This is becoming an issue among our members so let’s address it.  There are auditors that are saying it is not allowable. Some say to exclude out of the G&A Pool. Some say that the state taxes are to be included in the G&A base.

 

It may get a bit complicated but try to follow the logic. This is a more advanced issue than discussed in our class but let’s have at it!  Please review the entire discussion to see the issues that affect allocation of these costs.  Also, please note that comments in Blue are my opinion and interpretation for reference and not a part of government documented guidance.

 

Are State Income or Franchise Taxes Allowable?  Yes, Generally, Subject to guidelines.  That’s the simple answer.  Now for a few details…

 

Unallowable Taxes (as referenced in the auditors DCAAM 7640.1)

a.      FAR 31.205-41(b) states that the following types of taxes are expressly unallowable as costs under Government contracts:

1.    Federal income and excess profits taxes.

2.    Taxes in connection with financing, refinancing, or refunding of operations, or reorganizations (see also FAR 31.205-20 and 31.205-27).

3.    Taxes from which exemptions are available to the contractor directly or available to the contractor based on an exemption afforded the Government, except when the contracting officer determines that the administrative burden of obtaining the exemption outweighs the benefits accruing to the Government (see FAR Part 29).

4.    Special assessments on land that represent capital improvements.

5.    Taxes (including excises) on real or personal property or on the value, use, possession or sale thereof, which is used solely in connection with work other than on Government contracts (see also 7-1403.1a below).

6.    Taxes on accumulated funding deficiencies of, or prohibited transactions involving, employee deferred compensation plans pursuant to Section 4971 or Section 4975 of the Internal Revenue Code of 1986, as amended.

7.    Income tax accruals designed to account for the tax effects of differences between taxable income and pretax income as reflected by the books of account and financial statements (see also 7-1403.4a below).

 

Notice that State Income or Franchise Taxes Are Not Listed.

 

b. Contractors that elect Subchapter S Corporation tax status are not taxed at the corporation level and thus are not normally required to pay state or local income taxes or to accrue such tax liability. Instead, the corporate income passes through to the shareholders and is taxed on the shareholders’ personal income tax returns. Accordingly, state and local taxes that are passed through to the individual shareholders are not an expense of the corporation and as a result, are not allowable costs under Government contracts. Auditors should ensure that contractors who have elected Subchapter S tax status, or any other tax status (e.g., Limited Liability Corporation) in which taxes on the pass-through income of the corporation are required to be paid by the individual shareholders, are claiming only those taxes which are required to be paid or accrued by the contractor. Individual shareholder state and local income taxes claimed by the contractor on their pass-through income to the shareholders are unallowable in accordance with FAR 31.205-41, Taxes, and should be questioned.

Notice that if your corporate status results in pass-through income to individual shareholders then you State or Local Income Taxes are generally Unallowable.   They are not corporate taxes.

 

7-1403 State and Local Taxes (as referenced in the auditors DCAAM 7640.1)

State and local taxes, including property, franchise, and income taxes, are allowable contract costs in accordance with FAR 31.205-41. However, if the taxes are paid late or in error, any penalty, or interest on borrowings (see 7-1403.1(e)), assessed by the state or local government is an unallowable cost except in the limited circumstances described in FAR 31.205-41(a)(3)

 

Is that Clear Enough?  They Are Allowable per FAR 31.205-41

 

Watch out thought! It is in the Allocation of State Taxes that issues arise.  Especially if income is generated in more than one state or if there is more than one business segment.  Read on…

 

7-1403.2 Allocation Problems and Methods (as referenced in the auditors DCAAM 7640.1)

a. State income or franchise taxes sometimes present unique allocation problems.

 

So do not automatically assume or accept an audit position of unallowable.  An auditor may not agree with an allocation method but, in my opinion, that should be discussed and resolved rather than the cost deemed unallowable.

 

c. Contractors often include the above discussed taxes, along with other indirect expenses, in an established burden center for allocation to operating divisions located in various states. In reviewing these allocations, the general rule for the auditor to follow is to determine that the amount allocated to operations within a particular state approximates the amount of tax paid to such state. The further allocation of this amount to cost centers or contracts within the state should be made through divisional G&A. However, in those cases where a division is doing business in several states, the auditor may find that more equitable results are obtained by applying the method used by the state in assessing the tax, or through an established burden center of the contractor other than G&A.

 

 

7-1403.6 Special Considerations---Revenue Based State Taxes (as referenced in the auditors DCAAM 7640.1) 

Note: Sections b. and c. below are more applicable to the types of State Taxes under discussion. Section a. is shown for additional information as it may be applicable to some firms.

a. Some state taxes (e.g., New Mexico and Washington) are imposed on the seller, and are computed by multiplying the total revenues (with limited exceptions) received from doing business in the state by the applicable tax rate. There is no legal obligation for the seller to collect the tax from the buyer. For the purpose of Federal immunity, this makes these state taxes different from conventional sales taxes.. If the tax is imposed on the seller and there is no legal obligation to collect the tax from the buyer, then the seller is not exempt from paying state sales taxes on sales to the Government unless there is an express Government sales exemption in the applicable tax code. However, normally the seller has a legal obligation to collect the tax from the buyer. When there is a legal obligation to collect the tax from the buyer, and the buyer is the Government, the sales are exempt from state sales tax as a matter of federal supremacy. State law dictates whether the Government is the buyer or not in transactions involving Government contracts. For example, the Connecticut Supreme Court, applying Connecticut statutes, found that the United States is the actual buyer of personal property sold by third parties to a cost-reimbursement Government contractor because the one who takes title to the property is the United States. It held such sales exempt from Connecticut sales tax. In contrast, services sold by third parties to Government contractors were not exempt since a different statutory test applied and it identified the contractor as the buyer, not the Government. Determinations of whether state and local taxes are allowable contract costs under FAR 31.205-41 must be made on a case-by case basis based on each state’s tax laws. Questions regarding state-law exemptions and federal sovereign immunity should be addressed to the contracting officer’s designated legal counsel because they require interpretations of statutes, regulations, and case law (FAR 29.101).

 

b. Revenue based state taxes are levied on the contractor's revenue from doing business in the state, which generally comprises many contracts. Therefore, the costs incurred by the contractor are not identifiable to specific contracts. Accordingly, the state tax should be distributed to contracts using the contract revenue that is subject to the state tax as the allocation base.

 

c. Revenue based state taxes are overall costs of doing business in the nature of G&A expenses. However, these taxes, if material, should not be accounted for in the G&A pool. Any method of distributing material amounts of revenue based state taxes through overhead, G&A, or any other cost based allocation would be inappropriate, since the taxes are based on revenue rather than cost.

 

Here you have guidance clearly confirming Allowability of State Taxes.  But now you have another aspect to consider when identifying cost in your G&A or similar indirect cost pool.  State Taxes, If Material, SHOULD NOT be in the G&A Pool.  Our class information and references were designed under the assumption that many small firms that are not LLC, Sub S, or other legal forms that use pass-through for income, typically did not have material amounts of state taxes.

 

However, if material, state taxes should be allocated separately, i.e. a separate pool, based on contract revenue subject to the state tax. (see b. above).

 

d. Revenue based state taxes should be included in the total cost input (TCI) BASE for G&A allocation. Exclusion of these taxes through the use of a special allocation under CAS 410.50(j) is inappropriate, since such special allocations apply to final cost objectives, not specific cost elements.

 

Here you have another difference than what would normally be expected.  The guidance states that state taxes, revenue based, should be included in the TCI BASE.  Since these costs are not included in the G&A Pool, and are allocated as a specific cost element, the guidance is indicating that the costs are also part of TCI Base.  So,

 

(1) Out of G&A Pool,

(2) Included in the G&A TCI Base and,

(3) Allocated to contracts based on contract revenue subject to the state tax.

 

Note: As a result of including the State Tax in the G&A TCI Base, it seems one should add G&A on top of the State Taxes prior to allocating the costs to contracts.  This would follow the DCAA guidelines that a cost is to carry its’ fair share of related costs.  In this case, since state taxes are in the G&A base and excluded out of the G&A Pool, then G&A must be added to state taxes to ensure all G&A Pool Costs are accurately recovered. 

 

So there you have it.  Wow, what a handful!  Now you have reference support for the allowability of State Taxes.

 

Paul Sr.

 

For the more adventurous or larger firm with significant state taxes, or with multiple business segments, more detail on this and other formulas are available in the DCAAM 7640.1 7-1403.

 

 

The DCAAM 7640.01 7-1403 excerpted example below shows how one Large Firm with over $11,000,000 in State Taxes allocated their Taxes to Segments before including the cost in a pool to allocate to contracts follows.

 

 

a. A company has a California Franchise Tax expense of $11,000,000 and five segments --- A, B, C, D, and E with property, payroll, and sales of:

 

 

SEGMENTS

A

B

C

D

E

TOTAL

(in millions)

 

PROPERTY:

 

Total

$1,500

$ 800

$ 600

$ 400

$ 200

$3,500

Calif.

750

720

600

100

20

2,190

Calif. %

50%

90%

100%

25%

10%

62.6%

PAYROLL:

 

Total

$ 700

$ 300

$ 250

$ 100

$ 80

$1,430

Calif.

280

240

250

30

8

808

Calif. %

40%

80%

100%

30%

10%

56.5%

SALES:

 

Total

$2,000

$1,000

$ 800

$ 600

$ 300

$4,700

Calif.

600

800

760

240

45

2,445

Calif. %

30%

80%

95%

40%

15%

52%

AVG CALIF. %

40%

83.3%

98.3%

31.7%

11.7%

57%

                 

 

 

 

The five segments had the following net income (loss): (in millions)

Segment A

$(200)

Segment B

125

Segment C

180

Segment D

90

Segment E

20

Total Net Income

$ 215

 

 

 

b. Lockheed Two-Step, Four-Factor Method: The ASBCA and the Federal Circuit Court held that Lockheed's two-step, four-factor formula complied with CAS 403.40(b)(4).

 

·         The first step entails calculating each segment's net income derived from or attributable to a particular state's sources (e.g., California sources) using the ratio of in-state property, payroll, and sales, to total property, payroll, and sales for the segment.

 

·         In the second step, Lockheed totals individual segment net income derived from or attributable to profitable in-state sources and then assigns taxes only to each profitable segment in the proportion that the segment's profits bear to total profits. Segments with no net income get no allocation and segments that do get allocations get them based upon relative profitability.

 

 

 

 

STEP 1: (in millions)

 

 

Segment net income (loss)

Segment apportionment %

Segment net income from Calif. sources

 

Segment A

$(200)

X

40%

=

$0*

Segment B

$125

83.3%

$104

 

Segment C

$180

98.3%

$177

 

Segment D

$90

31.7%

$29

 

Segment E

$20

11.7%

$2

 

Total

                                                         $312

 

*Note: Credits are not permitted, therefore segments with losses always are assigned $0 income.

 
                 

 

STEP 2: (in millions)

 

Total Tax

Segment Contribution

Allocation

 

Segment A

$11

X

0

=

    $0

 

Segment B

11

104/312

$3.67

Segment C

11

177/312

$6.24

Segment D

11

29/312

$1.02

Segment E

11

2/312

$  .07

                                                                                        $11.00

 
               

 

 

 

END