State and local tax advisor: February 2023
Personal income tax: Taxpayer liable for tax on share of gain from sale of partnership interest
A nonresident taxpayer was liable for California income tax on his distributive share of gain from the sale of a partnership interest, because the gain was California-sourced income.
The taxpayer had an indirect ownership interest in a limited liability company (LLC) that was classified as a partnership for federal and California income tax purposes. The LLC had its principal office in Illinois and operated solely as a holding company, holding a direct membership interest in another LLC that was classified as a partnership for federal and California income tax purposes. The other LLC was based in Arizona and conducted a timeshare business within and without California.
In 2012, the holding company sold its entire interest in the other LLC to an unrelated third party, resulting in a net gain of over $53 million. On its 2012 return, the holding company recognized the entire net gain on its sale of its interest in the other LLC but didn’t source any of the gain to California. Thus, as an indirect pass-through member of the holding company, the taxpayer didn’t pay California income tax on any of the gain.
The taxpayer contended that the holding company’s interest in the other LLC was an intangible asset, so the gain from the sale of that interest should be sourced to the state where the taxpayer resided because it didn’t acquire a business situs in California. However, the taxpayer improperly focused the analysis on the gain at his level, when it was actually generated at the holding company’s level. Further, the evidence established that the holding company and the other LLC were engaged in a unitary business. Thus, the holding company’s gain on the sale of its interest in the other LLC was business income, which had to be apportioned to California using the holding company's share of the other LLC's apportionment factors.
Smith, California Office of Tax Appeals, No. 20036033, 2023-OTA-069P, Dec. 7, 2022.
Corporate, personal income taxes: Reporting requirements for analysis of partner’s tax basis capital account clarified
The Franchise Tax Board (FTB) has issued a notice clarifying the reporting requirements for the “Analysis of partner’s tax basis capital account” on Schedule K-1 (565) and Schedule K-1 (568) for taxable years 2021, 2022, and subsequent years. The notice supersedes and replaces FTB Notice 2022-1.
The FTB has become aware that certain persons required to file Schedule K-1 (565) and Schedule K-1 (568) may be unable to timely comply with the requirement to report partner capital on the tax basis method as calculated under California law for 2022. For taxable years 2021 and 2022, the FTB will permit a taxpayer who files Form 565 or Form 568 to report its partners’ or members’ capital accounts on Schedule K-1 (565) or Schedule K-1 (568) using either the tax basis method as determined under federal law, as reported on Schedule K-1 (Form 1065), or the tax basis method as determined under California law. This is limited solely to the capital account analysis on Schedule K-1 (565) and Schedule K-1 (568) for 2021 and 2022, and doesn’t allow taxpayers to use their federal tax basis in lieu of their California tax basis for any other purpose.
Beginning in taxable year 2023, and for every taxable year thereafter, the FTB will require a taxpayer who files Form 565 or Form 568 to report its partners’ or members’ capital accounts on the Schedule K-1 (565) and the Schedule K-1 (568) using the tax basis method as determined under California law. The 2022 Form 565 and Form 568 instructions contain methods to compute the beginning tax basis capital account analysis balance for those filing these forms who did not previously calculate their tax basis capital account on Schedule K-1 (565) and Schedule K-1 (568) under California law.
FTB Notice 2023-01, California Franchise Tax Board, Jan. 30, 2023.
Corporate, personal income taxes: Changes to REV Illinois, EDGE, MICRO, and other credits enacted
Illinois enacted corporate and personal income tax credit legislation that:
- Sets a 20-year limit for high-impact business credit agreements.
- Extends Reimagining Electric Vehicles in Illinois (REV Illinois) credit eligibility to renewable energy manufacturing and reduces the investment and new job creation thresholds.
- Increases the Economic Development for a Growing Economy (EDGE) credit for job retention to 50% of income tax withheld for taxpayers located in underserved areas in the state.
- Expands the number of nonresident employees for determining eligible wage expenses under the film production services credit and extends the credit sunset date to Jan. 1, 2033.
- Raises the Manufacturing Illinois Chips for Real Opportunity (MICRO) credit for job retention to 75% of the income tax withheld or 100% of the tax withheld for taxpayers located in an underserved or energy transition area in the state.
- Authorizes the renewal of MICRO credit agreements for an additional 10- or 15-year period.
P.A. 102-1125 (S.B. 2951), Laws 2023, effective February 3, 2023.
Sales and use tax: Taxability of various digital goods discussed
The Illinois Department of Revenue issued a general information letter discussing the applicability of sales and use tax to the sales of various digital goods by a digital goods distributor (taxpayer). Under the applicable statute, a provider of software-as-a-service acts as a serviceman. If the provider doesn’t transfer any tangible personal property to the customer, then the transaction generally would not be subject to retailers’ occupation tax, use tax, service occupation tax, or service use tax. Moreover, computer software provided through a cloud-based delivery system, where the software is never downloaded onto a client’s computer and is only accessed remotely, is not subject to tax.
However, if the provider transfers to the customer an API, applet, desktop agent, or remote access agent to enable the customer to access the provider’s network and services, the customer is receiving computer software that is subject to tax.
General Information Letter ST 22-0027-GIL, Illinois Department of Revenue, Dec. 2, 2022, released February 2023.
Sales and use tax: Taxability of software licenses and maintenance agreements discussed
The Illinois Department of Revenue issued a general information letter discussing the applicability of sales and use tax to computer software licenses and maintenance agreements. In this matter, the taxpayer inquired about the taxability of an invoice for continued maintenance and access to the software and an invoice for purchase of additional software.
Generally, the taxability of agreements for the repair or maintenance of tangible personal property (TPP) depends upon whether charges for the agreements are included in the selling price of the TPP. If the charges for the agreements are included in the selling price of the TPP, those charges are part of the gross receipts of the retail transaction and are subject to tax, but no tax is incurred on the maintenance services or parts when the repair or servicing is performed.
On the other hand, transactions where the repair or maintenance agreements are sold separately are not taxable. However, the maintenance or repair services or parts provided under those agreements would be subject to use tax. The sale of an optional maintenance agreement or extended warranty is generally not a taxable transaction, but the sale of a maintenance agreement that includes charges for updates of canned software is fully taxable as a sale of software.
General Information Letter ST 22-0023-GIL, Illinois Department of Revenue, Oct. 19, 2022, released February 2023.
Corporate income tax: Taxpayer couldn’t carry forward losses calculated under MBT to return filed under CIT
A corporate taxpayer transitioning from the Michigan business tax (MBT) to the corporate income tax (CIT) for tax year 2019 couldn’t carry forward prior losses calculated and submitted under the MBT as business losses on its first tax return filed under the CIT. Because the taxpayer didn’t previously file under the CIT, it had no CIT tax base prior to filing for the 2019 tax year; it only had an MBT tax base. Because it had no prior CIT tax base, there were no CIT losses that it could carry forward to the 2019 tax year.
The taxpayer filed returns claiming a Michigan Economic Growth Authority (MEGA) employment tax credit for tax years 2008 through 2011. When the CIT became effective for tax year 2012, the taxpayer elected to continue to file MBT returns for tax years 2012 through 2018, in order to use all of the MEGA employment tax credit that it had been awarded. Businesses making this type of election had to calculate both the amount of their tax liability under the MBT and the amount of their tax liability if they filed under the CIT, with their tax liability being the greater of the two amounts.
The taxpayer argued that because it had to calculate its tax under both the MBT and CIT and pay the greater of the liability computed under each tax, it was essentially subject to both taxes. But, the taxpayer was not actually subject to tax under the CIT for tax years 2012 through 2018. It simply made the CIT calculation to determine which tax liability (MBT or CIT) was greater. The taxpayer chose to file under the MBT for tax years 2012 through 2018, knowing the requirements, benefits, and potential tradeoff.
International Automotive Components Group North America, Inc. v. Department of Treasury, Michigan Court of Appeals, No. 360602, Jan. 19, 2023.
Corporate income, insurance taxes: Affiliated group, including insurance companies, couldn’t file as unitary business group
An affiliated group of companies, including insurance companies, was precluded from filing combined returns for Michigan premiums and retaliatory taxes. Although the companies satisfied the elements of a unitary business group (UBG), they could not, under Michigan law, file returns as a UBG. Michigan law requires UBGs to file combined returns for companies subject to a corporate income tax base. It doesn’t contain any provision for calculating the premiums taxes on a groupwide basis. Also, the UBG couldn’t be considered a single taxpayer for premiums tax purposes.
The statutory definition of “insurance companies” doesn’t include UBGs. Had the Legislature wanted to include them, it could have done so. The fact is that Michigan didn’t intend for premiums and retaliatory taxes to be calculated on an entity-by-entity basis.
Nationwide Agribusiness Insurance Company et al v. Michigan Department of Treasury, Michigan Tax Tribunal, No. 21-000039, Jan. 23, 2023.
Corporate, personal income taxes: Pass-through entity tax due dates and other information discussed
New York issued a notice discussing upcoming due dates and other important information for the state pass-through entity tax (PTET). The notice also contains information on the New York City PTET. For example, the deadline to opt in for tax year 2023 is March 15, 2023, for both the state PTET and the New York City PTET.
In addition, quarterly estimated PTET payments for tax year 2023 are due March 15, June 15, Sept. 15, and Dec. 15, 2023.
Other topics covered in the notice include the 2022 New York City PTET election, annual returns and extensions, and foreign partners, members, and shareholders.
Notice, New York Department of Taxation and Finance, Jan. 27, 2023.
New York City
Corporate income, miscellaneous taxes: Commissions paid to DISC were nondeductible payments for partner services
In a New York City unincorporated business tax case, it was improper for a firm to deduct commission payments to a domestic international sales corporation (DISC) in which the firm’s partners were the shareholders. While the partners received part of the compensation for their services and the use of their capital from the firm, they received the remainder from the DISC in the form of tax-favored qualified dividends. The DISC was merely a means to provide a tax benefit on payments to partners for services to the firm, and also to change the partner profit-sharing ratio on the income from those services. All of the firm’s income distributed to the partners compensated them for their services and for the use of their capital.
Regardless of whether all the income was paid to the partners by the firm, or part of it was paid by the firm to the DISC for distribution to the partners, the entire amount was allocated among the partners as payment for their services. Accordingly, the firm’s commission payments constituted amounts paid or incurred to a proprietor or partner for services or for the use of capital, within the meaning of the law, and were not deductible under the unincorporated business tax.
Skidmore, Owings & Merrill, LLP, New York City Tax Appeals Tribunal, TAT(E)17-21(UB), Jan. 26, 2023.
Sales and use tax: Taxpayer was a manufacturer for purposes of mill machinery exemption
A taxpayer who purchased tangible personal property from out of state for its production of hot mix asphalt was properly subject to the lower 1% North Carolina privilege tax (i.e., the mill machinery exemption) as opposed to the higher sales or use tax on those purchases.
Privilege tax on mill machinery
During the time period at issue, the taxpayer didn’t pay sales tax or accrue and remit use tax for certain property that it purchased out of state, including tools, parts, and equipment that it used in producing the asphalt in North Carolina. During that time, North Carolina imposed a 1% privilege tax on mill machinery purchased by a manufacturing industry or plant, with a cap of $80 per article.
Manufacturing industry or plant
At issue was whether the taxpayer could be classified as a “manufacturing industry or plant,” a term that the statutory exemption did not define. The taxpayer manufactured extremely large quantities of the asphalt throughout the relevant period and sold over 300,000 tons of that asphalt to third parties. It did so by producing a new article or use or ornament by the application of skill and labor to the raw materials that composed the asphalt, a process that the state supreme court had repeatedly described as manufacturing. As such, the taxpayer was entitled to the mill machinery exemption.
North Carolina Department of Revenue v. FSC II, LLC., Superior Court, No. 22 CVS 5410, Jan. 30, 2023.
Sales and use tax: Individual personally liable for LLC’s unpaid taxes
An individual, who was the president of a limited liability company (LLC), was personally liable for the LLC’s outstanding Ohio sales and use tax liabilities because the individual failed to establish that the assessments were erroneous. In this matter, the individual protested the assessments citing three objections: a purported lack of service of the underlying assessments on the LLC; the assessments did not reflect amounts paid by the LLC; and the responsible party assessments were time-barred.
The Tax Commissioner rejected these arguments, observing that the individual was a responsible person for the LLC’s tax liabilities for the tax period because he was listed as the president and reported 100% ownership of the LLC on the federal K-1 form. Specifically, the Commissioner determined that: (1) out of the total of 69 assessments against the LLC, 10 assessments weren’t successfully delivered and were canceled, but service was perfected for the remaining 59 assessments; (2) any payments made by the LLC or the individual would be credited toward the overall liability, but the amount of the assessment could not be challenged by the individual as a responsible party; and (3) responsible party actions are separate but derivative assessments, and therefore, the time-bar asserted by the individual would not apply until after the assessments against the individual were final and certified by the Commissioner. Upon appeal, the Board of Tax Appeals noted that the individual failed to demonstrate any error in the Commissioner’s findings and sustained the assessments.
Dillard v. McClain, Ohio Board of Tax Appeals, No. 2020-626, Feb. 6, 2023.
Sales and use tax: Remote seller collection thresholds amended
South Dakota has amended sales and use tax collection thresholds for remote sellers.
Remote seller collection threshold
A seller is liable for the collection and remittance of sales and use tax in South Dakota, even if the seller doesn’t have a physical presence in the state, if the seller, during the previous or current calendar year has gross revenue from the sale of tangible personal property, any product transferred electronically, or services delivered into South Dakota that exceeds $100,000.
Previously, the threshold was met if the remote seller, in the previous or current calendar year, had:
- Gross revenue from the sale of tangible personal property, any product transferred electronically, or services delivered into South Dakota exceeds $100,000.
- Sold tangible personal property, any product transferred electronically, or services for delivery into South Dakota in 200 or more separate transactions.
Remote sellers subject to excise tax on farm equipment
The new threshold will also apply to remote sellers subject to the excise tax on farm machinery, farm attachment units, and irrigation equipment.
Effective date for new threshold
The new threshold takes effect July 1, 2023.
S.B. 30, Laws 2023, effective July 1, 2023.
Sales and use tax: Local sales and use tax sourcing rules amended and clarified
Texas has amended local sales and use tax sourcing rules to clarify existing rules.
The definition of “fulfill” has been amended to:
- Require possession be transferred.
- Remove the requirement that the transfer be direct.
- Exclude receiving or tracking an order.
The general definition of “place of business of the seller” has also been amended. A place of business of the seller must be an established outlet, office, or location operated by a seller for the purpose of receiving orders for taxable items from persons other than employees, independent contractors, and natural persons affiliated with the seller.
New definitions are provided for “established outlet, office, or location” and “purpose.”
Changes to determining the place of business of a seller
Rule amendments have been made to the treatment of how orders are received. The amendments incorporate the updated definitions as discussed above. An order that is received by a salesperson who is not at a place of business of the seller when the salesperson receives the order is treated as being received at the location from which the salesperson operates. Examples include orders that a traveling salesperson receives while on the road by:
- Telephone (including VOIP and cellular phone calls)
An order that is not received by a salesperson is received at a location that is not a place of business of the seller. Examples are orders received by:
- A computer server through a shopping cart software program.
- An automated telephone ordering system.
Additionally, for distribution centers, manufacturing plants, storage yards, warehouses, and similar facilities, the forwarding of previously received orders to the facility for fulfillment doesn’t make the facility a place of business.
Use tax for order not fulfilled in Texas
Rules for orders not fulfilled in Texas have been amended. When an order is received by a seller at a location that is not a place of business of the seller in Texas, and is fulfilled from a location outside Texas, the sale is not consummated in Texas. However, a use is considered to be consummated at the first point in Texas where the item is stored, used, or consumed after interstate transit has stopped. Taxable items delivered inside Texas are presumed subject to local use tax unless otherwise established.
34 TAC 3.334, Texas Comptroller of Public Accounts, effective Jan. 30, 2023.
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