State and local governments are revisiting taxpayer compliance with nexus rules and other tax policies, considering new taxes on digital services, and reconsidering conformity with federal tax rules and legislation in an effort to rebuild their economies. The following is an in-depth look at five key state tax issues that taxpayers should begin considering now.
State "PTE Tax" Elections – Should You?
Individual taxpayers may find state pass-through entity (PTE) tax elections attractive following the enactment of the federal (SALT) deduction cap under the Tax Cuts and Jobs Act of 2017 (TCJA). However, it is important that individuals understand and model the state tax effects of the PTE tax election before making a decision.
Since 2018, 13 states have enacted legislation allowing PTEs (S corporations, partnerships, or limited liability companies taxed as partnerships) to elect to pay income tax at the entity level instead of paying tax on the owners' distributive share of income. These states generally have taken two approaches: Some do not tax the owners at all on their distributive share of income (e.g., Louisiana and Oklahoma), while others do but also provide the owners with a refundable pass-through tax credit (e.g., Maryland, New Jersey, New York state). Some states will only allow PTEs whose only owners are individuals to make the entity-level tax election (e.g., Georgia and South Carolina), while others aggregate corporate and other entity owners' distributive shares and subject the aggregated shares to different PTE tax rates or exclude such distributive shares from the PTE tax base calculation.
Since the IRS announced its intent to propose regulations that state and local income taxes imposed on and paid by a PTE are permitted as a deduction by the PTE and thus are not subject to the $10,000 SALT deduction cap, states and taxpayers alike have shown greater interest in PTE tax elections. As of June 2021, PTE tax election bills are pending in a number of other states, including California, Illinois, Massachusetts, and Michigan.
There are a host of questions that PTE owners must answer before they consider making a PTE tax election, but there are four key questions that PTEs and the owners must ask. How is the PTE's tax base calculated? This varies by state, and the differences can be significant. What are the owner-level reporting requirements — exclude their distributive share of income or loss or include it and get a refundable tax credit? How do you make the election — who is authorized to make the election? Will nonresident members get an "other state tax credit" in their resident state for a share of the PTE tax paid in the PTE tax election state(s) (like they did before the PTE tax election)? The answers to these and other questions must be carefully weighed.
Tax Reform and the States - History Repeating
On March 31, 2021, the Biden administration unveiled a jobs and infrastructure plan that includes a proposed overhaul of the corporate tax system, which will likely mean more challenges for taxpayers at the state level, as has been the case post-TCJA and the CARES Act. In general, states either choose to conform to changes in the federal tax code or to decouple from them. If a state chooses conformity, that state adopts the changes either on a rolling or fixed-date basis. For example, post-tax reform and following the CARES Act, states chose whether to conform to or decouple from the new rules. From early state reactions to 2019 laggards and even 2020 decouplers, the state responses to the TCJA, and then the CARES Act, were varied and complex, including complicated and often confusing state corporate and personal income tax changes, residual effects from federal conformity or decoupling, and modifications or limitations enacted with a state's federal conformity. Future tax reform will likely provoke the same issues for states and taxpayers with regard to state taxation.
In addition, taxpayers are now well into the post-TCJA state income tax return audit cycle. States have begun raising TCJA-focused issues during audit examinations of 2017 and 2018 returns. For instance, so-called state "gap" years, or periods during which state and federal law differ prior to state conformity, may have occurred. Some states treat distributions of previously taxed foreign earnings (global intangible low-taxed income (GILTI) and the transition tax) differently than the federal treatment. States also have been slow to issue guidance on Paycheck Protection Program loans, especially deductions for covered expenses impacting 2020 and 2021 returns. Further, state treatment of business interest expense beginning in 2018, whether conforming or decoupling from federal, is rife with state tax complications, potentially tax-year by tax-year. Because the pandemic forced many state legislatures to adjourn or suspend sessions, a number of states could not legislatively conform or decouple from the CARES Act federal tax changes. Now that state legislatures have returned to their regular legislative sessions, some may retroactively conform or decouple to provisions under the CARES Act.
While taxpayers must consider the possibility of future federal corporate and personal income tax changes, now is also a good time to review open year state tax returns and filing positions for refinements, reconsiderations, corrections, and even refunds related to the states' approach to TCJA, as well as to identify and prepare for potential audit issues.
The Emergence of Digital Advertising Services Taxes
Maryland was the first state to implement a digital advertising services tax. Rather than incorporating it into the Maryland sales tax base, the digital advertising services tax was adopted as a tax on gross revenues and is only applicable to companies with gross revenues of $100 million or more. Almost instantly, large tech companies challenged the new tax, alleging that it violates the Internet Tax Freedom Act, the Commerce Clause, and the Due Process Clause. Originally, Maryland's digital advertising services tax was set to be effective for tax years beginning in 2021. However, the effective date has been delayed until 2022.
Although other states have not enacted a similar tax yet, about a dozen have introduced bills to tax digital advertising services. All will be keeping an eye on Maryland's amended rules, along with the potential judicial outcome, and depending on the result, may tailor their legislation to withstand similar challenges.
Companies that provide digital advertising services should consult with their tax advisor to determine and plan for the possibility of future tax obligations.
Economic Nexus: Remote Sellers and Marketplaces
Since Wayfair, all but one state (Missouri) has implemented a bright-line economic nexus threshold to impose sales tax collection obligations on remote sellers whose sales exceed a monetary or transaction threshold, without regard to the physical presence of the business in the state. As of now, Missouri's governor is expected to sign the legislation into law to create remote seller and marketplace rules.
Retailers that make their own direct sales, as well as sales through a marketplace, should be aware of the timing differences between when a state began enforcing its economic nexus rules for remote sellers and when the state began enforcing its marketplace facilitator rules. Marketplace facilitator laws require facilitators to collect and remit sales tax on behalf of the marketplace sellers that are making sales through the facilitator's platforms. However, if those marketplace facilitator laws have a later effective date than the economic nexus law, then there may be a period of time during which the retailer first established nexus, and the marketplace facilitator is required to collect and remit sales tax. If a retailer exceeded a state's economic nexus rules for remote sellers, it might be liable for sales tax during that period until that state's marketplace rules became effective, which shifts the burden of collecting the tax to the facilitator.
Retailers should review their sales-by-state to determine if and when they exceeded each state's economic nexus rules. They should then check whether they were compliant before that state's marketplace regime was implemented. Retailers should also make sure that they are compliant with any direct sales made through their own websites.
Physical Presence Rules Still Apply
Though there are new economic nexus thresholds in place, the traditional physical presence rules still apply: Having employees or agents doing business in a state and having inventory in a state creates sales tax nexus. For example, retailers can create physical presence nexus by having inventory in a third-party logistics warehouse or through a marketplace facilitator fulfillment program. Even if the retailer does not own or lease the warehouse in which its inventory is stored, the retailer retains title to the inventory and thus holds property in the state where the inventory is stored. States are starting to audit companies more aggressively for pre-Wayfair periods if they think that the company had inventory in the state and was not registered or collecting sales tax. And because retailers using a marketplace facilitator can request reports on the location of their inventory at any time, taxing agencies are not buying the argument that the retailer does not know exactly where its inventory is located.
Retailers should review their activity for open periods to determine if they had nexus in a state based on physical presence. After calculating potential exposure amounts, retailers may want to consider remediation techniques, like voluntary disclosure agreements or amnesty programs. This step should be completed before automatically registering for sales tax in a state due to exceeding its economic nexus thresholds.
The Proactive Approach to Property Tax
Nearly all local taxing jurisdictions, including municipalities, counties, and boards of education, generate tax revenue through the imposition of property tax, which is one of the most substantial sources of local government revenue. The current economic environment further amplifies the need for jurisdictions to address budget deficits. Property tax is the largest state and local tax obligation for many businesses and one of the largest regular operating expenses incurred. Unlike other taxes, property tax assessments are based on the property's estimated value, and thus, are subject to varying opinions. Businesses that fail to take a proactive approach in managing their property tax obligations may be missing an opportunity to reduce their tax liability.
To successfully challenge a value, it is vital that taxpayers review their assessment annually to ensure their property is being taxed at fair market value as of the lien date (commonly January 1). Assessments based on the cost approach may lag behind values based on the market approach or the income approach. Factors that can lead to lower values include decreased revenue, vacancies, deferred maintenance, obsolescence, idle property, and many more. It is also crucial that taxpayers know the process and procedures that must be followed to challenge their values. Typically, taxpayers are required to exhaust their administrative remedies at the local level by certain statutory deadlines. If the procedures are not followed to the letter, then the taxpayer may miss their opportunity to challenge the assessment for that taxable year.
To navigate the nuances of analyzing whether the property is over-assessed, as well as understand the remedy requirements in your jurisdiction and maximize above-the-line savings, reach out to a property tax expert to help.
Machen McChesney Insights
Taxpayers need to be aware of the tax rules in the states in which they operate. In addition to revisiting taxpayers' compliance with their nexus rules and other tax policies, states are considering PTE elections, new taxes on digital services, and the extent to which they are willing to conform to federal tax rules and legislation. Businesses should review their state tax situations to understand their compliance obligations, identify ways to minimize their state tax liabilities, and eliminate any state tax exposure.
For more information about the above article or other business advisory services, contact Lesley L. Price, CPA, at (334) 887-7022 or by leaving us a message below.
Scott Smith | Managing Director, National State and Local Tax Technical Leader
Kent DeBruin | Manager, State and Local Tax
This article originally appeared in BDO USA, LLP's Insights/Tax/State and Local Tax -July 2021. Copywrite 2021 BDO USA, LLP. All rights reserved. www.bdo.com.