The Anatomy Of Resolving State Tax Matters
As many people realize, State and Local Taxes are a significant percentage of the overall taxes paid by companies and individuals. In 2017, State and Local governments in the United States collected $1,400,000,000,000 in state and local individual income, corporate income, sales and property taxes. This is equal to approximately 41% of the amount of 2017 U.S. income taxes collected by the federal government.
In light of the importance of State and Local Taxes, we’ve decided to dedicate this issue of the McGrath North Tax Planning Newsletter to addressing the principal Nebraska State and Local Tax issues that we have been working on with our clients and their in-house and outside tax professionals. More importantly, we’ll discuss what you can do about these issues.
As with all tax matters, State and Local Taxes offer the opportunity to choose to plan ahead or to choose to not plan ahead. Planning ahead usually results in the better outcome. In either situation, all taxpayers are subject to being audited. All Audits are either resolved at the Audit level or resolved on appeal. (While this Article focuses on Audits, the same points generally apply to Refund Claims and Amended Returns.)
This Article first looks at planning opportunities that can occur Before the Audit. This is followed by certain best practices During the Audit and then After the Audit (i.e. the Appeal).
Achieving the intended tax result is largely dependent on the planning and strategies deployed long before the Department of Revenue ever shows up for the Audit. Below are several, selected topics which we are addressing during the life of a business or individual, and which we are also seeing in Audits and Appeals, whether or not properly or fully addressed early on.
Sales Tax on Software Development
Problem: The Department of Revenue won’t recognize that custom software developed by outside firms for a company is exempt from tax, unless the software staff developers meet a 3 factor test to be treated as “temporary employees” of the company for sales tax purposes. NDR Rev. Rul. 1-02-1.
What To Do: If a company very precisely includes the 3 factors for temporary employees in its software development agreement, it may avoid Nebraska sales tax on that development. Audits and Appeals usually center around proving the agreement complies and that various contract terms or company practices don’t contradict this. The 3 factor test (ownership, liability and control) is actually a “safe harbor”, which enables other factors and legal grounds to apply if this harbor is not met.
Tax on Cloud Computing/Data Center Services
Problem: The Department of Revenue now alleges that sales tax is due on a part of cloud computing charges, because otherwise exempt cloud computing is protected by certain levels of software security measures.
What To Do: If cloud service contracts are carefully drafted, a company may reduce or eliminate the portion of cloud computing charges that the Department alleges are subject to the sales tax on security services. On Audit or Appeal we are addressing the legal position that security which is an integral part of the cloud computing or data center service should not be parsed and taxed.
Nebraska Residency For Income Tax Purposes
Problem: The Department of Revenue routinely follows individuals who move outside of Nebraska to attempt to classify these persons as still being Nebraska taxable residents.
What To Do: If your client intends to move out of Nebraska to nonresident status, the 12 principal factors for determining a person’s resident or nonresident status should be addressed and documented during and after the move. Frequently individuals will want to retain certain Nebraska connections (such as home or business ownership and frequent visits) which the Department uses against you. On Audit or Appeal, we usually find the taxpayer hasn’t met all of the 12 factors or kept the documents to best prove this, so this often becomes a matter of legal positioning and settlement.
Nebraska Tax For Trusts Administered Elsewhere
Problem: Nebraska’s statutes impose tax on irrevocable trusts created by a Nebraska resident. This may not be constitutional for trusts administered outside Nebraska.
What To Do: If a trust’s only contact with Nebraska was the residence of a grantor, the trust may not be subject to Nebraska income tax. This is best handled when the trust is designed and set up, which best supports the legal analysis upon Audit or Appeal.
Qualification For Nebraska’s Capital Gain Exclusion
Problem: The Department of Revenue is challenging the qualification for this exclusion in a number of situations, including pre-sale attempts to qualify, or when corporate stock is placed into an LLC, partnership or trust or when stock is sold under Sec. 338(h)(10) of the federal tax code.
What To Do: The selling owner needs to meet the statutory requirements at the time of sale. If an owner wants to transfer stock into an LLC, partnership or trust, the potential disqualification needs to be addressed before the stock is transferred. The case law provides debatable positions for Audit or Appeal when the ownership isn’t clean.
Qualifying For Tax Increment Financing
Problem: Multiple factors must be met to qualify for Tax Increment Financing for developing a business expansion project. Under Tax Increment Financing, the property tax increases resulting from a development can be earmarked to repay certain eligible costs required by a project.
What To Do: If a project is properly planned and located in a “blighted” or “substandard” area, the company may apply up front to use Tax Increment Financing to help pay for a part of the business expansion project. Local government approval is needed in advance.
Optimizing Nebraska Advantage Incentives
Problem: Most state tax incentive programs, including Nebraska’s, have certain requirements to qualify for and optimize the available incentives. These can relate to the level of new investment and jobs, the type of business, the level of compensation, the locations, the corporate structure and the type of property being acquired. We typically review over 25 factors in preparing Nebraska Advantage Applications (as well as ongoing project implementation).
What To Do: Under the Nebraska Advantage Act, the Project Application needs to be filed ahead of project commencement to optimize results. Ideally, potential issues are dealt with head on with the Department of Revenue before the project commitments are in place. Under this Act, a Project Agreement is entered into with the State of Nebraska. This is a contract. The Project Application is part of this contract. So, both the Application and the Agreement need to be addressed with the same level of legal review and care as with all contracts (which some companies and their tax advisors don’t realize until too late). Options for Appeal exist for issues that are not resolved, either during the Project Application process or during the Project Qualification and Maintenance Audits.
Wayfair Changes The Rules On Sales Tax Collection
Problem: In the recent Wayfair decision, the U.S. Supreme Court eliminated the traditional physical presence rule, which held that a company must have physical presence in a state in order to be required to collect sales tax in that state. This means that sellers may need to collect sales tax in a state even if they are not physically located in that state.
What To Do: Wayfair is a game changer. This reversal of the physical presence rule will mean that all companies selling products or services in multiple states will need to determine whether they now have a sales tax collection requirement. Failure to determine this accurately can result in under collection (with tax due upon Audit) or over collection (which in effect becomes a noncompetitive overcharge). Companies must also align their purchasing practices to be sure they are not inadvertently paying a use tax on purchases where the seller has stepped up its tax collections. Nebraska has issued guidance that out-of-state sellers must begin to collect tax in January 2019.
A Business Buyer’s Liability For The Seller’s Unpaid Taxes
Problem: Nebraska tax law can, in certain cases, require the purchaser of a business to pay the unpaid taxes of the predecessor owner.
What To Do: This can be largely addressed in the drafting of the Purchase Agreement, along with the due diligence process. In addition, if a company properly plans and requests clearance from the Department of Revenue, this will help avoid taxes of a predecessor.
Bundled Transaction Rules
Problem: An improperly structured purchase transaction, in which a purchaser receives multiple goods or services for one, non-itemized price, can cause tax to be imposed on the purchase of otherwise nontaxable goods or services.
What To Do: If a company plans its purchase or sale transactions to avoid classification as a bundled transaction, it may avoid unnecessary sales or use tax. On Audit or Appeal, we can also address whether this is actually one nontaxable transaction, or is to be broken into taxable and nontaxable portions.
Classification as Taxable Goods or Nontaxable Services
Problem: It is not always clear whether a purchase transaction is for taxable goods or nontaxable services. The answer to this drives whether the overall transaction is subject to sales and use tax.
What To Do: If a company structures its transactions in light of the Department’s six factor test for distinguishing nontaxable services from taxable goods, it may reduce its ultimate sales tax cost on the transaction to zero. When this reaches Audit or Appeal, we usually need to bring both the Department’s test as well as applicable “true object” Case Law into play.
Qualification for Alternative Apportionment
Problem: Within the last few years, Nebraska amended its statutes to add new apportionment rules that, in general, better reflect the relative economic activity of many companies in Nebraska. However, for some companies, the statutory apportionment rules do not fairly represent a company’s Nebraska activities.
What To Do: If a company receives an alternative apportionment ruling, it may apportion its income to Nebraska using a test appropriate for its business model. This now needs to be applied for before the tax year. This is subject to Appeal if not granted.
Real Property Valuation
Problem: Business property is often valued too high for property tax purposes. There are two general arguments against a county assessor’s valuation. First, that the property is simply overvalued. Second, that the property is overvalued in comparison with other, similar properties.
What To Do: We find that many potential property value disputes can be handled in advance informally, by working directly with the County Assessor’s office before the property assessment. Otherwise, we need to address this on Appeal to the County Board of Equalization or the Tax Equalization and Review Commission.
Companies are seeing the value in a Tax Defense Team. So they are having us work with their in-house and outside CPAs to have us review and vet potential tax issues and problem areas before the auditor is let into the door. This is so the best strategy can be determined up front. There is too much at stake. We want to help assure the fact issues and legal issues and positions are known and properly expressed from the get go.
Some of the best practices during the Audit phase are discussed next.
Behind The Scenes Involvement
Problem: Potential Audit issues can go off the track early on (often irretrievably) if facts are not correctly explained or the correct legal issue isn’t spotted or dealt with properly.
What To Do: We are often engaged to work behind the scenes (during the Audit Phase) to add legal insights, perspective, and strategy to the Tax Defense Team (or to “ghost write” the proposed response to key issues). We are also able to help move the Auditor (or Audit Supervisor) beyond spending time and resources in areas that are not being viewed correctly.
“Tenth Man Rule”
Problem: Both the taxpayer and Tax Defense Team can become unreasonably optimistic or pessimistic about an issue or case.
What To Do: We deploy the “Tenth Man Rule” (Before, During and After the Audit). The “Tenth Man Rule” (also known as the “Devil’s Advocate”) always has someone play the part of the contrarian – no matter how solid or weak your issue or case may seem. This helps uncover blind spots and helps assure both the strengths and weaknesses of the issue or case are properly vetted and considered.
Cost/Benefit
Problem: Each tax matter (usually) has a known benefit (during and after the audit cycle).
What To Do: Always estimate the cost (in-house and outside) to get to a win or favorable settlement – at each stage of the Audit and Appeal(s).
Sampling: Agree Or Not?
Problem: The Department of Revenue typically requests that taxpayers enter into a Sampling Agreement, giving it authority to employ a sampling method.
What To Do: We often suggest proceeding with sampling without a signed Sampling Agreement (which can have the effect of keeping your options open).
Objecting To Document Requests
Problem: The Department of Revenue has broad authority to subpoena a company’s records for the purpose of determining tax compliance.
What To Do: There are times to object to document requests that are not relevant to a tax issue, that request privileged communications, or that do not line up with an agreed upon sampling method. A letter from legal counsel can be used to back this up.
Preserving Privileged Communication
Problem: Privileged documents can lose protection if they have been provided by the taxpayer to an external third party or CPA.
What To Do: Taxpayers should ensure that they are not losing the privilege protection and are not providing privileged communications to the Department of Revenue.
The first step in the legal proceeding that is considered the Appeal of an Audit occurs when the “Petition for Redetermination” (often just called the “Protest”) is filed in response to the “60 day” letter issued by the Department of Revenue after a Sales/Use or Income Tax Audit that has not been yet resolved.
Depending on the tax matter, this can occur in other situations as well. This may be the Appeal of a property tax assessment or the Appeal of a Department of Revenue disagreement relating to an incentive matter.
In either case, this Petition (or Protest) is the initial official legal “pleading” in the case. It needs to carefully lay out the factual and legal grounds for the Appeal. It will impact the entire rest of the case, from the potential for settlement to the prospects for prevailing, should the case need to go on to Court.
The filing of the Petition (or Protest) should not, however, be considered to be destined to end up in the Nebraska Courts. Instead, in the usual Sales/Use or Income Tax Appeal, the case is assigned to a Department Attorney for us to work with. Both parties need to further develop the facts and the legal grounds and work towards possible Settlement. If the case cannot be resolved in this “informal” process, then either party may request that the case be set up for a Formal Hearing with a Hearing Officer appointed by the Tax Commissioner.
The purpose of this Hearing is two-fold. First is to create the official “record” of the facts (in the form of documents and testimony). The second is for the Hearing Officer, after the case has been briefed, to reach a recommended decision for the Tax Commissioner.
If this does not result in the Taxpayer’s favor, we can appeal the case to the Nebraska District Court. The District Court will schedule a Hearing, which will be based on the “record” of facts established at the Department Hearing. The District Court will render a judgment (after being briefed) based on the Court’s own view of the proper result. From there, either party may appeal.
Some further considerations are below.
Procedural Requirements
Problem: In any Nebraska tax dispute, certain procedural steps need to be taken in order to preserve the right to protest a tax assessment, file a refund claim, build the necessary factual record, and express and preserve all potential legal defenses.
What To Do: If a taxpayer wishes to protest an assessment, they must understand the procedural requirements associated with the desired filing, including the items that must be pled to constitute a valid Appeal.
Refund Claims
Problem: In Nebraska, the filing of a Refund Claim does not automatically entitle the taxpayer to an administrative Hearing.
What To Do: If a taxpayer wishes to file a Refund Claim, we must lay out the legally relevant facts and legal grounds in the Claim and request a backup Hearing to provide the necessary record in case of Appeal.
Settlement Strategies
Problem: Successful settlements are not a matter of chance. You can’t expect the Department to agree to a fair resolution, unless we have first presented a strong defense that the Department will recognize (as a matter of sound legal basis and litigation risk). So, while most of our cases settle, a number of steps must first be taken to lay in and position the proper groundwork for a successful settlement posture.
What To Do: To reach a favorable settlement, we must first demonstrate the strength of the taxpayer’s factual and legal position and then move ahead with the speed, clarity and attitude consistent with a belief in that position.
Beyond The Statutes
Problem: A winning tax defense position at all 3 stages (Before, During and After the Audit) needs to recognize (and potentially defend against) a variety of overriding tax law principles which extend beyond the wording of the statute, regulation or ruling.
What To Do: Legal “common law” doctrines, such as Substance Over Form, Step Transaction, Economic Substance, Sham Transaction and Business Purpose, need to be understood (and planned for) at the time of the transaction and deployed or defended against in the Audit or Appeal.
Rules Of The Game
Problem: Just as in any ongoing competition, the rules of the game must be known, understood and deployed, when appropriate, to your advantage. These may include, for example, Rules of Evidence, Protection of Privileges, Burden of Persuasion, Rules of Construction, Taxpayer Rights, Due Process, Assessment Standards, Equitable Recoupment, Nexus and Burden of Proof.
What To Do: Determine up front which of these game rules will come into play in your case. These can make the difference between a win, a loss or a great settlement.
The Science Behind It
Problem: Ultimately a tax matter is resolved by convincing the person reading your analysis of the soundness of your view. You can’t do this unless the reader understands your view (and in the case of tax matters, this means multiple readers, potentially from the auditor, to the supervisor, to the legal staff, to the settlement committee, to the Tax Commissioner, to the Hearing Officer and to the Court).
What To Do: Like it or not, people learn and understand in 4 different ways: Visual, Auditory, Reflective and Kinesthetic (known as VARK). A winning tax defense approach needs to deploy the best ways to reach and convince all 4 learning styles.
Unauthorized Practice of Law
Problem: The unauthorized practice of law by non-lawyers is an issue being taken seriously by State Bar Associations nationwide, as well as applicable judicial officials. In Nebraska, non-lawyers cannot take any action in a Nebraska tax defense that requires “the knowledge, judgment, or skill of a lawyer.” NDR Reg. 33-008 and Neb. Sup. Court Rule 3-1003. This is the situation in many Tax Audits as well as Appeals (i.e. protests) of tax assessments. This reality hit home recently when we were asked by a multistate company (headquartered outside Nebraska) to review a lengthy letter (essentially a Legal Brief) that had been sent to the Department of Revenue with little positive effect. This “Brief” had been prepared by an outside non-lawyer and was very official looking, being filled with over 30+ legal citations and a lot of legal discussion. The problem was that the non-lawyer had missed the critical issue and hadn’t marshalled the critical facts needed to make the case. Just as in other professions, these rules are in place to protect persons from those who try to deploy professional expertise and insights they don’t have (or may not be aware of). We urge caution by non-lawyers and companies alike.
What To Do: If your company, or a client, receives an Audit notice or tax assessment, a State Tax Attorney should be engaged upon receipt so that critical potential issues and a thoughtful game plan can be determined up front.
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