State and local tax advisor: December 2023
Corporate income tax: Late payment penalty following stock sale not abated
A corporation failed to establish reasonable cause for abatement of a penalty imposed for late payment of California income tax. The corporation was acquired by another company in a stock sale. The acquiring company made an IRC Sec. 338 election to treat its stock purchase as an asset acquisition for income tax purposes. The corporation timely filed its California return for its short tax year ending on Sept. 20, 2016, within the automatic extension period on June 22, 2017. The reported tax due was entirely attributable to the deemed sale of the corporation’s assets on Sept. 20, 2016, resulting from the acquiring company’s IRC Sec. 338 election. The due date for the payment of tax for the corporation’s short tax year was Jan. 15, 2017, the 15th day of the fourth month after the taxable year ended. Because the corporation didn’t fully pay the tax until July 5, 2017, the Franchise Tax Board properly imposed a late payment penalty.
Under California law, the late payment penalty may be abated if a taxpayer shows that the failure to make a timely payment was due to reasonable cause and not willful neglect. Additionally, under a federal regulation, a waiver of the late payment penalty is available to taxpayers who make a late payment because of circumstances that wouldn’t exist but for an IRC Sec. 338 election. For the waiver to apply, the taxpayer must take corrective action, including paying the tax due on or before the last day for making an IRC Sec. 338 election. An IRC Sec. 338 election must be made by the 15th day of the ninth month beginning after the month in which the acquisition date occurs. Here, because the corporation was acquired on Sept. 20, 2016, the last day for the acquiring company to make an IRC Sec. 338 election was June 15, 2017.
The corporation acknowledged that it didn’t meet the requirements for the waiver provision in the federal regulation for California purposes. Instead, the corporation argued that the penalty should be abated for reasonable cause pursuant to California law. Further, the corporation asserted that the penalty waiver provisions in the federal regulation couldn’t be used to interpret the reasonable cause provisions in the California law. But, contrary to the corporation’s assertions, the federal regulation applied for California purposes because it was promulgated under IRC Sec. 338, which California incorporated. The evidence showed that the corporation had all the information and documents necessary to calculate its tax due prior to the June 15, 2017, penalty waiver deadline, but nevertheless it failed to provide an acceptable reason for the delay in making its tax payment.
Red Vision Systems, Inc., California Office of Tax Appeals, No. 18124068, 2023 – OTA – 561P, March 23, 2023, (released December 2023).
Corporate, personal income taxes: Incorrect rule relating to Internal Revenue Code repealed
Colorado repealed a rule relating to the state’s incorporation of the Internal Revenue Code for income tax purposes because the Colorado Court of Appeals in Anschutz v. Department of Revenue, 2022 COA 132, 524 P.3d 1203 (Colo. App. 2022), determined that the rule was incorrect. The rule stated that “Internal Revenue Code” for Colorado income tax purposes incorporated changes to federal law only on a prospective basis. But, the court in Anschutz held that retroactive changes in federal law can affect a taxpayer’s Colorado taxable income.
Rule 39-22-103(5.3), Colorado Department of Revenue, repealed effective Dec. 30, 2023.
Sales and use tax: Taxpayers entitled to predominant use exemption
A group of related restaurants (taxpayers) were entitled to refunds of Indiana sales and use tax on their purchase of electricity because the taxpayers established that they predominantly used electricity in producing food for sale. Generally, to qualify for a predominant use exemption, a utility purchaser must show that it used more than 50% of the utility as an essential and integral part of an integrated production process.
In this matter, the Department of Revenue partially granted the refunds but denied the rest on the grounds that the taxpayers didn’t predominantly use the utilities at issue in an exempt manner. The taxpayers protested and provided additional documentation and analysis to support their position that the use of electricity satisfied the predominant use standards. Accordingly, the taxpayer’s protest was sustained.
Memorandum of Decision Nos. 04-20231183; 04-20231184; 04-20231185; 04-20231186, Indiana Department of Revenue, June 5, 2023, released Sept. 2023.
Plante Moran observation: Many states provide sales tax exemptions from utilities when consumed in the manufacturing process. However, utilities used outside of manufacturing, such as for an office, may not qualify for exemption. Thus, it’s important to document the use of utilities, such as using separate meters, to support the exemption, especially in case of an audit.
Sales and use tax: Reminder issued about computers and computer peripherals exemption
The Iowa Department of Revenue has issued a reminder that the sales and use tax exemption for purchases of computers and computer peripherals used in processing or storage of data or information by an insurance company, financial institution, or commercial enterprise ends Dec. 31, 2023. S.F. 2367, Laws 2022, strikes the exemption, effective Jan. 1, 2024. Therefore, starting Jan. 1, 2024, the purchase of computers and computer peripherals by insurance companies, financial institutions, or commercial enterprises for use in processing or the storage of data or information is subject to Iowa sales and use tax.
Notice, Iowa Department of Revenue, Dec. 14, 2023.
Corporate, personal income taxes: Flow-through entity tax reporting guidance provided
Michigan has released new guidance and changed a form requirement to aid taxpayers with Michigan flow-through entity (FTE) tax reporting and streamline return processing.
Tiered entities and indirect credits
The Department of Treasury has observed that one of the steepest learning curves with the FTE tax has involved tiered entities and indirect credits. When credits are generated by FTE taxpayers that have one or more direct owners that are other flow-through entities, those other flow-through entities can’t claim the credits and must pass them through to their owners via reporting required under the statute. Each respective share of a credit is ultimately claimed by taxpayers subject to Michigan individual income tax — i.e., a credit-generating entity’s indirect owners.
Templates for reporting information to members
As discussed in previous guidance, certain specific information about the credit, tax base adjustments, and credit-generating entity must be reported to members by flow-through entities, regardless of whether a flow-through entity elects in to the tax. Because the applicable statute doesn’t mandate any particular form or manner for this, flow-through entities can report the required information in Schedule K-1 notes or any other format they choose.
Recognizing that taxpayers, their return preparers, and Treasury staff may benefit from uniform templates that demonstrate the level of detail required, the Department of Treasury developed and published two such templates:
- Michigan flow-through entity tax information for direct members.
- Indirect share of Michigan flow-through entity tax information for direct member.
The templates are available here. The Department of Treasury encourages, but doesn’t require, taxpayers to use the templates. Taxpayers can attach the templates as PDFs to e-filed MI-1040 or MI-1041 returns.
Reporting indirect members on Form 5774
The FTE annual return filing includes Form 5774, Schedule for Reporting Member Information for a Flow-Through Entity. Part 2 of that form reports individuals, fiduciaries, and other flow-through entities and their respective shares of the tax (credit). Previously, instructions for that part stated that only direct members could be listed. Recently, updates have been made to remove that restriction. Beginning with 2022 FTE returns that haven’t yet been filed and all returns going forward, FTE taxpayers may report indirect members and their respective shares of income and credits in lieu of listing the direct member that’s another flow-through entity. This may reduce processing times for indirect members and requests for additional information.
Treasury Update, Michigan Department of Treasury, November 2023.
Personal income tax: Treatment of retirement income following enactment of Public Act 4 of 2023
Michigan has issued a Revenue Administrative Bulletin (RAB) discussing the income tax treatment of retirement and pension income following the changes enacted by Public Act 4 (H.B. 4001), Laws 2023. The bulletin updates and supplements:
- RAB 2017-21, Individual Retirement Arrangements.
- RAB 2017-25, Tax Treatment of Retirement Income from IRC 403(b) Plans.
- RAB 2018-21, Deduction of Retirement and Pension Benefits from a Public Retirement System.
The bulletin discusses the following issues:
- When Public Act 4 takes effect.
- What changes Public Act 4 made to the deduction limits on retirement benefits.
- Once Public Act 4 is totally phased in, whether this results in a return to the pre-2012 treatment of retirement and pension income.
- Whether state law enforcement officers and employees retired from states other than Michigan are eligible for the full deduction of public retirement income.
- Whether retirement benefits received from the Federal Employees Retirement System (FERS) that are attributable to service as a federal law enforcement officer are eligible for the full retirement income deduction.
- Whether the special rules for surviving spouses apply under Public Act 4 to all available deduction options.
- Under the new phaseout of deduction limitations, whether a taxpayer must reduce the maximum retirement benefits deduction by any public, military, Michigan National Guard, and railroad retirement deductions.
- Whether retirement and pension administrators must adjust the withholding on distributions based on the implementation of Public Act 4.
- If a recipient of a retirement or pension distribution eligible for the full retirement income deduction for fire, police, and corrections retirees rolls that distribution into a private individual retirement account (IRA), whether subsequent distributions from the private IRA qualify for the special treatment.
- Whether the unlimited retirement income deduction for fire, police, and corrections retirees is limited to retirement income received for covered services or applies to other retirement or pension income received by the retiree as well.
When does Public Act 4 take effect?
Public Act 4 takes effect on Feb. 13, 2024. But, as it relates to retirement income deductions, once it takes effect it applies beginning with the 2023 tax year.
What changes did Public Act 4 make relating to retirement income deductions?
Public Act 4 rolled back limits on the deduction of retirement income based on the taxpayer’s year of birth and age in the tax year. The rollback will occur over a four-year period beginning in 2023, thus reducing taxes on retirement income over a phase-in period. It also carved out an exception for certain public safety officers and employees, allowing them to fully deduct retirement income beginning in 2023. Both of these options are elective. Taxpayers may instead opt to calculate their deduction under the prior law.
What happens once Public Act 4 is fully phased in?
Once Public Act 4 is totally phased in, in tax years 2026 and later, this results in a return to the pre-2012 treatment of retirement and pension income, with one exception. In tax years 2026 and later, subtractions of retirement income from public sources are limited to the private retirement maximum, except for taxpayers born before 1946 for whom retirement subtractions are unlimited. More specifically, in applying the private retirement maximum, a taxpayer must combine all deductible public retirement income and any private retirement income and then apply the limitation to the combined amounts.
Are law enforcement officers from other states eligible for a full deduction?
State law enforcement officers and employees retired from other states aren’t eligible for the full deduction of public retirement income. To qualify for the full deduction, retirees must be subject to Michigan laws requiring compulsory arbitration of labor disputes.
Are federal law enforcement officers eligible for a full deduction?
Retirement benefits received from FERS for service as a federal law enforcement officer will generally qualify for the full public retirement income deduction. Although the statutory language limits the full deduction to certain retired state and local law enforcement and public safety employees, the intergovernmental tax immunity doctrine applies and allows federal law enforcement and public safety employees with retirement income from work earned in jobs to qualify for the full deduction.
Do the special rules for surviving spouses apply to all available deduction options?
The special rules for surviving spouses apply under Public Act 4 to all available deduction options if the surviving spouse meets the qualifying conditions.
Under the new phaseout of deduction limits, must a taxpayer still reduce the maximum deduction by other deductions?
A taxpayer electing to calculate the deduction under the new option phasing out deduction limits must still reduce the maximum amount allowed for that deduction by the sum of all deductions taken for retirement benefits from:
- Taxable military compensation, including pension or retirement benefits.
- Railroad retirement benefits.
- Michigan National Guard benefits.
- Federal and Michigan public retirement benefits.
Must administrators adjust the withholding on distributions based on the new law?
A retirement or pension administrator may withhold on the taxable portion of a distribution as currently known to the administrator, until the retiree submits a revised Form MI W-4P advising the administrator of the new withholding amount.
Will distributions from private IRAs qualify for the full deduction if funded from the rollover of an eligible plan?
An IRA distribution is deductible if the IRA is funded from the rollover of an otherwise exempt retirement plan. This is true regardless of the type of IRA into which those funds were converted. The tax-exempt character of the original retirement plan survives the rollover. Taxpayers may be required to submit all relevant account documentation regarding the original account and subsequent rollover to substantiate the claimed deduction.
Is the full deduction limited to retirement income received for covered services?
The unlimited retirement income deduction for fire, police, and corrections retirees is not limited to retirement income received for covered services. If a taxpayer receives a retirement or pension benefit for services performed by eligible public safety personnel, the taxpayer may also deduct other categories of retirement or pension benefits, subject to the private retirement or pension maximum.
Revenue Administrative Bulletin 2023-22, Michigan Department of Treasury, Nov. 22, 2023.
Sales and use tax: Reporting form required by data center operators
The Michigan Department of Treasury has reminded data center operators that they must submit form 5726 by January 31 if they claimed a sales or use exemption for the sale or purchase of data center equipment. If no equipment was purchased or sold or the exemption was not claimed in a particular calendar year, no form is required.
Treasury Update, Michigan Department of Treasury, Dec. 1, 2023.
Corporate, personal income taxes: Gain on sale of goodwill was apportionable business income
A nonresident’s gain on the sale of goodwill generated by her sale of stock ownership interests in an S corporation was apportionable business income for Minnesota income tax purposes.
What was the taxpayer’s position?
The corporation did business in both Minnesota and Wisconsin. Following the sale of the corporation to another company, the corporation and its nonresident owner filed Minnesota returns characterizing the gain on the sale of goodwill as income that was not subject to apportionment. The corporation’s accountants relied on the Minnesota Tax Court’s decision in Nadler v. Commissioner of Revenue to characterize the gain on the sale of goodwill as nonbusiness income that was subject to allocation rather than apportionment.
What was the Department of Revenue’s position?
However, unbeknownst to the corporation, its nonresident owner, and their accountants, the Department of Revenue had internally taken the position that it would not follow the Tax Court’s decision in Nadler. The Commissioner didn’t make this disagreement with the Tax Court’s decision public until it issued Revenue Notice 17-02, after the corporation and its nonresident owner filed their tax returns. Following an audit, the Commissioner then assessed tax on an apportioned share of the income from the sale, determining that the corporation had incorrectly assigned the income. The Tax Court affirmed the assessment, holding that the income from the sale of goodwill was business income of a unitary business.
What did the Supreme Court decide?
On appeal, the Minnesota Supreme Court acknowledged that the applicable statute wasn’t a model of statutory clarity. But, the Supreme Court looked at the contemporaneous legislative history, which it said provided compelling support for the Commissioner’s interpretation of the statute. Thus, the corporation’s income, which derived from a unitary asset, was business income subject to apportionment between Minnesota and other states.
Cities Management, Inc. v. Commissioner of Revenue, Supreme Court of Minnesota, No. A23-0222, Nov. 22, 2023.
Sales and use tax: Sales to out-of-state purchaser not subject to tax
A nonresident taxpayer was not subject to Missouri sales and use tax on the purchase of items from a Missouri manufacturer that were delivered to an out-of-state location because the title passed to the purchaser outside Missouri. Under the applicable statute, unless otherwise agreed by the parties, when a Missouri seller delivers tangible personal property to a third-party common or contract carrier for delivery to an out-of-state location, the title does not transfer in Missouri, and the sale is not subject to Missouri sales tax.
In this matter, the Missouri seller delivered the items to a third-party contract carrier for delivery to an out-of-state location (Montana), and the parties didn’t make specific arrangements regarding title. Therefore, the title transferred in Montana, and because there was no taxable event in Missouri, the transaction was not subject to Missouri sales tax.
Letter Ruling No. LR 8271, Missouri Department of Revenue, Oct. 30, 2023.
Plante Moran observation: Determining which state(s) can tax an interstate transaction can be confusing. The imposition state’s sales tax rules, including exemptions, are used to determine the taxation and rate of tax. Often, the destination state, rather than the origination state, can impose sales tax when a third-party common carrier or contract carrier is used. However, this may not always be the case.
Corporate income tax: Allocation and apportionment of contract manufacturing service fees
The North Carolina Department of Revenue issued a private letter ruling regarding the allocation and apportionment of contract manufacturing service fees for corporate income tax purposes. Under the applicable statute, the gross receipts derived from contract manufacturing services should be sourced to the ultimate destination of the finished product.
In this matter, the department noted that a taxpayer was required to source the service fees derived from its contract manufacturing services to North Carolina, because the finished products were ultimately delivered by its related entity to customers located in North Carolina. Moreover, for transactions where the ultimate destination couldn’t be determined, the service fees were sourced to North Carolina, the location where the contract manufacturing services were performed.
CPLR 2023-02, North Carolina Department of Revenue, June 20, 2023, released September 2023.
Corporate income tax: Challenge to combined reporting requirement rejected
In an amended corporate income tax ruling, a South Carolina administrative law judge found that it was reasonable and equitable for the Department of Revenue to require combined reporting and that separate entity reporting didn’t fairly represent the parent company’s business activity in the state. Separate reporting allowed the group’s business structure to dilute the parent’s income and business activity in South Carolina by shifting income under a procurement agreement. According to the Administrative Law Judge (ALJ), it was clear that the company was using a transfer price/markup on inventory to misrepresent its business activity in the state and lower its tax burden, without a reasonable and reliable justification from a transfer pricing or economic perspective.
The company argued that the law authorized the department only to employ an alternative apportionment method (i.e., the formula or ratio), not an alternative reporting method such as combined unitary reporting, but that argument was rejected, as was the argument that the term “taxpayer” left no room for a group of related entities to be taxed together. Finally, the ALJ also rejected the claim that the department’s application of combined unitary reporting violated the South Carolina Administrative Procedures Act.
Tractor Supply Co. v. Department of Revenue, South Carolina Administrative Law Court, No. 19-ALJ-17-0416-CC, Dec. 4, 2023.
Sales and use tax: Factors for determining real property from tangible personal property explained
Washington has provided guidance on distinguishing tangible personal property from real property, for purposes of sales taxation. If items qualify as real property, a portion of the sale attributed to their value are subject to real estate excise tax.
The following factors determine whether an item has become part of real property:
- Actual annexation
- Application to the use or purpose for which the realty is purchase
- The intent of the party to make the item a permanent part of the realty
Tax Topics, Washington Department of Revenue, Dec. 1, 2023.
Plante Moran observation: The determination of whether an item is tangible personal property or real property is important for purposes of determining how to tax a purchase. States may use different criteria for making this determination, and, thus, the same item may be subject to sales tax in one state while be treated as realty in another state.
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