Alabama Ruling Demonstrates Complications of Separate State Filings for Consolidated Groups

February 2, 2017

Certain transactions which have no immediate impact for federal tax purposes can have an immediate state income tax impact if a member of an affiliated group files separately for state income tax.

Nearly all states that assess a corporate income tax use a company’s federal taxable income as the starting point for computing state income tax liability. In general, state-specific adjustments are made to federal income to reach state taxable income, followed by state apportionment/allocation and the application of the state’s tax rate. While straightforward in concept, this exercise becomes complicated when a state does not conform to major federal tax concepts such as the consolidated tax filing of affiliated corporations. A recent Alabama Tax Tribunal Decision outlined one such challenge by rejecting a federal consolidated filer’s federal tax deduction that was required to be recomputed for its Alabama separate tax return filings. [1]

In this ruling, the taxpayer was a member of a group of affiliated corporations that filed a consolidated tax return for federal purposes but filed separate state tax returns for its taxable (i.e., nexus) group members in Alabama. [2] The company, a manufacturer of paint and related supplies, computed a Domestic Production Activities Deduction (“DPAD”) for its affiliated group of corporations at the federal tax level. [3] Since the company was filing its Alabama state income tax returns on a separate-entity basis, the DPAD had to be recomputed to reflect only the activities and income of such member.

In its recalculation of the DPAD by separate entity, the taxpayer used its Alabama taxable income (meaning the separate entity’s federal taxable income after all Alabama-specific adjustments had been made) as the basis for the DPAD’s net income limitation. Due to various additions to its federal taxable income required by Alabama law, this entity’s Alabama taxable income was higher than its federal taxable income which resulted in a more favorable outcome for purposes of the DPAD. Upon review, the state rejected the taxpayer’s separate DPAD computations and contested that the DPAD income limitation should be computed using separate federal taxable income before the required Alabama additions and adjustments.

Although there is no specific Alabama law or regulation addressing the actual DPAD calculation, the state does address how to calculate state adjustments to federal deduction limitations. In Department of Revenue Regulation 810-3-1.1-.01, Alabama instructs that when deductions and limitations such as DPAD are determined in accordance with the Internal Revenue Code, they should be “applied to the amount determined under Alabama law.” The taxpayer argued that this phrase meant Alabama taxable income after adjustments but before allocation and apportionment. The state argued that the phrase simply meant federal taxable income as determined under Alabama law (i.e., federal taxable income computed on a separate-entity basis as required by Alabama law for separate filers). The judge in this case agreed with the state’s interpretation, thereby rejecting the taxpayer’s DPAD calculation.

Nuanced rules such as these can vary by state and make state income taxes for corporate members of affiliated groups a complex endeavor. Further, certain transactions that have no immediate impact for federal tax purposes, such as the distribution of appreciated property between a subsidiary and parent that are members of a consolidated group, can result in an immediate and significant state income tax impact when a member of the affiliated group is required to or chooses to file separately for state income tax purposes like the taxpayer in this Alabama ruling. Aprio’s SALT group has experience advising on the complexities and effects of your multistate business’ activities and transactions and can help with planning for the accurate and most favorable tax outcome. We constantly monitor these and other important state tax issues, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

Contact Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at [email protected] for more information.

This article was featured in the January 2017 SALT Newsletter. To view the entire newsletter, click here.

[1] The Sherwin-Williams Company v State of Alabama, Docket Nos. BIT. 13-359, BIT. 11-741 (Nov. 30, 2016).

[2] While Alabama permits a federal consolidated group to file a single consolidated Alabama tax return, it does not require it. There are several reasons an affiliated group of corporations may choose to file separately when permitted such as excluding a profitable group member that does not separately have nexus in the state. See Alabama Code §40-18-39(c)(1).

[3] The DPAD, found in IRC §199, permits U.S. manufacturers to compute an additional tax deduction based on the portion of its net income deemed to relate to its domestic manufacturing activities. It is limited by taxable income so as not to create a loss.

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding this matter.