Small Businesses Protest Backdoor State "Activity" Taxes

When Barry Godwin, the comptroller of a South Carolina pleasure boat company, received a call from a New Jersey revenue agent last July, he could hardly believe his ears. A truckload of boats bound for Massachusetts had been stopped at a weigh station, and the agent was demanding $46,200 in "back taxes."

Goodwin's 240-employee company, Stingray Boats, has never had a physical presence in New Jersey. But the revenue agent had determined through a conversation with the driver that Stingray had a "business nexus" with the state because it supplied boats to an independent New Jersey dealer. Therefore, it owed state taxes. It was either pay up or the boats would be impounded, he was told. The company had little choice; it paid.

"The manner in which the State of New Jersey acted is commonly defined as extortion," Goodwin told the House Small Business Committee this week. The hearing was called to examine a trend that is alarming small businesses across the country. A growing number of states are imposing so-called "business activity" taxes on companies that have a connection, or "nexus," with the state. A nexus can exist, even though a business has no employees or physical presence in the state.

Rep Steve Chabot, R-Ohio, the committee's ranking member, said the hearing revealed that the definition of what constitutes "economic activity" left too much room for small businesses' comfort. "These new avenues of commerce have become frequent and favorite targets of overeager tax assessors," he said.

Before 2005, so-called business activity taxes were virtually unheard of. But as the economy has grown slower, more and more states are enacting such measures. About a dozen now impose business activity taxes; the most prominent include Chabot's home state of Ohio and such states as Washington, Michigan, New Jersey, Maine, California, Pennsylvania, and Florida. And the trend is likely to get worse.

According to a new study by the Center on Budget and Policy Priorities, a nonpartisan Washington, D.C.-based research group, at least 25 states are facing budget shortfalls in Fiscal 2009, which begins for most in July. Total figures are unavailable, but 20 of those states so far have reported a collective shortfall of $34 billion. Three more states expect budget shortfalls in Fiscal 2009. Unlike the federal government, the vast majority of states are required by law to enact a balanced budget, and many states are now facing the prospect of cutting services or raising taxes. That makes businesses, particularly small businesses, vulnerable to these levies.

"We don't know what other states will come at us next," said David Rolston, president and chief executive of Hatco, a Milwaukee-based maker of commercial food equipment. His company currently pays a business activity tax in four states, simply because sales representatives and service agents visit businesses there that use its products. According to Rolston, the locals often play hardball.

"One state originally demanded that we pay eight years of back taxes. This would have been significant. Others have threatened penalties," he testified. "Litigation, of course, is impractical for a small firm. We try to negotiate, and then we pay up. We can't pass the costs on, so both the tax payments and, even worse, the administrative costs are off our bottom line."

Administrative costs are a particular problem because different states use different standards to justify taxing an out-of-state business. Some states take the position that a business whose trucks pass through the state six or even fewer times in a year -- without picking up or delivering goods -- has sufficient connections to justify imposing taxes. Other states assert that having a Web site on a server in the state creates a sufficient connection, according to Rep. Rick Boucher, D-Va., who has taken up the cause of small businesses on the issue.

"Currently, no clear national standard exists to define a substantial nexus for the taxation of business activity by the states," Boucher said in a statement. "This uncertainty has allowed some states to impose unfair taxes on businesses which have no physical presence in those states and do not benefit from the services provided by the tax revenue."

Boucher and Rep. Bob Goodlatte, R-Va., who both serve on the House Judiciary Committee, have cosponsored a bill known as The Business Activity Tax Simplification Act. It would require local governments to establish that an out-of-state business benefits from tax-supported services before it can be taxed.

The powerful Consumer Electronics Association (CEA), which represents 2,200 companies, many of them online, has been lobbying for the measure for the past two years. Last year, an identical bill failed in the Senate after it got caught in a legislative logjam. "This developing patchwork of state levies on nonresident firms creates a chilling effect that inhibits commerce and innovation. The burden falls heaviest on small businesses that do not have the resources to contest these ill-founded taxes," says CEA chief lobbyist Michael Petricone.

Although the bill has yet to make it out of Congress, supporters say they have some precedent to rely on. In the 1950s, Congress enacted the landmark Federal Aviation Act to prohibit states from imposing "flyover taxes" on commercial aircraft. More recently, Congress enacted legislation to prohibit taxing Internet access and discriminatory taxes on electronic commerce. But state governments are a powerful lobbying force in Washington, and in the current economic climate, they will not surrender tax revenues lightly.