Legal Definitions - throwback rule

The throwback rule refers to two distinct concepts in taxation, both designed to prevent tax avoidance by reassigning income or sales to a different tax period or jurisdiction.

1. Throwback Rule (Trust Taxation)

In the context of trusts, the throwback rule is a tax principle that applies when a trust distributes more income to a beneficiary in a given year than it actually earned (or is considered to have earned) in that same year. If the trust has accumulated income from previous years that was not distributed and taxed at the time, the rule treats the excess distribution as if it came from that undistributed accumulated income from those prior years.

The purpose is to prevent beneficiaries from deferring or avoiding taxes on accumulated trust income by receiving large distributions in years when the trust's current income is low. Instead, the distribution is "thrown back" to the years when the income was originally earned and accumulated by the trust, and the beneficiary's tax liability is calculated as if they had received that income in those earlier years, though the tax is paid in the current year.

• Example 1: Large Distribution from Accumulated Income

  A family trust, "The Evergreen Trust," accumulates significant investment income over several years, paying tax on it at the trust's rates. In 2023, the trust has very little current income but decides to distribute a large sum of $100,000 to its beneficiary, Sarah, to help her purchase a home. Only $10,000 of this distribution comes from the trust's 2023 income. The remaining $90,000 is drawn from income the trust accumulated in 2020, 2021, and 2022.

  How it illustrates the rule: Under the throwback rule, the $90,000 excess distribution to Sarah is treated as if it were distributed in 2020, 2021, and 2022, when the income was originally earned and accumulated by the trust. Sarah will pay tax on this $90,000 in 2023, but the tax calculation will consider what her tax rate would have been in those prior years, effectively preventing her from receiving tax-advantaged income that was deferred by the trust.

• Example 2: Timing a Distribution to Lower Tax

  The "Future Generations Trust" has accumulated $50,000 in income over the past five years, which it has not yet distributed. In 2024, the trust earns only $5,000 in current income. The trustee decides to distribute $55,000 to the beneficiary, David, hoping that by distributing it in a year with low current trust income, David might face a lower overall tax burden on the distribution.

  How it illustrates the rule: The throwback rule would apply to the $50,000 portion of the distribution that exceeds the trust's 2024 income. This $50,000 would be "thrown back" to the prior years when it was accumulated. David's tax on that $50,000 would be calculated based on his tax rates in those earlier years, rather than solely on his 2024 tax rate, ensuring that the accumulated income is taxed appropriately and preventing manipulation of distribution timing for tax advantages.

2. Throwback Rule (State Income Tax Apportionment)

In state income taxation, the throwback rule is a principle used by some states to determine where sales revenue should be taxed for multi-state businesses. When a business sells goods or services into another state, states typically "apportion" (divide) the company's total income among the states where it operates, based on factors like sales, property, and payroll within each state.

The throwback rule applies when a sale is made from a company in one state (the "seller's state") to a customer in another state (the "destination state"), but for some reason, the destination state cannot tax that sale. This might happen if the destination state does not have an income tax, or if the selling company does not have a sufficient connection (known as "nexus") to the destination state for that state to impose its income tax. In such cases, if the seller's state has adopted a throwback rule, the sales revenue that would otherwise go untaxed by any state is "thrown back" and attributed to the seller's home state for taxation purposes.

• Example 1: Sales into a No-Income-Tax State

  Apex Manufacturing is based in State A, which has a corporate income tax and has adopted a throwback rule. Apex sells $5 million worth of specialized machinery to customers located in State B, which does not impose a corporate income tax. Apex has no physical presence or employees in State B.

  How it illustrates the rule: Since State B has no income tax, it cannot tax Apex's sales there. Without the throwback rule, this $5 million in sales might escape state income tax entirely. Because State A has a throwback rule, these sales are "thrown back" to State A. This means the $5 million in sales revenue will be included in the sales factor of State A's apportionment formula, increasing the portion of Apex's total income that is taxable by State A.

• Example 2: Sales Without Nexus in the Destination State

  Digital Solutions Inc. operates solely out of State X, which has a corporate income tax and a throwback rule. Digital Solutions sells its software licenses to clients in State Y. While State Y has a corporate income tax, Digital Solutions does not have any employees, offices, or property in State Y, meaning it lacks the "nexus" (sufficient connection) required for State Y to impose its income tax on Digital Solutions' sales.

  How it illustrates the rule: Because Digital Solutions lacks nexus in State Y, State Y cannot tax the income from these software sales. To prevent this income from escaping state taxation, State X's throwback rule dictates that these sales to State Y clients are "thrown back" to State X. Consequently, these sales are included in Digital Solutions' sales factor for State X's apportionment calculation, ensuring that State X taxes the income generated from these sales.