NPT components of EIT

Township of Lower Merion

Earned Income Tax

Analysis of Net Profit Tax Component

by Ronald G. Henry

September 26, 2002

The following provides more detailed background on the net profits tax (“NPT”) component of Pennsylvania’s Earned Income Tax (“EIT”), and its applicability to the Township of Lower Merion. Specifically, it provides answers to the following questions:

· Which types of corporations or business entities does the NPT apply to?

· How does the NPT work for a current business which now pays the business privilege tax (“BPT”) or mercantile tax (“MT”), as to the prospect of double taxation, offset, etc.?

NPT Overview

Local governments are authorized to impose a net profits tax under the provisions of the Local Tax Enabling Act (53 P.S. §6901). According to the Pennsylvania Department of Community and Economic Development (“DCED”):

The tax is levied on the wages, salaries, commissions, net profits or other compensation of persons subject to the jurisdiction of the taxing body. Municipalities and school districts levying earned income taxes may exempt persons whose income from all sources is less than $5,000 per year from the earned income tax.[1]

….

Section 13 of the Local Tax Enabling Act establishes uniform definitions for earned income, net profits, domicile and other terms. These definitions supersede any omission or contrary definitions in any local tax ordinance or resolution adopted under the Act. The definitions are designated as exclusive, and political subdivisions are prohibited from altering or changing the definitions.[2]

Rather than two separate taxes, the EIT and the NPT in reality is a single tax applied with respect both to personal earned income and to the net profits of individual- and partnership-owned businesses.

Application of the NPT

In general terms, the most important factors which should be taken into account in considering the NPT are that it applies only to “persons,” and the definition of “net profits.” The Local Tax Enabling Act defines “net profits” as:

The net income from the operation of a business, profession, or other activity, except corporations, after provision for all costs and expenses incurred in the conduct thereof, determined either on a cash or accrual basis in accordance with the accounting system used in such business, profession, or other activity, but without deduction of taxes based on income.[3] [emphasis added]

In comparison, the same statute defines “earned income” as:

Salaries, wages, commissions, bonuses, incentive payments, fees, tips and other compensation received by a person or his personal representative for services rendered, whether directly or through an agent, and whether in cash or in property; not including, however, wages or compensation paid to persons on active military service, periodic payments for sickness and disability other than regular wages received during a period of sickness, disability or retirement or payments arising under workmen's compensation acts, occupational disease acts and similar legislation, or payments commonly recognized as old age benefits, retirement pay or pensions paid to persons retired from service after reaching a specific age or after a stated period of employment or payments commonly known as public assistance, or unemployment compensation payments by any governmental agency or payments to reimburse expenses or payments made by employers or labor unions for wage and salary supplemental programs, including, but not limited to, programs covering hospitalization, sickness, disability or death, supplemental unemployment benefits, strike benefits, social security and retirement.[4]

The NPT is assessed on “net” income, and as noted above is calculated after making provision for numerous deductions and exclusions. In general, local tax collectors look to Internal Revenue Service Form 1040, particularly Schedules C (“Profit or Loss From Business”), F (“Profit or Loss From Farming”) and 1065 K-1 (“Partner’s Share of Income, Credits, Deductions, etc.”) to determine appropriate EIT/NPT deductions. Schedule 1065 K-1 relates to Form 1065, which is the “U.S. Return of Partnership Income.”

The EIT/NPT is not a mirror image of the state personal income tax, and although there are many similarities between the two, the differences are significant. For instance, net profits received by a taxpayer as a “pass through” from Subchapter S corporations are not subject to the local earned income tax, and liability for earned income taxes on net profits is to be calculated for each business separately. The rules are every bit as complicated as they are for the business privilege and mercantile taxes.

Relationship Between the Net Profits Tax and the Business Privilege and Mercantile Taxes

A particular question has been raised as to whether Lower Merion taxpayers now paying BPT/MT would be subject to double taxation were the Township to enact the EIT/NPT.

Lower Merion Township imposes a business privilege tax (“BPT”) and a mercantile tax (“MT”) on both resident and non-resident businesses, the exact application depending on a series of qualifications and exclusions relating to such considerations as (but not limited to) the type of business, domicile, and taxes paid to other jurisdictions. Unlike the EIT/NPT, the BPT/MT may be imposed on corporations.

According to DCED, seven municipalities in Montgomery County levy both BPT/MT and the EIT/NPT (Cheltenham Township, East Norriton Township, Lower Gwynedd Township, Borough of Rockledge, Borough of Conshohocken, Plymouth Township and Borough of Norristown). Seven municipalities in Delaware County do the same (Aston Township. Borough of Brookhaven, Chester Township, Borough of Darby, Borough of Media, Borough of Millbourne, and the City of Chester).[5] Restrictions have been imposed by state law to limit more localities from imposing taxes based upon the gross receipts of businesses, and it also sets limitations on the application of such taxes which are currently in effect.[6]

Corporations now paying BPT/MT would not be subject to the net profits tax. As noted above, “pass through” distributions from Subchapter S corporations to individuals also would not be taxable under the EIT/NPT.

It is my understanding that individual business owners generally deduct their BPT/MT payments on Line 23 of Schedule C (“Taxes and licenses”) and partnerships customarily take the same deduction on Line 14 of Schedule 1065 (“Taxes and licenses”), which reduces the net profit of the partnership accordingly (and thereby lowers the partners’ allocated share of net profits). Pennsylvania law does not permit taxes paid on income to be used as a deduction for earned income tax or net profit tax purposes, but does allow other taxes to be deducted. Because the BPT/MT is based on sales rather than income, the BPT/MT is deductible in the determination of net income for NPT purposes. On that basis, there should be no risk of double taxation.

Impact on Township Finances

The August 12, 2002, Assessment of Revenue Options report to the Township’s Acting Manager was based on conservative assumptions, in part due to the absence of detailed data concerning the composition of the Township’s prospective EIT/NPT base. There are, however, several points which may be made relating to the possible impact of the BPT/MT being deductible under the EIT/NPT.

It has been noted above that the EIT/NPT does not apply to corporations; and, as such, Township BPT/MT revenues from that group of taxpayers would not be adversely affected by imposition of an EIT/NPT.

The more serious question is whether the ability of individuals and partnerships to deduct BPT/MT payments would cause Township EIT/NPT proceeds to be lower than has been anticipated.

The Assessment of Revenue Options is based on relatively conservative assumptions, and takes that factor into account in its estimate of probable yield from the EIT/NPT in several ways. The estimates in that report for EIT/NPT proceeds largely were based upon an analysis of information developed from tax collection agencies and IRS data. In the case of EIT/NPT tax collection figures, those amounts already reflect the impact of all allowable deductions, including the BPT/MT to the extent those reporting jurisdictions collect both that tax and the EIT/NPT. The IRS data included only Line 7 of Form 1040 (“wages, salaries, tips, etc.”). Schedules C and 1065 K-1 bring net profit or loss from business activities into Form 1040 at Lines 12 and 17, respectively, and both are inclusive of already-deducted BPT/MT payments.

No weight was given to any EIT/NPT-taxable income from Line 12. No reliable information was identified to show what such an amount might be, and no data were available as to possible deductions which might be made against Line 7 income for such items as unreimbursed employee business expenses. It is likely that the net profit of businesses, and of partners of partnerships, subject to EIT/NPT will at least equal (and most likely exceed) those deductions.