Legal News and Articles

January 25th, 2012

Written by Thomas Barnes, Esquire

Introduction.  Businesses operating in Pennsylvania, whether organized under Pennsylvania law and based here, or organized in another state and doing business here, are subject to the capital stock tax.  The tax’s name is somewhat misleading, because it applies not only to corporations, but also to limited liability companies and certain other entity types.  The taxed is assessed on a combination of the historical net income and net worth of the entity.  This is a general overview of how the tax is imposed, and on whom.  This is of course not intended as legal advice, and the reader is encouraged to consult counsel about any provision of the law he or she suspects may apply to their business.

General Rules.  Pennsylvania’s capital stock tax is imposed on corporations.  The statute defines the term “corporations” broadly.  Not only are regular business corporations with capital stock included in the definition, but it also defines “corporations” to include joint-stock associations, limited liability companies, business trusts, and other companies doing business within Pennsylvania. § 7601(a).[1]  Limited partnerships are not specifically included in the definition, nor are they specifically included in the list of excluded entities.  Nonprofit corporations are exempt.  Domestic corporations are subject to the capital stock tax while foreign corporations are subject to the foreign franchise tax on capital stock apportioned to Pennsylvania. § 7602.  In this brief summary, we will use the term “corporation” as a shortcut to refer to all these other entities, including corporations.

The capital stock tax for domestic firms is imposed on the corporation’s capital stock value, as derived by the application of a formula. §§ 7601(a), 7602.  Pennsylvania courts have held that the capital stock tax is in the nature of a property tax. [2]

The foreign franchise tax is imposed on out-of-state corporations, LLCs and other entities.  Pennsylvania courts classify it as a tax on the privilege of doing business in Pennsylvania, instead of a property tax. [3]

Computation of the Tax.  The tax is imposed on the capital stock value attributable to Pennsylvania; that is, the assets located in this state and the net income derived in Pennsylvania from the use of Pennsylvania assets.

Both the capital stock tax and the foreign franchise tax are based on two factors, the entity’s average net income and net worth.  For both taxes, the capital stock valuations are computed by using a mathematical formula, which is found in § 7601(a).  However, for the foreign franchise tax, there are reductions to average net income for business done out of state and certain other factors.  § 7401.  The formula is:

(0.5 X [Average Net Income/0.095 + (0.75 X Net Worth]) – $160,000.

The valuation deduction at the end of the formula, $160,000, will remain unchanged until 2014, when the tax expires.  §§ 7602(h), 7607.

Average net income is the average of the last five years’ income, but cannot be less than zero.  § 7601.  If there are less than five years of operating results available, the results that are available are averaged.

Net worth is net stockholders’ or owners’ equity as of the close of the tax year, either as shown on the federal tax return or determined in accordance with Generally Accepted Accounting Principles. § 7601.

Exemptions.  Companies engaged in manufacturing, processing, research or development plant are exempt from the capital stock tax to the extent their net worth is devoted to those activities.  § 7602(a).  For example, a distributor of equipment who also has fabrication operations can exempt that part of its asset base, net of liabilities, which is devoted strictly to fabrication.  § 7602(a).

Both foreign and domestic corporations can use either a single exempt assets factor or a three-factor apportionment to determine the portion of capital stock value attributable to Pennsylvania. Corporations use the exempt assets factor to exclude certain nontaxable assets.

The single-factor apportionment formula refers to one of two formulas utilized by domestic and foreign corporations to determine the taxable portion of their capital stock value under code.  Currently, it is: Taxable assets (total assets-exempt assets) / Total Assets x actual value x 1.89 mils = Tax Due. Both foreign and domestic corporations can use either the three-factor or the single fraction method.[4]

The three-factor apportionment is composed of property, payroll, and sales fractions. Under the three-factor apportionment method, the three factors taken into consideration in arriving at the apportionment factor are: (1) tangible property; (2) payroll, and (3) sales. 72 P.S. § 7401(3)2.(a)(9)-(18). The tax due is calculated by multiplying the apportionment factor by the capital stock value and the applicable tax rate, as follows:

The apportionment factor is the sum of three ratios[5]:

(i)                 Tangible property in PA / Total tangible property +

(ii)               Wages, salaries, etc. assignable in PA / Total Wages, salaries, etc. +

(iii)             Sales assignable in PA / Total sales

The result is divided by 3 to get the average, which is the apportionment factor.  To get the tax due, the apportionment factor is multiplied by the capital stock value and the tax rate:

Apportionment factor X capital stock value X tax rate = tax due.

The tax rate for 2012 will be 1.89 mills, and 0.89 mills in 2013, the last year of the tax.  § 7602(h).

For further information, contact Tom Barnes at (215) 886-6600.