HB 36-TAX: INCOME FROM NON C CORP ENTITIES  4:16:03 PM CHAIR KITO announced that the final order of business would be SPONSOR SUBSTITUTE FOR HOUSE BILL NO. 36, "An Act bearing the short title of the 'Fair Contribution by High Profit Businesses Act'; requiring certain persons in the business of oil and gas production or transportation to pay income tax; establishing a tax on the income of a sole proprietorship, partnership, limited liability company, or an S corporation; relating to exemptions from the tax on corporations; and providing for an effective date."   4:16:24 PM REPRESENTATIVE WOOL moved to adopt the proposed committee substitute (CS) for SSHB 36, Version 30-LS0148\E, Nauman, 3/29/17, as the working document. There being no objection, Version E was before the committee. 4:16:50 PM REPRESENTATIVE LES GARA, Alaska State Legislature, as the sponsor introduced SSHB 36 via a PowerPoint presentation entitled, "HB 36: Fair Contribution by High Profit Businesses Act." He explained SSHB 36 tries to close a number of exemptions that Alaska has [slides 1-3]. Until 1980 when Alaska had an income tax, every business in the state contributed towards the state's public services and roads - the business owners paid an income tax. He said the profits that the owners owned through their business, whether lawyers, doctors, engineers, architects, oil field service companies, or any business of which the state has 40,000, paid a portion of the business's profits to the state to help support public services. REPRESENTATIVE GARA said SSHB 36 tries to solve the state's current problem, which is that the 9,000 C corporations in Alaska are subject to the state's corporate business tax while most other businesses are not. Most people see C corporations as publicly traded corporations, he noted, but they are more than that. Although some businesses are subject to a fisheries tax or a mining tax, most other businesses lawyers, doctors, architects pay no tax to the state other than a $50 license fee per business. So, a company making $10 million in profits contributes $50 to the state. He advised that SSHB 36 tries to recognize that struggling businesses cannot afford to pay a tax, but that those who are doing much better in terms of profits can afford to contribute to the state's schools and infrastructure. People who are successful benefit from the things the state pays for, such as roads and infrastructure, energy projects, and the public schools that produce the employees who work for the business. Members of society want to support the next generation that benefits from those things, which is the point of contributing back. 4:20:00 PM REPRESENTATIVE GARA pointed out that 9,000 S corporations in Alaska pay no corporate tax [slide 4]. Regardless of whether these S corporations make $10 million or $500,000 in profits, their tax is only the $50 in license fees paid per business. Obviously, jobs in this economy are important, he continued, but in some sense for the state treasury every business right now actually costs the state money for roads, schools, and the other infrastructure that is provided by the state. From a budget standpoint, one would hate to have businesses be a money drain, but that is the way things are set up in Alaska. Businesses certainly help with local property taxes, but for the state budget businesses cost more money than the state gets back. He noted that there are 45,000 businesses in the state that are not S corporations, and related that when he was a salaried attorney at a law firm, the firm took in $10-15 million in profits and paid $100 to the state with two lines of business license fees. This is the same for doctors' offices and many other businesses, he continued. He said he didn't feel that the law firm contributed back and when he became a partner at that firm, he felt the firm should contribute back more than the license fee that it paid. REPRESENTATIVE GARA advised that the number of non-corporate businesses that pay tax in Alaska is zero, regardless of the amount of their profits [slide 5]. He said the corporations that do pay tax are the roughly 9,000 C corporations in the state as there is a tax structure for C corporations. The types of business not currently paying tax in Alaska include S corporations, limited liability companies (LLCs), partnerships, and sole proprietorships. Those are the classes of the [45,000] businesses that don't pay a tax in Alaska. 4:22:27 PM REPRESENTATIVE GARA stated that the matter of fairness is one reason why he introduced SSHB 36 [slides 8-9]. He offered his belief that people who are successful in society should chip in to help society run. The state's current exemption, which is every business that is not a C corporation, does not help close the state's deficit. REPRESENTATIVE GARA pointed out that Alaska law has a confidentiality provision and every business that does not pay a tax is considered a taxpayer under Alaska law because that is how the law is written [slides 10-11]. That confidentiality provision for taxpayers, even taxpayers that pay no tax, requires that the Department of Revenue not reveal the name of any business that does not pay a tax. In some sense, he said, it is almost good not to know the names of the businesses that don't pay taxes. The purpose of the bill is not to target any business. It is to say that if a business makes a certain amount of income it should chip in toward the ability for the state to provide public services. REPRESENTATIVE GARA stated that SSHB 36 tries to draw a line between those businesses that are successful and those that are struggling because it is not wanted to tax a business out of business [slide 12]. He said he drew a line that says the first $200,000 of profit/net income is nontaxable under the bill, which he thinks is generous. The bill does not change the current corporate tax on C corporations, he explained, and less profitable businesses will remain fully exempted from any business tax under SSHB 36. He allowed there could be differing views on whether the $200,000 mark is the right mark. 4:24:58 PM REPRESENTATIVE GARA advised that SSHB 36 would not tax Alaska Native corporations specifically, which the bill states [slides 13-14]. Most, if not all, Native corporations are covered as C corporations given the number of shareholders that they have, and if they make a profit, they probably pay a tax to the state under the C corporation tax. He said it is the same with village corporations and that the village corporations often don't make a profit. REPRESENTATIVE GARA pointed out that the tax schedule set under SSHB 36 is lower than the schedule under the current corporate tax, mostly because the first $200,000 of income is exempt [slide 15]. He noted that the top tax rate under the current corporate tax for C corporations is 9.4 percent of income above $222,000 a year, and that there is a smaller tax on lower levels of income. He explained that by exempting the first $200,000 of income the proposed tax is a lower tax and the proposed tax gradually moves the tax from 5 percent to 9.4 percent at $1,000,000. He allowed it is for the committee to decide whether those are the right graduations, but that the exemption under the current C corporation statute only excludes the first $25,000 of income. One reason a less aggressive tax than the corporate tax is sought is that many larger companies and publicly traded companies are going to be under the C corporation tax. A larger company probably has a greater ability to weather the storm in down years with a tax than would a much smaller company. REPRESENTATIVE GARA reiterated that the first $200,000 is tax- free and then the tax starts at 5 percent for income over $200,000. At $500,000 the tax goes to 7.5 percent and at income above $1 million it caps out at the current corporate tax rate of 9.4 percent, whereas the current corporate tax rate is 9.4 percent at income above $222,000. He noted that the bill's effective tax rate is even lower because, like the corporate tax, it is deductible from federal income tax. Thus, under this bill the effective payment may possibly be 20-39 percent lower. For example, a 9.4 percent tax would be closer in effect to about 6 percent tax because it is deductible from federal tax. 4:29:10 PM REPRESENTATIVE GARA pointed out that there is one exception to what he has said so far - Alaska has a separate corporate tax for oil and gas producers and pipeline owners [slide 17]. If it is a C corporation it pays the 9.4 percent tax at $222,000. Under current law, an oil and gas producer or a pipeline owner that is formed as an S corporation or as an LLC avoids the corporate tax. He said SSHB 36 would put all companies that are inside the state's oil and gas corporate tax into the existing corporate tax structure - an oil and gas producer formed as an S corporation would be treated as a C corporation. That tax has a different definition on income than the corporate tax for all non-oil and gas companies. He noted that under the bill, if [Hilcorp Alaska, LLC], the fourth largest oil and gas producer in the state, made profits it would be subject to the existing oil and gas corporate tax, while currently it is not. REPRESENTATIVE GARA said SSHB 36 uses the same definition of taxable income as existing law because he didn't want to create a new definition. He stated: "There is one definition of income for non-oil and gas companies that's based on a multi-state tax compact that's designed so many states don't tax the same income. Income for oil and gas companies will be defined the way it's defined for oil and gas companies; it's a complex formula that is ? referred to as worldwide apportionment." 4:31:29 PM REPRESENTATIVE GARA continued his discussion of how taxable income is defined (slide 19). A few policy calls were made in the bill, he said, and one was whether to tax the business or the individual shareholders. It was decided to levy the tax on the business to minimize the cost of administration for both the business and the state, but primarily to minimize the costs for the businesses and their shareholders. Rather than make each shareholder or each partner pay tax separately, SSHB 36 provides that the business pay the tax on the business's net income. The business can then apportion its net income and the tax paid between its shareholders. REPRESENTATIVE GARA reported that the corporate income tax produces roughly $100 million annually (slide 20), but that the amount of oil and gas corporate income tax produced each year depends very much on oil prices. For example, in 2016 there was a negative amount. It was negative, he explained, because companies pay estimated taxes and by the end of the year the Department of Revenue (DOR) owed money back. The current projections for 2017 and 2018 are about $100 million and $200 million, respectively, as oil prices are projected to rise. 4:33:23 PM REPRESENTATIVE GARA stated that originally the thought was to only cover those corporations that are not covered (slide 21). So, he continued, why does this bill go beyond corporations? Why does it add partnerships? Why does it add general businesses? He explained that as an attorney he could form a law firm as a corporation, which many law firms do. Or, he could form a law firm as a partnership. Or, he could form as a sole proprietorship and hire a number of lawyers. He said that if a law firm took in $10 million in profits, he could not find an answer as to why he should pay a tax if he files as an S corporation but not if he files as a sole proprietorship. It's the same business activity, the same benefits from the state, and the same cost to the state (for example, the court system). He said he therefore doesn't think the form that someone creates a corporation under should determine whether or not that person pays a tax; rather, the activity and the level of profit should determine whether or not someone pays a tax. He added that he cannot come up with a logical reason why he would tax the same business that forms as an LLC differently than a business that does the same exact thing and makes the same exact money as a sole proprietorship, for example. REPRESENTATIVE GARA said much time was spent on ensuring that there would be no double taxation under the bill (slides 22-23). Any income taxed under SSHB 36 would be exempted from a personal income tax if one were adopted in Alaska. The bill is modeled as much as possible under existing law - the definitions of income used in the bill are the same as under existing law. Also, he continued, the bill avoids double taxation in cases where one business owns another business. There would not be a tax on the owner business as well as a tax on the business that it owns. The owning business is already going to be paying taxes on the business that it owns. Additionally, he said, current C corporation law says that if a corporation pays another tax, such as a fishing or mining tax, those taxes are deducted from the company's corporate tax, and this same rule is followed in SSHB 36. REPRESENTATIVE GARA stated that the bill's biggest goal is to make sure everyone is chipping in together (slide 24). The bill is one way to help address the state's $2.8 billion deficit. In looking at the various plans out there, he continued, there are none on the table that would allow legislators to both fill the deficit and return to having a capital budget. A number of different approaches are needed, he said, and it is his hope that as many good ideas as possible will advance forward and people will decide which ones are needed as a fiscal plan. 4:38:38 PM REPRESENTATIVE JOSEPHSON observed that the first bullet on slide 19 states, "To minimize the costs of administration, tax is placed on the business and the individual owners". He further observed that the second bullet on slide 19 states, "Business will apportion taxes based on ownership shares, so that each owner does not have to hire their own accountant". He said the second bullet seems to be the opposite of the first bullet. REPRESENTATIVE GARA replied that the tax would be placed on the business so only one filing would have to be made. If a business had 20 shareholders and the individual was taxed, then 20 filings would have to be made and those 20 different people might have to hire 20 different accountants. When the tax is placed on the business, then the business will apportion taxes based on a person's shares for what the person's net income was and what the taxable portion attributed to that was. Then, each person can figure out his or her federal taxes. 4:39:37 PM REPRESENTATIVE JOSEPHSON said it appears to be in the Gardner memo that Alaska is one of only two states that fully exempt this sort of income. He inquired whether this is correct. REPRESENTATIVE GARA offered his belief that that is correct. He further offered his belief that 41 states have an income tax and business owners pay their share of the income they get from their law firm, oil field services company, or store as an income tax. Some states have both an income tax and a business tax, he advised, and most states that don't have an income tax have some sort of law like SSHB 36 that taxes non-C corporations; they may just tax S corporations and LLCs. He reiterated his earlier statement that he doesn't understand why a state would tax the same business as an LLC but let them avoid taxation if they formed under some other form. He added that he thinks some states go beyond LLCs. 4:40:44 PM REPRESENTATIVE BIRCH expressed his concern that the bill would [create double taxation] and that, in the absence of imposing a statewide personal income tax, an entry-level tax on pass- through businesses would in fact double up. He said the bill needs a lot more work because he is very concerned about cranking up the taxes when [the legislature] is not making the budget reduction that needs to be done. REPRESENTATIVE GARA answered that much care and work has been taken to ensure there will be no double tax under the bill. "If an income tax were to be adopted," he explained, "the income that you pay under this tax would not be subject ? to the income tax." He pointed out that this provision is on page 2, starting on line 5. He added that SSHB 36 also avoids the other possible double taxation issue of an entity that owns another entity that would be taxed under this bill. He said he understands the concern of whether members believe people should be paying taxes, but that there is no double taxation under SSHB 36. 4:42:29 PM CHAIR KITO turned to invited testimony. 4:42:56 PM JOHN LETOURNEAU, Certified Public Accountant, Thomas, Head & Greisen, PC, stated he doesn't have prepared testimony, but, per the sponsor's invitation, he is before the committee to answer questions on SSHB 36 as a person who is a practicing certified public accountant (CPA) and involved in preparing income tax returns for C corporations, S corporations, LLCs, and sole proprietorships. 4:43:32 PM REPRESENTATIVE BIRCH posed a scenario of a group of attorneys that have an S corporation. He asked whether the tax return would roll down to where it would be individually accountable to each partner. MR. LETOURNEAU replied yes. He posed a scenario of a group of attorneys that choose to form a corporation and do business as an Alaska for-profit corporation that elects to be taxed as an S corporation. The attorneys as shareholders would be allocated a share of the taxable income of the S corporation, he said, and they would report that on their federal income tax return. If the attorneys were residents of the state of California, they would also pay tax on their share of the income to the State of California. If the attorneys were residents of Alaska and all the operations of the law firm were in the state of Alaska, there would be no income tax on the profits of the law firm. 4:44:50 PM REPRESENTATIVE KNOPP surmised that the focus is really on taxing S corporations. He asked whether the multi-national companies operating in Alaska, such as Tesoro, Walmart, or Fred Meyer's would be C corporations subject to taxation under the structure currently in place. MR. LETOURNEAU responded yes and offered his belief that the most common form of business organization for a large multi- national entity is to be taxed in the U.S. as a C corporation. However, he pointed out, certain transportation companies in the oil and gas industry public pipelines have elected to be organized as limited liability companies (LLCs). They would not be taxed under the C corporation rules for income tax, but they might be taxed under the special oil and gas rules. REPRESENTATIVE KNOPP posed a scenario of an oil and gas company doing business in Alaska as an S corporation that the state does not tax. He inquired whether an S corporation or an LLC might consider changing to a C corporation should SSHB 36 pass. MR. LETOURNEAU answered that it is possible for an organization to make different tax elections. However, in his experience, an organization that would consider that would be driven largely by the federal tax implications first and foremost and then they would consider the state tax implications. So, he continued, it would be unusual for an entity that had elected to be an S corporation for federal income tax purposes to elect to change to a C corporation simply as a result of this proposed statute. But, he added, any analysis would be very company specific. 4:47:40 PM REPRESENTATIVE WOOL recalled [slide 6] says 9,000 C corporations [do pay tax] and [slide 4] says 9,000 S Corporations [do not pay tax]. He asked whether those numbers are a typographical error or a coincidence. LAURA CHARTIER, Staff, Representative Les Gara, Alaska State Legislature, confirmed the numbers are correct. She pointed out that the fiscal note repeats those same data points. Out of the 18,000 corporations, roughly half are C corporations and roughly half are S corporations, which is the federal designation. REPRESENTATIVE WOOL remarked that it is a funny coincidence and seems like a lot of corporations for a state with less than a million people. He recalled that Alaska had an income tax prior to 1980 and inquired whether it is correct that all these entities would have paid state tax through their income tax and so this corporate tax was not necessary. REPRESENTATIVE GARA replied that this exemption didn't exist before 1980 because all the non-C corporations distributed their profits to their owners and then their owners would pay the income tax on that share of their profits. When the income tax was eliminated in 1980, he continued, the state did not impose a business tax and so that left C corporations taxed and all other business and corporate forms untaxed other than the $50 license fee. He asked Mr. Letourneau whether this is something that an accountant could do for a business if SSHB 36 were to pass as currently written. MR. LETOURNEAU offered his belief that, yes, an accountant could file the tax return based on this bill. Based on how it is set forth in the bill, he said he would anticipate that the Department of Revenue (DOR) would issue regulations and forms, which he doesn't think would be tremendously different than the forms and regulations governing C corporations. He stated that accountants already deal with taxation of C corporations, LLCs, S corporations, and sole proprietorships, and therefore he doesn't think this is something an accountant would have a hard time helping clients and taxpayers comply with. 4:50:54 PM REPRESENTATIVE GARA said his concern is that a C corporation might say the tax is lower under this new bill and might decide to become an S corporation but recalled that Mr. Letourneau had responded that that would be difficult. He asked Mr. Letourneau to address C corporations becoming S corporations. MR. LETOURNEAU answered that the Alaska state corporate income tax is adopted by reference to the Internal Revenue Code (IRC). There is a provision that if a C corporation elects to become an S corporation it is considered a prospective election with the possibility that the C corporation could pay a toll charge. It is referred to as a toll charge in the applicable Alaska statute. It's called a built-in gains tax, he continued, and is a tax that Congress has chosen to levy when a C corporation chooses to change its form of organization. This would present a substantial issue for any C corporation thinking that it could change to an S corporation. He further pointed out that S corporations are much more restricted than C corporations in terms of their allowable shareholders, so not all C corporations would have the opportunity to convert to S corporations. 4:53:14 PM MATTHEW GARDNER, Senior Fellow, Institute on Taxation and Economic Policy, provided invited testimony on SSHB 36. He said that most states currently tax the income of both of the broad types of businesses that have been discussed C corporations through the corporate income tax and pass-through corporations through the personal income tax. Nine states depart meaningfully from this, he continued, and within that there are two states that exempt all the income of pass-through entities while fully taxing the income of C corporations. Those two states are Alaska and Florida. MR. GARDNER explained that in the 42 states with both types of taxes, the main concern of policymakers about the relationship between these two types of business taxes is whether the tax system is prompting businesses to make their entity choices based on the tax rules. If there is a big gap between the personal corporate income tax rate and the corporate income tax rate, are companies, going to change their entity form based only on tax reasons? In most states and at the federal level this isn't really a concern, he said. Where this concern crops up most is in exactly the situation that Alaska finds itself in now and has found itself in for the last 30 years, which is that Alaska has a corporate tax rate that tops out around 9 percent and a pass-through business tax rate of 0 percent. MR. GARDNER recounted that 15 years ago a deputy revenue commissioner argued that in a place with no state income tax a person would be an idiot to start up a C corporation. He said he thinks that is overstating things because there are non-tax reasons, regulatory reasons in particular, why businesses choose the entity that they choose. The federal tax system is a much bigger driver to the extent tax rates matter at all. MR. GARDNER noted, however, that other things equal there is still a clear incentive in place in Alaska for companies to shift toward the pass-through form. He said SSHB 36 would reduce that incentive by narrowing the gap between the 0 percent rate that currently exists on pass-through businesses and the 9.4 percent top marginal rate that currently exists on C corporations. The proposed bill wouldn't end that incentive because the rates aren't exactly equal between the two, but it would sharply reduce that incentive. The main benefit of the proposal, he continued, is that it would get the state of Alaska closer to the principle of tax neutrality where individuals and businesses make their investment decisions based on the economic merits of those choices rather than making those decisions purely or even primarily for tax reasons, which is the main point that he wanted to add to the discussion. 4:57:11 PM REPRESENTATIVE JOSEPHSON inquired whether a corporation, such as Coca Cola, that is nationally a C corporation could pursue a different structure within Alaska. MR. GARDNER replied that such a corporation could not. The choice of entity for a multi-national company like Coca Cola is a monolithic choice and it is going to be made primarily for reasons having to do with the federal tax laws and with the other regulatory framework within which these companies operate. 4:58:04 PM CHAIR KITO stated that public testimony on SSHB 36 would be taken on [April 3, 2017]. He noted that the public can also provide written comments via email, letter, or other means to his office and those would be included in the committee packet.