The 2016 Year-End State and Local Tax Update
The landscape of state taxation is ever-changing, with states seeking to tax an increasingly larger portion of both individual and corporate income. Over the past decade, states have implemented laws to expand their ability to subject a person or entity to tax.
There are three major issues states have addressed to seek an increased revenue stream:
- u Expansion of sales tax nexus (filing requirements).
- u Economic nexus.
- u Market-based sourcing.
Expansion of Sales Tax Nexus
In a world of internet shopping, states have seen a decline in the sales tax collected from local merchants as commerce has moved increasingly to an online platform. States have applied two tactics in seeking to curb this erosion in their sales tax base. The first is attempting to find an activity conducted by an online merchant that the state can leverage to force the collection of sales tax, and the second is seeking authority from Congress to allow taxation of internet sales outside of the current rules and laws.
While activity in a state creating nexus is a concern to the major players on the internet (think Amazon), the more prevalent threat to small businesses is the potential statutory changes that states are seeking to push through Congress. These rules would allow a state to set thresholds on the amount of sales a company can conduct with residents of a state before they are required to collect state sales tax. States would seek to obtain the right to require any company, person or disregarded entity that has sales in excess of a specified ceiling in a calendar year to collect sales tax in that state. For a small or medium-sized company, that could create a significant hardship by increasing administrative costs and cost of compliance.
The more onerous aspect of the sales tax is that ignorance of the law is no excuse. Should a small company not be aware that it had exceeded a threshold within a state and should have collected sales tax, the company would still be liable for the tax it should have collected. This is why the discussions in Washington related to sales tax bear significant scrutiny, as any change will have a potentially wide-ranging impact on both merchants and consumers.
Economic nexus relates to laws passed in many states in prior years and some that are being added to the list for 2016. This statutory application follows the same concept being used for sales tax collection nexus, in that a company or entity would be taxable for income tax in a state based purely on the level of sales made to residents of that state.
Approximately 10-15 states have established some measure of economic nexus, whereby an income tax can be imposed upon a taxpayer based purely on the level of sales made to state residents. This is especially problematic for the service industry, as there is no requirement that services be performed in a state; they merely need to be performed on behalf of a resident of a state. Resident also includes companies in a state.
The final change states have enacted is a shift to market-based sourcing (MBS) of service revenue from a cost of performance (COP) basis. Here is how the shift works:
Previously, under state laws, service revenue was deemed to be in a state, based upon COP. In other words, the revenue was realized in the state in which the service was performed. A simple example would be a tax return prepared by Marcum on behalf of a client. If the client was located in Connecticut, but all the work to prepare the return was done in New York, under the old COP laws the revenue earned by Marcum from that tax return was treated as New York revenue, since that was where the work was performed. Under the new MBS rules, it is immaterial where the service is performed. All that matters is the location of the customer that benefits by the service. In the example above, while all work is done in New York, the revenue is treated as Connecticut revenue and applied toward the threshold to meet the economic nexus rules and require an income tax return. Approximately 30 states have adopted a market-based sourcing taxation model, as of 2015.
States have gradually and systematically implemented statutes to broaden their ability to tax more individuals and companies that never set foot in that state and whose only connection to the state is a customer residing there. As more states shift to market-based sourcing taxation system, it is conceivable that small and medium-sized businesses and individuals will be required to file income tax returns in 10, 20 or even 30 states, while never leaving the comfort of their home state.
|Significant statutory tax changes were implemented in only a few states during 2016. The following summarizes these:|
The Franchise Tax Board’s legal division issued a ruling in July 2016 clarifying the LLC fee calculation for dealers in real property. Total income for calculating the LLC fee should include gross receipts from the sale of real property held for sale to customers in the ordinary course of business. However, gross income (i.e., gain amounts) rather than gross receipts should be utilized in calculating the fee for sales of real property held for investment.
The California Supreme Court considered whether a couple living in the same house could be “living separate and apart” to determine the date at which community property ended and individual property accumulation began (separation date). Prior to this case, the date of separation was often determined to be the date that the spouses, by their conduct, parted ways and showed no intention of reuniting. In Davis, one spouse moved out of the household years after the conduct between the spouses otherwise indicated they had separated and their marriage had ended. The Court concluded that the relevant statute required the spouses to live in separate residences to mark the separation date.
While market-based sourcing for C-corporations is in effect for tax years beginning on or after January 1, 2016, market-based sourcing for individuals, S-corporations, partnerships and trusts is effective for tax years beginning on or after January 1, 2017. The way in which revenue is sourced pursuant to these changes depends on what activity revenue arises from. The sourcing rules, in general, are as follows:
- Sales of tangible personal property are CT receipts if delivered in the state.
- Service revenues are CT receipts if the market for the service is in the state. Note that the market for the services is CT if and to the extent the service is used at a location in the state.
- Receipts from rents, leases, or licenses of real or tangible personal property are CT receipts to the extent the property is situated in CT.
- Note that for personal income tax purposes, starting in 2017, receipts from the sale, rental, lease or license of real property are excluded from the receipts factor. Individuals must directly allocate such receipts where applicable per CT’s regulations (e.g., income from CT real estate is allocated to CT).
- Receipts from rents, leases, or licenses of intangible property are CT receipts if and to the extent the property is used in the state. Intangible property utilized in marketing a good or service to a consumer would be deemed used in the state if that good or service is purchased by a consumer in the state.
- Receipts from interest are CT receipts if managed or controlled within the state.
- Receipts from the sale or other disposition of property (real, tangible personal, or intangible) are excluded from the factor if the property is not held by the taxpayer primarily for sale to customers in the ordinary course of the taxpayer’s trade or business.
- All other gross receipts are assigned to CT based upon market-based sourcing rules.
- Note that for tax years beginning on or after January 1, 2017, nonresident individuals must source business income to CT (including distributive income from S corporations, partnerships, and LLCs treated as partnerships for income tax purposes) using the sourcing provisions discussed above.
In May 2016, the Florida Supreme Court upheld the constitutionality of a Florida sales tax statute that requires florists to source transactions based on the location of the seller rather than the location of the purchaser. The ruling could have far- reaching implications for other industries. The Court’s conclusion that the origin-based sourcing for sales tax purposes was constitutional could be the first step for states to examine whether it would be advantageous to change their sales tax sourcing laws from a destination to an origin-based model.
Sales Factor Regulation Amended for Hedging Transactions
The Illinois Department of Revenue has amended the regulation that addresses the corporate sales factor treatment of hedging and foreign currency transactions, effective January 5, 2016. In general, any income, gain, or loss properly identified by a taxpayer as a hedging transaction for Federal tax purposes, should be excluded from both the numerator and denominator of the Illinois sales factor. The amendment allows a taxpayer to include the gain or loss from a hedging transaction as an adjustment to the gross receipts from the transaction(s) being hedged. Specific identification of the hedging transaction to the related gross receipt is required. If the transaction being hedged is included in the sales factor, the corresponding gain or loss from the related hedging transaction would also be included. Foreign currency gains and losses are afforded similar treatment.
Sales and Use Tax Regulations Amended for Delivery Charges
aaaEffective April 1, 2016, the Illinois Department of Revenue has amended the regulations governing the treatment of shipping charges for sales tax. Prior to the amendments, shipping charges were not taxable, if they were separately negotiated from the price of the product being delivered. The amended regulations clarify that delivery charges are taxable, if there is an inseparable link between the sale of property and the delivery of the property. An inseparable link exists when 1) delivery charges are not separately identified to the purchaser on the invoice OR 2) the delivery charges are separately stated, but the seller does not offer the option to receive the property via pickup or a free shipping option.
Research and Development Credits have Expired
In 2011, the Illinois legislature approved a five year extension of the state’s Research and Development Tax Credit. That extension of the credit expired for tax years ending after December 31, 2015. Absent legislative action, Illinois R&D credits are not available for 2016 and future tax years.
Property Tax Credit
Effective July 1, 2016, Indiana has implemented an indefinite carryforward period for certain acute care hospitals that have an unused portion of the state income tax credit for property taxes paid by the hospital. The credit became effective for tax years beginning January 1, 2016. A credit can be taken against the hospital’s income tax liability for an amount equal to 10% of the property taxes paid for property used as a hospital.
Income Tax Check-off for Charitable Purpose
Effective July 1, 2016, personal income tax forms will be modified to allow individuals to designate portions of his or her income tax refund to the military family relief fund, providing financial assistance to service members and their families.
During 2016, Louisiana implemented a ruling that made clear that the Net Operating Loss (NOL) deduction is the lesser of 72% of the NOL carryforward for the year or 72% of Louisiana net income. This change applies to Louisiana corporate income tax returns filed on or after July 1, 2015. In addition, Louisiana also changed the ordering for the use of NOLs to require that the most recent or newest loss be used first (e.g., last in, first out). Louisiana’s new NOL ordering and priority rules are now completely different than the federal provisions, and any other state’s. This rule will require taxpayers to track NOLs separately for Louisiana.
Additionally, for years after January 1, 2016, Louisiana changed to a single sales factor apportionment formula for most taxpayers. In the past, Louisiana generally required a three-factor apportionment formula, allowing for change based upon the taxpayer’s industry. In addition to the change in the factor, sales of services are now going to be sourced to Louisiana based upon market- based sourcing.
Department of Treasury Increases Identity Theft Efforts
Michigan’s Department of Treasury has implemented increased security measures to prevent identify theft, specifically with the use of a short online quiz to confirm the taxpayer’s identity. The Department will send letters to those chosen to confirm their identity, instructing the taxpayer to visit the Department’s website, where the following requirements are needed before the taxpayer’s identity is verified:
- Quiz ID, located at the top right hand portion of the letter,
- Refund, tax due or property tax credit,
- Last name,
- Last 4 digits of the primary social security number on the tax return, and
- 3-4 personal-related questions to be answered.
Income Tax Check-off for Charitable Purpose
Effective for the 2016 tax year and tax years thereafter, individuals can designate portions of their income tax refund to be credited to the Michigan Junior Achievement Fund and to the American Red Cross Michigan Fund. Income tax forms will have check-offs for the designation of funds.
Pass-through Entity Withholding Tax
Effective July 1, 2016, the Department of Treasury discontinued its requirement that flow-through entities withhold tax on non-resident members’ distributive share of income. However, for tax years beginning before July 1, 2016, quarterly withholding and an annual reconciliation are still required. Non-resident members of Michigan flow-through entities should be aware of impact on their estimated tax payment requirements at the individual income tax level.
Sales and Use Tax Exemption for Data Centers
Effective January 1, 2016 through December 31, 2021, data center equipment sold to the owner or operator of a qualified data center or a co-located business for assembly, use or consumption in the operations of the data center, are exempt from sales and use tax. The exemption will extend to contractors to the extent equipment is affixed to or made a structural part of a qualified data center. The legislation has built-in expiration hurdles. The exemption can apply through December 31, 2035, if the following job creation criteria are met by the collective data center industry:
- If at least 400 data center industry jobs and related jobs are established through December 31, 2021, the tax exemption will continue.
- If 1,000 or more jobs are established through December 31, 2025, the tax exemption will continue.
New York passed market-based sourcing in its statute during 2015, and as a result, for 2016, the state has released proposed regulations on its application. Among the items discussed within these draft regulations is sourcing of receipts from other services or business activities not otherwise enumerated in the new statutes. According to draft regulation, such revenue should be sourced based on the following order:
- Where the benefit is received, then by
- The delivery destination, then by
- Using the apportionment fraction for the preceding taxable year, and then by
- Using the apportionment fraction for the current tax year, based on other sourced sales determined by “benefit received” and “delivery destination” methods.
In addition, the draft regulation provides guidance on the sourcing of sales of digital property, which should be sourced in the following order:
- The location of the customer’s primary use, then by
- Where the digital product is received, then by
- Using the apportionment fraction for the preceding taxable year, and then by
- Using the apportionment fraction for the current tax year, based on other sourced sales of digital property.
These draft regulations require that a taxpayer engage in due diligence and record- keeping each year in order to resolve whether a particular category of sourcing cannot be determined, before moving on to the next sourcing method.
The state has expanded its definition of tangible property subject to sales tax by adding digital products to items subject to sales tax. The definition of digital products will include “video; photographs; books; any other otherwise taxable printed matter; applications, commonly known as apps; games; music; any other audio, including satellite radio service; canned software, notwithstanding the function performed; or any other otherwise taxable tangible personal property electronically or digitally delivered, streamed or accessed.”
These items will be subject to tax “whether electronically or digitally delivered, streamed or accessed and whether purchased singly, by subscription or in any other manner, including maintenance, updates and support.”
Effective January 1, 2017, the corporate minimum tax will decrease by $50 to $400 per year and will apply to:
- Limited partnerships.
- Limited liability partnerships.
- Limited liability companies.
- Single member limited liability companies.
The state also implemented two new revenue enhancement initiatives:
- Transfer pricing – The Division of Taxation plans to identify as candidates for audit certain entities that have intercompany transactions between related companies.
- Nexus Program – The Division of Taxation will step up attempts to locate and identify out of state companies that have not filed the appropriate corporate, withholding and/or sales and use taxes in Rhode Island.
For sales tax purposes, Rhode Island has implemented a tax on “transportation network companies,” sometimes called ride-sharing, or ride sourcing companies. These services are added to the list of taxable services subject to the 7% state sales tax, effective July 1, 2016.
TennesseeEffective January 1, 2016, economic nexus will exist in Tennessee if any one of the following tests is satisfied:
- Sales. The company’s gross receipts in Tennessee exceed the lesser of (a) $500,000 or (b) 25% of its total receipts everywhere;
- Property. The average value of the company’s real and tangible personal property owned or rented in Tennessee exceeds the lesser of (a) $50,000 or (b) 25% of the average value of the company’s total real and tangible personal property everywhere; or
- Payroll. The total amount paid by the company for compensation in Tennessee exceeds the lesser of (a) $50,000 or (b) 25% of the company’s total compensation everywhere.
- The apportionment formula (property, payroll and sales) for franchise and excise taxes is changed from a double-weighted sales factor to a triple-weighted sales factor.
- The sourcing method for sales of services is changed to market-based sourcing principles. These principles look to where the consumer is located to determine whether a sale should be sourced to Tennessee.
Sales and Use Tax Exemption for Contractor Materials
Effective January 1, 2016, contractors who purchase materials in fulfillment of a real property construction contract on behalf of certain tax exempt entities, can do so on a tax-exempt basis. The exemption applies to contracts with any 1) county, village, municipality, town or school district, 2) city and county hospitals, and 3) certain charitable, educational, religious and other non-profit organizations. The exemption applies to all construction materials used in a real estate construction project for a qualifying entity. Certain types of projects and certain tax-exempt entities are excluded from the exemption.
Business Development Tax Credit
While both the Jobs Tax Credit and Economic Development Tax Credits expired on December 31, 2015; a new Business Development Tax Credit is effective for tax years beginning on or after January 1, 2016. The credit aims to incentivize businesses to remain in, relocate to, and/or expand within the state. The credit is obtained via an application and certification process with the Wisconsin Economic Development Corporation (WEDC). The credit is driven by employee retention and expansion, employee training initiatives, and investment in real and personal property. An approved taxpayer must enter into contract with the WEDC for a period of up to 10 years.