended. It was widely conjectured that Texas lacked the will to eliminate this tax benefit. It took a significant movement (and not displeasure with the loophole itself) to reform the state's property tax system, and that reform ultimately led to the demise of the Texas limited partnership structure. We therefore believe that a provision that is born as a loophole can, over time, lose its loophole status because of the common knowledge that it existed and the failure to remove it.


Now we turn to instances of how the description has been overused. Unfortunately, various parties have labeled tax provisions as loopholes in an attempt to seek their repeal. Although some of those provisions are loopholes, others clearly are not.

Combined Reporting

When the Maryland General Assembly considered combined reporting in 2007, Gov. Martin O'Malley (D) said, "Today, we are taking steps to close corporate loopholes that allow large corporations off the hook, while Maryland's middle class families and small businesses foot the bill."7 When the Massachusetts legislature considered and ultimately enacted combined reporting this year, Gov. Deval Patrick (D) advocated combined reporting as a "loophole" closer.8 Adopting combined reporting does not close a loophole. Rather, the movement from separate reporting to combined reporting is a change in tax systems — each of those systems can have loopholes within it, and neither system is perfect.

The continued application of separate reporting — which reflects taxation on an entity-by-entity basis — must be viewed as a rejection of combined reporting, because the two systems serve as alternatives to each other. The imposition of separate reporting (and the rejection of combined reporting) could have been made for any number of reasons (including the effectiveness of lobbying by the in-state business community against combined reporting), but the imposition of a separate reporting regime (and the rejection of the combined reporting regime) cannot be seriously viewed as a loophole. Labeling separate reporting regimes as loopholes is nothing more than a name-calling exercise intended to further the lobbying for combined reporting. California has imposed combined reporting for decades; separate reporting states have known of its existence and just have not adopted it.

Further support for the notion that separate reporting is not a loophole is evidenced by the results of separate and combined reporting. Separate reporting states prevent related corporations from offsetting current-year income and losses. This feature can be a significant detriment to groups of companies with profitable and loss companies. Combined reporting generally allows the offsetting of current-year income and losses between related, unitary corporations. Although proponents of combined reporting may argue, "Give me a break — taxpayers can change their structures to take advantage of separate reporting regimes," that is not universally true. Although some taxpayers have altered their corporate structures to ensure that losses are not "trapped" in related parties, not all of them can. We interact with many companies that run into regulatory and business constraints (for example, union contracts, financial reporting systems) that prevent them from liquidating entities to ensure that income and losses are offset. Thus, separate reporting is favored by only some companies. And some companies prefer separate reporting in some states and combined reporting in others. The varying support of separate versus combined reporting is further evidence that the failure to adopt combined reporting does not reflect a tax loophole.

Public Law 86-272

In his State of the State address to the General Assembly on January 15, Iowa Gov. Chet Culver (D) proposed fixing the state's corporate tax structure by closing a "loophole" that allows out-of-state corporations to avoid Iowa income taxes — he was referring to Public Law 86-272 (15 U.S.C. Sec. 381, et. seq.). That federal law was enacted in 1959 in response to a U.S. Supreme Court decision that allowed a state to impose tax based on the presence of a salesperson (Northwestern States Portland Cement Co. v. Minnesota, 358 U.S. 292 (1959). The federal law preempts states from imposing a net income tax if the taxpayer's in-state presence is limited to the solicitation of sales of tangible personal property.

The Iowa governor went on to say that:

    if a business has a physical presence, such as a store, or if it installs or repairs what it sells, it does have a nexus and can be taxed. Yet businesses can have fleets of traveling salespersons and sell hundreds of millions of dollars of goods in the state and make millions of dollars of profit by doing so, but not be taxable by the state. That is a huge loophole. Businesses can establish sales fleets to travel and market their goods, without establishing a nexus.

Although one can understand why a governor would like to impose tax on all companies selling into his state, the federal preemption — which clearly intended to protect from tax companies that limit their activities to solicitation activities — cannot seriously be viewed as a loophole. P.L. 86-272 is serving the same purpose in 2008 as it did when it was enacted in 1959. Culver's diatribe is a classic example of misusing the word "loophole" to cast aspersions on a disliked tax provision.

Net Operating Losses

In what may be the most egregious misuse of the word "loophole," a July 8 press release issued by California Senate President Pro Tem Don Perata (D) and California Assembly Speaker Karen Bass (D) claimed that net operating loss carryforwards are corporate tax loopholes. The legislators, who were trying to build support for a California budget proposal that would suspend NOL carryforwards for three years, said, "These tax breaks are used primarily by large corporations, many of them in the manufacturing and finance area. Companies with more than $5 million in gross receipts account for just 13% of total businesses but 80% of the NOL deduction."

The silliness of the contention that NOL carryforwards are loopholes is apparent to those who have a smidgen of tax experience. Nevertheless, we cannot help but note that NOL carryforwards have long been a mainstay of our federal and state income tax systems. The intent of those provisions is, in part, to avoid penalizing companies that earn income in one year and experience a loss in another. Although we are unaware of any state that has permanently eliminated the NOL carryforward deduction from its income tax system, some states have suspended the availability of NOLs during tough economic times. However, no one should label an NOL carryforward a loophole — doing so is just another example of an attempt to serve the policymaker's own political agenda regardless of the accuracy of the characterization.

Stop the Madness!

Each of the aforementioned examples illustrates how the use of the term "loophole" has become so pervasive that it is worth considering its appropriate use and meaning. We have shared our views on loopholes — please share yours with us. Most of us will at least agree that the word has been used so frequently that its relevance is being diminished — which may be appropriate given its overuse and misuse.

We hope you have enjoyed this first installment of A Pinch of SALT. Some will welcome this pinch, while others may view it as annoying. Either way, we appreciate you taking the time to read our inaugural edition, and we will be back next month.

* * * * *

Jeffrey A. Friedman, Michele Borens, and Charles C. Kearns are members of Sutherland's State and Local Tax (SALT) Practice. Sutherland's SALT Practice is comprised of 17 full-time attorneys who focus on planning and controversy associated with income, franchise, sales/use, unclaimed property, and property tax matters. Sutherland's SALT Practice also monitors and comments on state tax legislative and policy efforts.


1 See, e.g., Gretchen Morganson and Stephen Labaton, "Proposed Law on Bankruptcy Has Loophole," The New York Times, Aug. 25, 2008.

2 See IRC sections 901, 902.

3 See Massachusetts HB 4904.

4 See Massachusetts G.L. Ch. 62, section 8.

5 See, e.g., Lanco, Inc. v. Director, Div. of Taxation, 908 A.2d 176 (N.J. 2006), cert. denied, ___ U.S. ___, 127 S. Ct. 2974 (2007). (For the decision, see Doc 2006-21177 or 2006 STT 199-22 (1).)

6 See Letter No. 9909263L, Texas Comptroller of Public Accounts, Sept. 28, 1999; Letter No. 200012943L, Texas Comptroller of Public Accounts, Dec. 12, 2000.

7 Press release by Gov. Martin O'Malley, Sept. 21, 2007.

8 Press release issued by Gov. Deval Patrick, Jan. 17, 2008, titled "Governor Patrick Proposes to Close Corporate Tax Loopholes, Cut Business Taxes to Ensure Commonwealth's Global Competitiveness."


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