TWIST - This Week in State Tax

Welcome to TWIST for the week of November 15th, featuring Sarah McGahan from the Washington National Tax State and Local Tax practice.

First up today is an Illinois appellate court decision holding that a taxpayer using the cash basis method of accounting was entitled to a refund of sales tax when its customers defaulted on their installment contracts. The taxpayer used the cash basis method of accounting and therefore was prohibited from taking a federal bad debt deduction. Accordingly, the Department denied the taxpayer’s refund claim for sales tax that it had remitted upfront on cars purchased through installment contracts that were later repossessed due to customer default. The court concluded that purpose of the bad debt statute was to ensure retailers could obtain refunds of sales tax prepaid on defaulted goods, and the legislature did not intend for cash basis taxpayers to be prohibited from obtaining such refunds.

Next, the Texas Comptroller issued a private letter ruling concluding that a taxpayer selling information on prospective students to higher education institutions was providing a taxable information service. Although the sale of information compiled on behalf of a particular client is not taxable if the information is not sold to others, in this instance the information from each prospective student could be, and often was, shared with multiple clients. Therefore, it was not proprietary in nature.

In marketplace facilitator news, the Arkansas Department of Finance and Administration responded to a request for guidance from a taxpayer that maintained an online platform used by government entities to sell surplus items. The Revenue Legal Counsel responded that when the taxpayer acted as a marketplace facilitator by facilitating a taxable sale by a government body, the sale became the sale of the marketplace, and the marketplace (i.e., taxpayer) was required to collect and remit the tax. The Department next confirmed that for purposes of computing the economic nexus threshold for a marketplace facilitator, sales in which the marketplace did not collect and transmit payment to the marketplace seller were not counted in calculating the threshold.

In other indirect tax news, the Colorado and Arkansas tax authorities both addressed the taxability of food tours.

Finally, the Massachusetts Department of Revenue recently issued guidance on the new pass-through entity tax election that is effective for tax years beginning on or after January 1, 2021. The guidance, which is in the form of FAQs, resolves questions as to how to elect into the pass-through entity tax, compute the tax, and pay the tax and estimated payments. 

Thank you for listening to TWIST this week and stay well.

Arkansas: Legal Opinion Addresses Issues when a Marketplace Facilitates Sales for Local Governments

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The Department of Finance and Administration recently issued a legal opinion addressing the application of the Arkansas marketplace facilitator statute.  The taxpayer requesting guidance maintained an online platform used by government entities to sell surplus items. The government entities managed the listings and set the prices themselves. At times, the taxpayer collected payments, but in other instances payments were collected directly by the government entity. The taxpayer sought clarification as to whether the government sellers or a marketplace facilitator working with a government seller needed to collect sales tax on sales transacted through the marketplace. The Revenue Legal Counsel responded that when the taxpayer acted as a marketplace facilitator by facilitating a taxable sale by a government body, the sale became the sale of the marketplace, and the marketplace (i.e., taxpayer) was required to collect and remit the tax. The Department next confirmed that for purposes of computing the economic nexus threshold for a marketplace facilitator, sales in which the marketplace did not collect and transmit payment to the marketplace seller were not counted in calculating the threshold. The Department also clarified that the marketplace facilitator law became effective on July 1, 2019, and there was no additional time given after that date for marketplace facilitators to come into compliance with the requirement to collect and remit. Please stay tuned to TWIST for more marketplace facilitator developments. 

Illinois: Cash Basis Taxpayer Entitled to Sales Tax Bad Debt Refund

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An Illinois appellate court recently reversed the Tax Tribunal and held that a taxpayer using the cash basis method of accounting was entitled to a refund of sales tax when its customers defaulted on their installment contracts. The taxpayer operated a used car dealership and sold certain cars to buyers on installment contracts. After a customer entered into an installment contract, the taxpayer remitted the full amount of sales tax associated with the vehicle sale to the Department of Revenue, despite the fact that the customer had only paid (as part of the down payment) a portion of the sales tax due. Federal income tax laws require taxpayers to use the accrual method of accounting unless a taxpayer has less than $25 million in average annual gross receipts over the prior three-year period. Here, the taxpayer qualified for this exclusion and therefore reported its income and expenses using the cash basis method of accounting. Because the taxpayer elected to use the cash basis method, however, it was not eligible to claim a business bad debt deduction on its federal income tax return when a customer defaulted on an installment contract. Prior to July 2015, and pursuant to the Department’s regulation, if a customer defaulted on an installment contract, the taxpayer could submit a refund claim to the Department for the portion of the sales tax that it had paid upfront but could not collect from the customer; the Department had generally honored these refund claims. In 2015, the Illinois legislature amended the statute concerning deductions for uncollectible debt to require taxpayers that taxpayer must have claimed a bad debt deduction on their federal income tax returns to be eligible for a bad debt sales tax refund. The Department similarly amended its regulation to require that a taxpayer must (1) charge off bad debt on its books, and (2) claim a deduction on its federal income tax return to qualify for a refund of sales tax on a defaulted installment contract. Because the taxpayer used the cash basis method of accounting and was prohibited from taking a federal bad debt deduction, the Department denied its refund claim for sales tax that it had remitted upfront on cars purchased through installment contracts that were later repossessed due to customer default. The taxpayer challenged the Department’s denial of its refund claim before the Illinois Tax Tribunal, which issued a summary judgment in favor of the Department. The taxpayer then appealed to the Illinois Court of Appeals.

Before the appellate court, the taxpayer argued that the amended statute should be read to allow the taxpayer’s refund claim. Alternatively, it argued that the statute’s application in this case violated the uniformity clause of the Illinois Constitution. The uniformity clause requires tax classifications to be based on real and substantial differences between the people taxed and not taxed.  Classifications must bear some reasonable relationship to the object of the legislation or to public policy. Upon review, the appellate court first noted that before the Tax Tribunal, the Department failed to meet its initial burden of proof on the taxpayer’s constitutional claim, which requires the Department to produce a justification for the tax classification. The Department had merely stated that there were clearly real and substantial differences between cash basis and accrual basis taxpayers. However, because the court decided cases on constitutional grounds only as a last resort, the court first addressed the taxpayer’s statutory argument.

A review of the bad debt statute led the court to determine that the law was ambiguous as to whether cash basis taxpayers were entitled to refunds for bad debt. As the law was ambiguous, the court looked to legislative history as an interpretive aid. The court then concluded that purpose of the statute was to ensure retailers could obtain refunds of sales tax prepaid on defaulted goods, and the legislature did not intend for cash basis taxpayers to be prohibited from obtaining such refunds. Moreover, the court found that the stated purpose of the statute—that a retailer has paid money to the state that is actually not the state’s sales tax revenue— applied equally to both cash basis and accrual basis taxpayers. The court concluded that cash basis taxpayers that prepay sales tax on goods sold through installment contracts are entitled to bad debt deductions. Please contact Drew Olson with questions on Kishwaukee Auto Corral, Inc. v. Department of Revenue.

Massachusetts: Department of Revenue Issues Guidance on New Pass-Through Entity Tax

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Effective for taxable years beginning on or after January 1, 2021, legislation in Massachusetts (House Bill 4009 enacted over the Governor’s veto) responds to the current $10,000 cap on the federal state and local tax deduction for individuals. Similar to legislation adopted in over half the states, the bill allows an “eligible pass-through entity” to annually elect to pay a five percent excise tax on “qualified income taxable in Massachusetts.” “Qualified income taxable in Massachusetts” is the income of an eligible pass-through entity determined under Massachusetts income tax law allocable to a qualified member and included in the qualified member’s Massachusetts taxable income. An “eligible pass-through entity” is an S corporation, partnership or a limited liability company treated as an S Corporation or partnership. A disregarded entity is not an eligible pass-through entity. “Qualified members” are natural persons, estates, and trusts subject to Massachusetts income tax, whether as a resident or nonresident. Corporations or other partnerships are not considered qualified members. However, a pass-through entity is not precluded from making the election if it has partners or shareholders that are not “qualified members.” Each qualified member is provided with a 90 percent refundable credit for the pass-through entity tax. The tax will not apply for any taxable year for which the federal limitation on the state and local tax deduction has expired.

The Massachusetts Department of Revenue recently issued administrative guidance in the form of FAQs to resolve questions as to how to elect the pass-through entity tax, compute the tax, and pay the tax.

How to Elect the Pass-Through Entity Tax

The election for the pass-through entity tax is due annually each year. Once the election is made it is binding on all qualified members. The election is irrevocable. The election is made by filing Form 3, Form 355S, or Form 2 and is confirmed by filing the new pass-through entity tax return, Form 63D-ELT. On the draft Partnership Return, Form 3, Question L – “Annual Voluntary Election” has been provided to submit the election. The election must be filed on or before the due date of the pass-through entity tax return, taking into account valid extensions.

How to Compute the Pass-Through Entity Tax

The PTE tax is computed on federal adjusted income for Massachusetts residents and on apportioned Massachusetts income for Massachusetts non-residents. As an example, assume that Partnership ABCD does business in Massachusetts with 50 percent apportionment:

• Partnership net income for 2021 is $1,000
• Partners A and B are Massachusetts resident individuals
• Partner C is a nonresident individual
• Partner D is a resident partnership
• Each partner is a 25 percent owner

The pass-through entity excise would be calculated as follows:

1. Determine the partners subject to tax in Massachusetts under chapter 62. Here it would be partners A, B and C
2. Determine the amount of taxable income allocable to each partner. Partners A and B each have $250 of income ($1,000 x 25 percent). Partner C has $125 of income. ($1,000 x 25 percent x 50 percent apportionment). Total income subject to tax under chapter 62 = $250+$250+$125 = $625. Partner D is not a qualified member, and its share of income is not taken into account
3. Apply the 5 percent pass-through entity excise rate to such income ($625 x 5 percent = $31.25).

Note that in this example no excise is allocable to Partner D—the upper-tier pass-through entity—regardless of the identity of the partners of Partner D.

How to File and Pay the Pass-Through Entity Tax

Estimated payments are required if the electing pass-through entity would have $400 or more of tax.  Estimated payments are due for a taxable year even though the election for the taxable year cannot be made until the return is filed. In general, estimated payments for calendar year filers are due on April 15, June 15, September 15, and January 15 (the due dates for fiscal year filers are adjusted based upon their fiscal year).  Special rules apply for the tax year beginning on January 1, 2021 due to the recent enactment of the bill. The total amount of all estimated payments for the 2021 tax year must be made by January 15, 2022.  For future years, a pass-through entity’s required estimated payments will be equal to the lesser of:

• 80 percent of the pass-through entity excise ultimately determined to be due on the entity’s current year Massachusetts Form 63D-ELT; or
• 100 percent of the pass-through entity excise shown on the entity’s prior year Massachusetts Form 63D-ELT, if the entity made the election for the prior year and filed a prior year return that covered a 12-month period.

The FAQs confirm that that if a qualified member of a pass-through entity has made estimated income tax payments for 2021, those payments cannot be applied to the pass-through entity excise. The burden is on the pass-through entity to pay the excise separately from the personal income tax liability of qualified members.  Tax payments for the elective pass-through entity tax must be submitted electronically through MassTaxConnect.

Annual Tax Return Reporting

Massachusetts also issued a draft of the new elective pass-through Entity-Level Tax Return, Form 63D-ELT. The new Form 63D-ELT must be filed electronically either through MassTaxConnect or third party software. The credit for the elective pass-through entity tax is reported to the qualified members on their Massachusetts K-1. A draft of the Massachusetts Partnership Form 3K-1 has new line 41 to report both the full entity-level tax and the partner’s 90 percent share of the refundable credit.

Contacts

Please contact Jamie Posterro or Brad Wilhelmson with questions on the Massachusetts pass-through entity tax. 

Texas: Taxpayer Not Providing a Proprietary Information Service

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In a Private Letter Ruling, the Texas Comptroller of Public Accounts recently addressed the taxability of an information service utilized by higher education institutions. The taxpayer was an enrollment marketing service that helped higher education institutions connect with prospective students. Prospective students were targeted via social media and online advertisements that invited the students to complete an online form used to match the student with a higher education institution program. A prospective student was able to select programs that were of particular interest from a list of programs that appeared to match certain criteria. The taxpayer retained “exclusive control of the record” and retained “authority to change, delete, and reject any record.” The prospective student’s information was sold only to the institutions the prospective student selected.

In the ruling, the Comptroller concluded that the taxpayer was required to collect sales tax on its sales because it was providing taxable information services when it gathered and maintained student information for clients that paid for marketing leads on prospective students. The Comptroller further determined that although the taxpayer retained control over the information, the information sold was not proprietary because the ultimate owner of the personal information was the student, not the taxpayer’s client. In addition, the information from each prospective student could be, and often was, shared with multiple clients. In the Comptroller’s view, this further evidenced that the information was not proprietary to any one of the taxpayer’s clients. An exemption applies to taxable items sold to public educational organizations and the Comptroller noted that the taxpayer would need to receive an exemption certificate from the customer at the time of sale to claim this exemption. For more information on Private Letter Ruling No. PLR20201012121830, please contact Sarah Vergel de Dios.

Multistate: Arkansas and Colorado Address Taxability of Tours

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The Arkansas Department of Finance and Administration and the Colorado Department of Revenue recently issued letters discussing the sales and use tax consequences of food tours. First, the Arkansas Department of Finance and Administration addressed whether a food tour company should collect and remit sales tax on tickets. The taxpayer organized tours of 4 to 6 restaurants over a 3-hour tour. The cost of a ticket included the food consumed at the restaurants. The Department determined that the taxability of the tickets hinged on whether the food tour was a bundled transaction consisting of the sale of food and the service of the tour, or if the food tour was purely a service. In the Department’s view, because the tour operator paid the restaurants for the food consumed by guests, the ticket was not a bundled transaction but was a service not subject to sales tax. However, the taxpayer was responsible for collecting and remitting the 2 percent Arkansas Tourism Tax on its sales of tickets.

The Colorado Department of Revenue issued a general information letter addressing whether (1) guided walking tours are subject to the state’s sales and use tax when food and beverages are not included in the cost of the tour, (2) guided walking tours are subject to sales and use tax when food and beverages are included in the cost of the tour, and (3) a resale certificate could be used to  purchase food for guests during a guided walking tour. The Department first noted that guided walking tours are not explicitly subject to the sales and use tax. However, without directly answering the taxpayer’s question, the Department cautioned that a service may be subject to the sales and use tax if the service also includes the sale of taxable property or services. Lastly, a retailer’s purchase of food or drink will be considered nontaxable if the retailer sells the food to a customer in a later separate transaction. The retailer’s original purchase is treated as a tax-free wholesale purchase, and the latter sale to the consumer is the taxable sale. Please contact Sarah McGahan with questions on these developments.