The average Pennsylvania family makes $50,702 a year and pays roughly $1,556 in state income taxes.

Corporations that make millions of dollars in Pennsylvania often face a far lower state income tax bill.

In fact, 71 percent pay nothing at all.

Some companies don't make a profit, so they don't owe state tax.

But other corporations — including many household names — avoid paying Pennsylvania's corporate net income tax by shifting profits to subsidiaries in states with special tax exemptions, like Delaware.

Taking advantage of the so-called "Delaware loophole" is perfectly legal. Experts say it's simply a smart business strategy employed by countless large, multistate corporations.

"If I were a corporate tax counsel who didn't suggest this, I would be fired," said Dr. Joseph J. Galante, a Millersville University professor of accounting, taxation and business law. "It's legal. Why wouldn't you do it?

"Whether it's ethical or not is a different story."

As the recession drags on and the state's new budget comes with deep spending cuts and the potential for hundreds of layoffs, experts estimate that corporate tax avoidance costs Pennsylvania $450 million annually in lost revenue.

Critics also claim that corporations that don't pay state income tax leave smaller businesses and families to shoulder a disproportionate share of the tax burden.

Corporations have major incentive to avoid the corporate net income tax. At 9.99 percent, Pennsylvania's tax rate is the second highest in the nation.

Pennsylvanians of all political persuasions agree that the state's business-tax system is broken — and especially that something must be done to lower the corporate tax rate.

The agreement ends there.

Since 2004, Gov. Ed Rendell has tried to pass a tax-reform package that includes a measure called combined reporting, which he said will close the loophole, lowering the tax rate for all corporations, recovering lost state revenue or both.

Currently in Pennsylvania, a corporation and its subsidiaries must file separate state tax returns. This allows corporations to avoid paying the state income tax by shifting profits to out-of-state subsidiaries, called passive investment companies.

Combined reporting, adopted by a growing number of states, attacks passive investment companies and other corporate tax-avoidance strategies.

The reform requires a corporation and all of its subsidiaries to file a single tax return in each state where it does business. How much tax the corporation owes in each state depends on the amount of profit acquired within its borders.

"We could lower the tax rate for all corporations by closing that loophole and having everyone pay their fair share," Rendell spokesman Gary Tuma said. "The state could gain a little extra revenue, which we need in these economic times."

But critics — with state and local chambers of commerce among the most vocal — argue that combined reporting would deal another blow to the state's already shaky business climate and encourage corporations to leave Pennsylvania, taking jobs with them.

Gene Barr, the Pennsylvania Chamber of Business and Industry's vice president of government affairs, said combined reporting is an overly complex system that will raise taxes, threaten jobs and bring in an uncertain amount of revenue.

"It's another hurdle, another roadblock for economic development ... in Pennsylvania," he said.

Supporters of combined reporting contend that it's unfair for large corporations to avoid taxes, while small businesses and individuals must pay what they owe.

The current tax system is especially unfair, they say, to the thousands of corporations that do pay the 9.99 percent rate.

State Rep. Mike Sturla, a Lancaster Democrat, said corporations that do business in Pennsylvania — using the state's roads, schools, courts and other infrastructure — should pay state income taxes.

"Pennsylvania-based corporations ... pay taxes in this state," he said. "If you're a [multistate] corporation, you don't. That's what this is all about. ...

"It's absolutely an issue of fairness."

Megan DeSmedt, state director for PennPIRG, a public-interest research and advocacy group, said the current tax system puts small businesses at a disadvantage, forcing them to compete against companies that don't pay the corporate income tax.

"They can't afford to pay fancy accountants. They have to pay the taxes they owe," she said of small businesses. "The idea that we're giving a handout to these larger corporations is outrageous."

As more states move to enact combined reporting, the Pennsylvania proposal ran into another roadblock late last month.

The governor and Legislature agreed to a budget for the next fiscal year, and combined reporting did not make the final cut.

Welcome to Delaware
Critics describe Pennsylvania's overall business climate as unfriendly, with an out-of-date corporate tax system among the chief complaints.

"Pennsylvania has one of the worst corporate tax structures in the world," the state chamber's Barr said.

Measured against other states, Pennsylvania has high worker compensation costs and property tax burdens. It is one of the few states where corporations pay a capital stock tax, which is based on their value and calculated using millage. The tax is being phased out, though more slowly than originally intended.

Pennsylvania's corporate income tax rate is 60 percent higher than the national average of about 6.23 percent, according to data from The Tax Foundation, a Washington, D.C.-based tax research group.

The state's tax rate was actually higher — 11.99 percent — just 15 years ago.

A company's state tax bill depends on how it is organized. Only C corporations, which may have an unlimited number of owners, are subject to the corporate income tax. All publicly traded companies are C corporations.

Owners of more closely held, often smaller, businesses, such as limited liability companies, partnerships and S corporations, pay the personal income tax rate of 3.07 percent on any profits.

Pennsylvania's corporate income tax rate is so high in part because so few companies actually pay the tax, said Stephanie Weyant, spokeswoman for the state Department of Revenue.

"Pennsylvania is missing out on revenue it should be collecting, and there's really not much the department can do about it," she said.

In 2005, the department's most recent figures, 71.3 percent — or nearly 95,000 — Pennsylvania C corporations paid no state income tax.

Weyant estimates that about 45 percent of those companies broke even or lost money, so they didn't owe any tax.

But an unknown number of others avoided the tax by shifting profits to passive investment companies in states with favorable tax laws, she said.

Delaware is known as a business-friendly state, with strong trademark protections and a favorable court system.

In the late 1970s, Delaware enacted legislation aimed at attracting the banking industry, said Michael Mazerov, a senior fellow with the Center on Budget and Policy Priorities, Washington, D.C.

One provision made any income related to intangible assets, such as patents, copyrights and trademarks, exempt from taxation.

Savvy large, multistate corporations soon established Delaware holding companies, some consisting of little more than a post-office box, with few or no employees.

To legally shift their income, corporations transfer ownership of intangible assets to these passive investment companies.

Corporate locations in other states, such as Pennsylvania, pay the passive investment company a substantial sum to use the assets, which could be a mascot or "secret" recipe.

The shift effectively reduces or eliminates the corporation's taxable income — and thus its tax liability — in Pennsylvania. It has no effect on the corporation's federal tax bill.

David Nace, executive vice president of Wickersham Construction & Engineering, a Lancaster C corporation, said smaller Pennsylvania-based businesses generally lack the resources to take advantage of tax-avoidance strategies like passive investment companies.

"Big companies have options small companies don't," he said. "We just get to follow the rules and pay our taxes. We're not going to change the rules."

'Nothing wrong or illegal about it'
Passive investment companies are standard practice for large, multistate C corporations with solid legal counsel, said Dean Glick, vice president of corporate tax for The High Cos., a Lancaster-based S corporation.

"The tax system we have says there's nothing wrong or illegal about it. I'd go so far as to say it encourages it," he said. "If you're paying 9.99, you'll do whatever you can to drive it down. ... These people are just doing what makes good business sense."

The exact number of passive investment companies is unknown. In 1998, Mazerov estimated there were at least 6,000 in Delaware, with an additional 600 -800 established each year.

A corporation does not have to identify a subsidiary as a passive investment company. Corporate tax records are confidential and exempt from freedom-of-information laws.

Mike Cortez, vice president and general counsel for Sheetz Inc., an Altoona-based C corporation, said passive investment companies are legitimate tax-planning devices that should not be vilified.

"It's sometimes called a 'loophole,' " he said. "That's just wrong. It's no more of a loophole than deducting your mortgage interest is. It's the way the tax system is set up."

In fact, the tactic is so above-board that several sources interviewed for this story said state officials advise corporations that are leery of Pennsylvania's high corporate income tax to contact an attorney or accountant about setting up a passive investment company.

The identities of some corporations with passive investment companies have emerged in recent years, as states challenge corporations in court.

Evidence disclosed shows that a single corporation's tax-avoidance strategies can cost states significant revenue.

A 1993 South Carolina case revealed that Toys R Us shifted $55 million to its passive investment company, Geoffrey Inc., by charging stores to use the Toys R Us name, trademarks and "merchandising skills," Mazerov reported.

A 2002 North Carolina case showed that passive investment companies of The Limited Brands, which includes Victoria's Secret, Express and Lane Bryant, earned $949 million in royalty income in two years by licensing trademarks to stores, he wrote.

So far, Mazerov said, Pennsylvania has not challenged passive investment companies or other corporate tax shelters in court.

The Pennsylvania Department of Revenue has audited companies, disallowed expenses for certain payments made to passive investment companies and issued tax assessments, Weyant said.

Some companies have appealed the assessments, but the cases were settled before reaching court.

Attacking the 'loophole'
Besides court challenges, a growing number of states are taking legislative aim at corporate tax avoidance.

Twenty-three states have adopted a combined reporting system, which combats a number of tax-avoidance strategies, including Delaware holding companies.

Since 2004, seven states have enacted combined reporting, an increase of nearly 50 percent. Several other states have passed more specific laws directly targeting passive investment companies.

In 2004, Rendell convened a 12-member bipartisan business-tax reform commission. The panel's eight recommendations included reducing the corporate income tax to between 6 and 7 percent, eliminating the capital stock tax and adopting combined reporting.

High's Glick, who served on the commission along with Cortez, said the recommendations were intended as a package. But so far, Glick said, the state has fully implemented just two.

"We were able to get comfortable with combined reporting as one element of a plan," he said. "We didn't support it... [without] the other seven choices."

The governor's latest combined-reporting proposal, introduced in February, would have lowered the corporate tax rate to 8.99 percent and put any additional revenue toward a state budget shortfall, Tuma said.

Rep. David Levdansky, who chairs the House Finance Committee, has introduced at least three combined reporting bills since 2004. Only one made it out of the committee.

Levdansky, a Democrat who represents Washington and Allegheny counties, blames his stalled proposal on successful lobbying by big business.

He calls passive investment companies "an outrageous scheme.

"It's a big paper chase, is what it is. It doesn't produce anything of value," he said. "But it certainly does lower the taxes a company owes Pennsylvania."

Supporters say combined reporting would be a significant step in the right direction, but they acknowledge that further reform would be needed to improve the state's business climate.

The revenue department supports combined reporting because it would eliminate abuse and create a more equitable tax system, Weyant said.

Galante, the MU professor, said corporate tax avoidance leaves small businesses and individuals with disproportionately higher tax bills.

"There's no fair, and there's no share," he said. "Whatever they (small businesses and individuals) make is going to be taxed."

Sharon Ward, director of the Pennsylvania Budget and Policy Center, Harrisburg, said leaving other businesses and individual taxpayers to shoulder the costs of public services is "not a good economic development strategy."

Former state Secretary of Revenue Tom Wolf, now chairman and CEO of The Wolf Organization Inc., a York-based C corporation, said combined reporting would fairly apportion the tax among all businesses.

"If you're taking advantage of things a democratic government does for its citizens, you ought to pay your share," said Wolf, who served as secretary from 2007-2008. "Everybody would pay a little, instead of a few people paying a lot."

Winners and losers
Opponents of combined reporting argue that it would deal another blow to Pennsylvania's business climate.

Most, like Republican state Sen. Lloyd Smucker, recognize a compelling need to reform the state's business tax structure. But Smucker said combined reporting would amount to a "backdoor tax increase" for businesses that are already struggling.

"In theory, combined reporting would redistribute the tax burden," he said, via e-mail. "In practical application, it would increase the tax burden overall and prove an accounting and enforcement nightmare."

Opponents cite general confusion, reams of paperwork and the possibility of costly litigation over how to combine parent companies and subsidiaries, and allocate the taxes they pay.

"Combined reporting is a tax system that would tax our department of revenue," Lancaster Certified Public Accountant Russell P. Wickrowski said. "They can hardly handle what they're doing now."

(Weyant said the department can administer combined reporting with an additional $1.5 million.)

Glick, of The High Cos., said combined reporting is not just a simple tweak but an entirely new tax system with a steep learning curve.

"It's anything but simple," he said. "The simpler you can make a tax system, the more people are going to like it."

Barr, of the state chamber, said if combined reporting is enacted, large corporations that could no longer avoid the 9.99 percent tax would go to other states, taking significant numbers of jobs with them.

"It's a business tax increase at a time when we can least afford to take money out of the private sector," he said. "Job creation should be the first priority. ... This works against that."

But Ward, of the budget and policy center, said nearly all of Pennsylvania's largest for-profit employers, including Wal-Mart Stores Inc., Giant Food Stores and United Parcel Service, already operate in combined-reporting states.

According to U.S. Bureau of Labor Statistics data, just eight states increased manufacturing jobs from 1990 to 2008. Seven of those are combined-reporting states.

Lancaster Certified Public Accountant Steven J. Geisenberger said some companies would pay less in taxes under combined reporting. But others, including some without passive investment companies, could pay more, depending on how the tax is apportioned.

"I just don't think it's a panacea," said Geisenberger, a partner with Walz, Deihm, Geisenberger, Bucklen & Tennis, who serves on the local chamber's taxes and fiscal policy committee. "There's winners, and there's losers."

Small businesses that provide goods and services to larger corporations could be among those losers, he said.

Businesses that don't pay the corporate income tax still make significant contributions to the state's economy, Geisenberger pointed out. They pay property taxes and collect sales taxes. Their employees pay taxes.

Opponents of combined reporting call for everything from spending cuts to a uniformly applied tax as alternatives.

Wickrowski, a partner with Reinsel Kuntz Lesher, who also serves on the local chamber committee, said combined reporting is too heavy-handed an approach to closing the Delaware loophole.

He and other accounting professionals said passing a law aimed directly at Delaware holding companies would be a far simpler strategy.

But Mazerov said passive investment companies are just one tax-avoidance technique large, multistate corporations employ.

Only combined reporting also effectively counters other common tax-sheltering tactics, such as captive real estate investment trusts, he said. The U.S. Supreme Court has twice upheld its legality.

"If you try to attack them one by one, you're always going to be one step behind lawyers and accountants trying to figure out new ways [to avoid paying taxes]," Mazerov said.

What's next?
Rendell's spokesman, Tuma, said it's unlikely that a combined reporting bill will pass the General Assembly before the governor leaves office next winter.

But the debate shows no sign of ending.

Republican gubernatorial candidate Attorney General Tom Corbett calls combined reporting "bad for business" and "one of the biggest job crushers Pennsylvania has seen."

His Democratic opponent, Allegheny County Chief Executive Dan Onorato, says only that he is committed to studying business-tax loopholes.

The candidates agree that lowering the corporate tax rate is crucial to making Pennsylvania more competitive.

Rep. Levdansky said he will keep trying to pass a combined reporting bill.

"At some point," he said, "the public is going to look at this and say, 'This is outrageous, and it ought to stop.' "

mschweigert@lnpnews.com