Don’t be surprised by state excise taxes

Starting a new business brings its own set of challenges, not the least of which involves navigating the complex landscape of the multitude of taxes you may face.  One overlooked tax regime is state excise taxes.  When businesses are formed, many founders obsess about income taxes and are caught off guard when they learn they have another tax liability despite losing money in some cases.

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Excise taxes are assessed on specific business activities or aspects of a business, such as net worth or gross receipts, and they can significantly impact a business's financial planning. Being prepared for these taxes will help with cash flow planning but also buy time to explore little-known strategies.  

Entity type matters

Understanding state excise taxes requires looking at specific examples across different states, which can vary significantly in how they are assessed and what they target.  To make it more confusing, states have different rules for different entity types.  In some states, S Corporations act more like C Corporations and C corporations face taxes despite massive losses.  When setting up a business, most founders (and many tax strategists) only focus on the federal implications.  While the federal tax situation rightly takes center stage, failure to consider these state-level items can put you in a bind later. 

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The following list will provide examples of the unique taxes states impose on businesses, regardless of their success or failures. 

Massachusetts corporate excise tax

In Massachusetts, the corporate excise tax is particularly noteworthy. This tax combines a measure of a corporation's income and its net worth. The net worth component is calculated at $2.60 per $1,000 of the corporation's tangible property or its total taxable net worth, subject to a minimum tax of $456 each year.  Having practiced in Massachusetts for years, we often hear shock from new clients when we project their excise tax liability as they believe their “loss” status will eliminate all taxes.  Not in Massachusetts! 

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This means that even a small startup with a substantial initial investment in assets (including cash infusions from venture capitalists) could face a considerable tax bill, regardless of whether it has started earning profits. It's important for businesses in Massachusetts to monitor their asset management and valuation strategies to manage this tax burden effectively.

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In addition to the corporate excise tax, Massachusetts also has an S Corporation “sting tax”.  Massachusetts imposes a “sting” tax on S corps where the total receipts are $6 million or more but less than $9 million of 2% on their net income.  If you grow past $9M, this tax increases to 3%.  As an example, an S Corporation in Massachusetts has $7M in sales but only $1M in profit.  In addition to personal income taxes the owners will face in Massachusetts (5%), they will also pay 2% or $20,000 at the S Corp level.  There are some strategies to avoid this but careful planning with tax strategies is necessary. 

Tennessee franchise and excise taxes

Tennessee charges both a franchise tax and an excise tax on businesses. The franchise tax is levied at $0.25 per $100 of the greater of net worth or real and tangible property in Tennessee, with a minimum tax of $100. The excise tax is a 6.5% tax on net earnings derived from business conducted within the state.  This applies to both S Corporations and C Corporations, occasionally catching S Corp owners off guard.  This can substantially erode the tax savings generated at the federal level.

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This dual structure means businesses need to be mindful of both their asset valuation and their income levels. Various planning strategies may include minimizing taxable net worth, possibly by strategic asset sales or depreciation, and maximizing deductible expenses to reduce taxable income, especially close to year-end.

Ohio Commercial Activity Tax (CAT)

Ohio's CAT presents an interesting challenge as it taxes businesses on gross receipts rather than profit. This tax impacts all businesses with taxable gross receipts of more than $150,000 annually.  These tax regimes are particularly difficult as it is difficult to use “sales mitigation” as a tax strategy.  

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The tax starts at $150 for receipts up to $1 million, with a rate of 0.26% applied to receipts above that threshold. This setup can be particularly tough on businesses that operate on thin profit margins, such as restaurants and retail. It is particularly important to have strong bookkeeping practices to ensure sales is accurate and certainly not overstated. 

Washington business and occupation tax (B&O)

Washington is a tax haven...right?  Well, the B&O tax in Washington is another form of gross receipts tax that varies significantly depending on the industry, with rates ranging from 0.138% to 1.5%. Businesses are required to carefully track their revenue by industry category to apply the correct tax rate (which can cause a burden as well). 

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Companies that operate across multiple industries or sectors need to ensure they are not only tracking and reporting their income accurately but also taking advantage of any lower rates or exemptions that might apply to portions of their operations.

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Washington is notorious for deploying their revenue agents into grocery and retail to look for businesses that have not properly registered and paid the annual B&O tax. 

Effective strategies for managing excise taxes

Choosing the right business structure

The type of business entity you choose can significantly impact your tax obligations.  In some cases it may make sense to start as one entity type and convert to your desired entity type later, to mitigate or avoid these excise-based taxes. 

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For example, forming an LLC might offer more favorable pass-through tax treatment and flexibility, avoiding some of the heavier burdens of corporate or S corporation state-level taxation.

Utilizing tax credits and deductions 

Many states offer specific tax credits and deductions that can help offset the cost of excise taxes. 

For example, investment in certain equipment or technology might qualify for tax credits, and hiring practices might meet the criteria for workforce-related deductions.  Particularly, Research and Development Tax credits are offered in multiple states and pair well with startups who are facing these excise tax burdens.

Each state offers dozens of business tax credits that are generally very “targeted”.  Talk with your CPA or tax advisor early in the process to ensure you are capturing and “banking” every available credit.  Even if you do not have a current-year excise tax opportunity, you may need to bank credits for future years. 

The main things to take away about excise taxes

For new business owners, the surprise of state excise taxes can catch them off guard and in some cases, put them in a budget bind.

By understanding the various types of state-level excise taxes, you will be leap years ahead of most business owners who are shocked when the bill comes due. 

Being proactive about your business tax situation can save thousands of dollars per year and give you room to grow your business.  Do not be afraid to reach out to your tax advisor to ensure state-level tax planning is being considered year-round.

The information provided in this article does not constitute accounting, legal or financial advice and is for general informational purposes only. Please contact an accountant, attorney, or financial advisor to obtain advice with respect to your business.

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