States and Tax Incentives — What You Need to Know
When deciding where to establish or relocate a business, tax rates, credits, and incentives are an important consideration. And as corporate and income tax rates vary by state, it’s crucial to know the landscape before entering a market. Here’s an in-depth guide and what you should focus on.
July 14 2011 by Dean Zerbe
The recent survey of 550 CEOs by Chief Executive Magazine certainly makes clear that taxes remains a big factor for business executives in deciding where to relocate or expand a business or to start a new business.
While states have a range in the overall tax burden they impose on business it is important to bear in mind the tax incentives that the state has in place and whether they are a good fit for your business and also to be aware of the mix of taxes (property, sales, income, etc.) as it relates to your particular business.
Taxes — Don’t Just Focus On Corporate Rates
Given that the vast majority of start-ups and existing small and medium businesses are pass-thru entities (ie not taxed as a C Corporation) it is the individual rate that should be of greatest interest to business owners. The fact that a state has no corporate rate (or a low rate) is of zero importance if you are not a C Corporation. Yes — a zero individual income tax rate, now that is of interest for small and medium business executives since as a pass-thru they will be taxed at the individual rate.
However, bear in mind that states will have some type of tax(es) on business regardless of whether or not the state imposes a corporate tax — example, a business activity tax, licensing, etc. You should understand what is the mix of taxes and the impact of those taxes on your company’s bottom line. For example, if you will have a large number of employees be mindful of states that have a high per employee tax. If you anticipate your business owning costly machinery then understand how the state taxes a company’s personal property. If your company is going to have a large amount of real property, then know the tax treatment of real property. The state is going to be collecting revenue from business — and it is typically a mix of different taxes — know how they fit with your business.
Tax Credits and Incentives — What Does Your Company Qualify For?
States should not only look at the overall tax structure and the mix of taxes as it applies to their business — but as important is considering specific credits and incentives that are available for their business. Too often, small and medium businesses leave billions of dollars in tax breaks on the table — failing to take advantage of the benefits provided in the state tax codes. Business executives need to sharpen their pencils when it comes to taxes — low taxes aren’t just for GE.
Perhaps fading away are the old-school tax breaks for big business in which the governor’s office (often the economic development agency) would provide a basketful of one-time tax breaks to a large business to induce them to come to the state.
The St. Louis Post-Dispatch had a recent article “With eye on jobs, states compete to wine and dine corporations” highlighting that Illinois was providing Motorola more than $100 million in incentives over 10 years to retain is headquarters in Libertyville — employing 3,000. These sweetheart deals are at times not greeted with hosannas, as they are often viewed as: costly per job retained; often cause resentment among existing businesses (where’s my break?); create a moral hazard (suddenly every business decides they may leave as well and look for incentives); and, in practice, effectively shut out the engines of job growth — new and existing small and medium businesses. New small and medium businesses are having difficulty enough just getting their doors open in this tough economy much less spending valuable time and paying a small army of lobbyists and glad-handers to knock on the right doors to get the tax incentives.
The better move (and the more common action) by states has been to instead provide tax credits and incentives that are available for all those who qualify — thus providing business executives confidence that they can plan on these tax benefits as they go forward.
The R&D Tax Credit — States Providing a Bigger Credit
States have been especially targeting for expansion these tax breaks (for both policy reasons and to limit the loss to the fisc) to small and medium businesses. In particular, states have been focused on increasing the research and development tax credit (R&D). This is because the R&D tax credit attracts the two types of jobs in which states have the greatest interest — high-tech and manufacturing. States have also looked closely at hiring credits — particularly hiring in areas of high unemployment.
If your company is a manufacturer (very widely defined); science (biotech, pharmaceutical, etc.); computer software; architect or engineer you need to focus on the most valuable tax credit — the research and development (R&D) tax credit. The R&D tax credit is certainly the largest federal tax credit and often at the state level as well. The R&D Tax Credit is a broadly available credit — the biggest problem is self-censoring by business executives that think their company doesn’t qualify.. You don’t need to have a lab, a fistful of patents or be working for NASA or Silicon Valley to qualify for the R&D tax credit. Your work just has to be new to you. Unless you are building the exact same widget the exact same way — your company should look at the R&D tax credit.
Businesses have benefitted from recent competition by states to have the most attractive R&D tax credit. The winners — Louisiana and Minnesota. Why are these two states so much better? One word — “refundable.” The R&D tax credit in these two states is refundable for small businesses — meaning that even if your company is not making a profit (ie in a loss position) they can still receive dollars from the state. Given that almost every start-up is not going to be making a profit in the near future — a credit that is refundable is incredibly important in providing cash to help a new (or struggling) business keep the doors open.
Working with companies in both Louisiana and Minnesota to secure the R&D tax credit, we’ve seen first-hand the benefits to companies — with the refundable credit influencing their decision to relocate to the state, keep doors open or expand operations. Just to focus on the benefits in Louisiana, companies benefitting from the Louisiana R&D tax credit include: a food processing company with 30 employees; a software developer with 40 employees; an architectural firm with 25 employees; a machine shop with 15 employees; and a manufacturer with 45 employees. Each of these companies received tens of thousands of dollars and more from the Louisiana R&D tax credit (and many are often eligible for the Federal R&D tax credit as well).
In addition to these businesses that received the Louisiana R&D tax credit, certainly more commonly expected companies benefit as well — for instance a biotech company with less than 10 employees received over $100k in credits. Oil, gas and energy technologies; chemicals and petrochemicals; environmental technologies and healthcare are all in the sweet spot for the Louisiana R&D tax credit.
Along with Louisiana and Minnesota, New York also has a very good refundable R&D credit for small business — the delightfully named Qualified Emerging Technologies Company (QETC) Facilities, Operations and Training Credit. Unfortunately the QETC is expiring at the end of this year (but businesses should take advantage this year — and can also amend and take it in earlier years as well).
Just to give readers a sense of the power of this refundable credit (and the R&D credit in general) consider the following example — a software development company in New York City. This software development company, consisting of approximately 16 employees, incurred over $470,000 in qualified property expenses used in development. These property expenses included computers, monitors, servers, memory and other pieces of hardware used in the development and testing of the client’s service lines. These property expenses in conjunction with the qualified research expenses generated over $230,000 in QETC Credits over a four year time period. Nice work if you can get it.
Iowa, Virginia and Arizona have also put in place refundable R&D tax credits — however in some cases these states have capped the amount available that is refundable. By capping the amount, it becomes a competition that leaves businesses up in the air and difficult to make long-term business plans. While a good start, hopefully these states will expand these refundable R&D tax credits down the road.
While these are the six (soon to be five) states that have a refundable credit, other states have a good credit (such as California) as well — often matching the federal R&D credit. However, again because these R&D credits are not refundable they will be of little to no benefit to startups and companies not making a profit.
States have looked to expanding hiring credits. The difficulty — especially for small and medium businesses is that these credits in practice are often of the hop-on-one-foot and wear a pink dress variety. They are cumbersome and costly for businesses to qualify and receive the tax benefits. Too often there is a slip between cup and lip between the finely tuned policy goals put together by legislators and economists as opposed to what actually happens at a business.
The hiring credits will usually focus on employing certain targeted groups (ex. Individual on public assistance) and/or in a certain geographic location. For businesses that are looking at hiring a significant number of low-wage employees it may make sense to see where the greatest incentives are available to locate a facility.
States that have recently been active in offering expanded hiring credits include Illinois with the Economic Development for a Growing Economy (EDGE) — and requires not only new hiring but also capital investments to qualify. Arizona also has a new incentive — the Quality Jobs Program — providing a $3,000 credit for new qualified jobs — but requiring employers to provide health insurance. With all these hiring credits it is very important to read the fine print — all the bells and whistles can often cost an employer more than the tax benefit.
Probably the most powerful hiring credit recently enacted is the New Mexico High Wage Jobs Credit. The incentive provides refundable credits of 10% of wages plus benefits (up to 12k in credits per employee per year) for high wages jobs. High wage is defined as over 40k if you’re in one of the cities (Santa Fe, Albuquerque) and 28k everywhere in the state.
The decision of where to start a new business or relocate an old business is never easy. In considering taxes — the smart executive looks beyond just the rates and considers how the state tax system will apply in practice to her company and also what credits and incentives will be available to their company to reduce that tax bill. Understanding the overall tax picture and taking full advantage of the credits and deductions available will go far in putting more black ink on your company’s bottom line.