TWIST - This Week in State Tax

Welcome to TWIST for the week of June 13th, featuring Sarah McGahan from the Washington National Tax State and Local Tax practice.

First up today, in a recent published opinion, the California Court of Appeal held that nonresident trusts were subject to income tax on gain associated with the sale an S Corporation’s stock. The taxpayers at issue were nonresident small business trusts that were shareholders in an S corporation that did business in California and other states. On appeal, the taxpayers argued that the relevant laws for taxation of S corporations and S corporation shareholders must be applied independently. Thus, it was the taxpayers’ position that income from the sale of the S corporation stock may be characterized as business income under the corporate tax law, but treated as a sale of intangible property under the personal income tax law. The Court of Appeal rejected this argument and concluded that the gain was properly sourced using the rules applicable to an S Corporation.

In other news, the Wisconsin Tax Appeals Commission concluded that a taxpayer was doing business in Wisconsin for tax years before the Wayfair decision. Although it lacked a physical presence in the state, the taxpayer sold travel services to Wisconsin customers through independent consultants with addresses in Wisconsin who received commissions for facilitating the sales of travel services. The Commission concluded that the taxpayer was doing business in Wisconsin for the tax years at issue and was required to pay corporate franchise tax measured by net income.

In sales and use tax developments, in case you’ve been hiding under a rock, the current hot topic in sales and use tax is the tax treatment of Non-Fungible Tokens or NFTs. NFTs are tokens that represent ownership of unique digital assets, such as digital art. Thus far there has been much debate, but no state guidance or legislation addressing the taxability of NFTs. However, on Saturday June 11, 2022, the Pennsylvania Department of Revenue issued a revised Notice of Taxable and Exempt Property. In the Notice, the Department indicates that NFTs are considered taxable in the state.

In Texas, the Comptroller concluded that a corporate payment card management program was not a taxable data processing service. A 2021 legislative change clarified that processing of electronic payment transactions is not data processing. The Comptroller concluded that because the taxpayer at issue was sponsored by issuing banks to settle electronic transactions – including the authorization, clearing, or funding of a card payment – and the taxpayer authorized the card transactions, the taxpayer’s program was a nontaxable payment processing service.

Finally, recently approved legislation in Tennessee adopts a food sales tax holiday. Specifically, effective August 1, 2022, through August 31, 2022, food and food ingredients may be purchased free of sales tax. The Department of Revenue recently issued Notice 22-10 instructing retailers how to report all sales made during the holiday period.

California: A Not So Blue-Ribbon Decision; Gain on sale of an American Classic Apportionable

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In a recent published opinion, the California Court of Appeal held that a taxpayer was subject to income tax on gain associated with the sale of an S Corporation’s stock. The taxpayers at issue were nonresident small business trusts (Trusts) that were shareholders in Pabst Corporate Holdings Inc. (Pabst), an S corporation that did business in California and other states. Pabst sold its interest in a wholly owned subsidiary, reporting the gain as apportionable business income. The trusts initially apportioned their pro-rata share of the gain to California using Pabst’s apportionment factors. Later, the trusts filed for a refund, claiming the gain was from the sale of an intangible (goodwill) and, under California Revenue & Taxation Code section 17952, was not apportionable income unless the property sold has a business situs in California.

After the FTB denied the refund request and the Office of Tax Appeals (OTA) upheld the FTB’s action, the trusts filed in trial court arguing the income was from the sale of intangible property that had not acquired a business situs in California. The trial court granted summary judgement for the FTB, concluding that the trusts’ gain was properly characterized using the rules applicable to the S corporation. Additionally, the court found that the goodwill had acquired a business situs in California due to the Pabst’s corporate headquarters and marketing and sales departments located in California.

On appeal, the taxpayers argued that the relevant laws for taxation of S corporations and S corporation shareholders must be applied independently. Thus, the income from the sale of the S corporation stock may be characterized as business income for Pabst under the corporate tax law. However, for the trusts, the same transaction is characterized as a sale of intangible property under the personal income tax law.

The appellate court affirmed the trial court decision, agreeing with the FTB that the trusts’ approach ignored the conduit rule and the passthrough entity nature of an S corporation. The court noted that IRC section 1366(b) provides that the character of any item of income is determined at the S corporation level. Prior California case law had concluded that nonresidents may be subject to tax in the state “to the extent that the income is fairly attributable to the activities of the S corporation in the state.” Further, the court determined the California legislature intended that S corporation income be determined by applying the conduit rule. Therefore, court concluded that the income from the sale of the stock was corporation income derived from corporate activities and passed through to the shareholders.

Further, the appellate court rejected the trusts’ argument that the statute that sourced the gain on the sale of an intangible to the taxpayer’s domicile, California Revenue and Taxation Code section 17952, trumped the FTB regulation 17951-4, which required apportionment of a nonresident S corporation shareholder’s distributive share of income. The court explained that the legislature granted the FTB substantive rule making power regarding a nonresident S corporation shareholder’s distributive share of income, and thus regulation 17951-4 should be accorded the same weight as the statutory section 17952. Because California Revenue and Tax Code section 17952 applies to income from intangibles generally, and regulation section 17951-4 applies specifically to a nonresident S corporation shareholder’s distributive share of income, the more specific statute controls. Therefore, S corporation shareholders must apportion the gain realized by the S corporation on the sale of the subsidiary using the S corporation’s apportionment factors. 

Even if the regulation did not control, the court concluded that the subsidiary stock had established a business situs in California and therefore, would be taxable in California regardless. Please contact Oksana Jaffe with questions on The Metropoulos Family Trust v. FTB decision.

Pennsylvania: Department Issues Guidance that NFTs are Subject to Sales Tax

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In case you’ve been hiding under a rock, the current hot topic in sales and use tax is the tax treatment of Non-Fungible Tokens or NFTs. NFTs are tokens that represent ownership of an asset, often unique digital assets, such as digital art or legal documents. Until now there has been much debate, but no state guidance or legislation addressing the taxability of NFTs. However, on Saturday June 11, 2022, the Pennsylvania Department of Revenue issued a revised Notice of Taxable and Exempt Property. In the Notice, the Department indicates that NFTs are considered taxable in the state. There is no explanatory guidance for this conclusion, which is found in the section of the Notice that addresses digital products, computers, software and streaming services. Please contact Mark Balistrieri with questions. 

Tennessee: Food Sales Tax Holiday Enacted

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Recently approved legislation in Tennessee adopts a food sales tax holiday. Specifically, effective August 1, 2022, through August 31, 2022, food and food ingredients may be purchased free of sales tax. “Food and food ingredients” are defined as liquid, concentrated, solid, frozen, dried, or dehydrated substances that are sold to be ingested or chewed by humans and are consumed for their taste or nutritional value. Food ingredients do not include alcoholic beverages, tobacco, candy, dietary supplements, and prepared food. Food and food ingredients purchased from a micro market or vending machine remain subject to sales tax. The exemption applies to state and local sales taxes, although the state will reimburse local governments for the sales tax revenue loss resulting from the tax holiday. The Department of Revenue recently issued Notice 22-10 instructing retailers to report all sales (taxable and nontaxable) made during the holiday period on Page 1, Line 1 of the sales tax return. Sales of exempt food and food ingredients made during the holiday period must be reported on Schedule A, Line 10 and Schedule G- temporary Exemptions. Please stay tuned to TWIST for additional updates on state sales tax holidays. 

Texas: Payment Card Management Services Not Taxable Data Processing

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In a recently issued Private Letter Ruling, the Texas Comptroller of Public Accounts addressed whether a corporate payment card management program (PCM Program) was a taxable data processing service. The taxpayer’s services included a PCM program that allowed its customers’ corporate card managers the ability to deny or authorize transactions initiated through payment cards used by customers’ employees. It also allowed the card managers to customize cards with spending controls that limited users by restricting spending amounts, locations, and frequencies. The taxpayer did not have the authority to issue cards; instead, it contracted with issuing banks that had the necessary authority to issue payment cards to the PCM Program. The taxpayer also worked with issuing banks and payment card networks to authorize, process and settle it customers’ card transactions; the issuing banks sponsored the taxpayer’s access to the payment card networks.

Texas imposes sales tax on data processing, which is defined, in part, to include the processing of information for the purpose of compiling and producing records of transactions, maintaining information, and entering and retrieving information. A legislative amendment in 2021 clarified that processing of electronic payment transactions is not data processing and “does not include settling of an electronic payment transaction by a person who has entered into a sponsorship agreement with a federally insured financial institution for the purpose of settling that entity’s electronic payment transactions through a payment card network. The Comptroller determined that because the taxpayer is sponsored by issuing banks to settle electronic transactions – including the authorization, clearing, or funding of a card payment – and the taxpayer authorized the card transactions, the PCM Program was a nontaxable payment processing service. For more information on Private Letter Ruling No. PLR20200303153929, please contact Sarah Vergel de Dios.

Wisconsin: Florida-Based Travel Company was Doing Business in Wisconsin 

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Recently, the Wisconsin Tax Appeals Commission ruled that a Florida-based travel company was doing business in Wisconsin and subject to corporate franchise tax for the pre-Wayfair tax years at issue. The Company sold travel packages to customers through Independent Travel Consultants, approximately 100 of which were Wisconsin residents during the tax years involved. The Company used three arguments to argue it was not doing business in Wisconsin. The Company’s first argument, that it was protected under P.L. 86-272, was quickly rejected by the Commission because travel services are not tangible personal property and P.L. 86-272 protection applies only to taxpayers selling tangible personal property.  The Company next argued that it was selling Software as a Service to the independent consultants, and not selling travel services through the consultants; it was not clear why the taxpayer believed that selling SaaS, as opposed to travel services, would result in a different determination. The Commission, noting that none of the taxpayer’s contracts with the Independent Travel Consultants referred to the sale or licensing of software, determined that this claim was “utterly lacking in credibility.” Finally, the Commission addressed the Company’s position that it lacked nexus because its only activities were the electronic solicitation of sales from its headquarters in Florida. Under Wisconsin law, doing business in the state includes regularly selling services or soliciting sales of services to in-state customers who receive those services in state. The Company had over 100 Independent Travel Consultants with addresses in Wisconsin who received commissions for facilitating sales of travel services to customers receiving those services in Wisconsin. The Commission concluded that the Company was doing business in Wisconsin for the tax years at issue and was required to pay corporate franchise tax measured by net income. Please contact Brad Wilhelmson with questions on ASAP Cruises, Inc. v. Wisconsin Department of Revenue.