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Procedure

State Revenue Departments Misapplying Federal Tax Law

by McDermott Will & Emery | Sep 9, 2014 | Audits, Federal Tax, Idaho, Income Tax, Maryland, Nationwide Importance, Procedure

State income tax laws generally build on federal tax law. The typical pattern is to begin the calculation of state taxable income with federal taxable income and then to modify it by adding or subtracting items where state tax policies differ from federal tax policies. As a result, a corporation’s state taxable income can be affected by the application of the federal Internal Revenue Code. State revenue departments generally do not consider themselves bound by Internal Revenue Service determinations respecting the application of federal tax law and believe that they are free to interpret the Internal Revenue Code as they see fit. Unfortunately, this has led to problems because state tax auditors often are not well trained in federal tax principles. We had an instance earlier this year in which an auditor claimed that the merger of a wholly-owned subsidiary into its corporate parent was taxable because there was an increase in the parent’s retained earnings. The merger was a plain vanilla tax-free liquidation under Sections 332 and 337 of the Internal Revenue Code (there was no intercompany debt and the subsidiary was clearly solvent), but sending copies of these provisions to the auditor left him unmoved. We finally got him to back down by showing that the parent’s increase in retained earnings was matched by a decrease in the subsidiary’s retained earnings so that there was no overall increase. As we explained to the client, a win is a win, even if for the wrong reasons. Nevertheless, if the auditor had been properly versed in the most basic federal corporate tax principles, this exercise would not have been necessary.

Two recent decisions illustrate misapplications of federal tax law by state revenue departments.

The Idaho Tax Commission recently held that a subsidiary’s net operating loss (NOL) carryovers did not pass to its parent in a merger of the subsidiary into the parent. The parent did not continue to operate the business of the merged subsidiary and the Commission held that “based on IRC §382, the Petitioner cannot carry the loss forward after the merger.” Idaho State Tax Commission Ruling No. 25749 (Apr. 17, 2014). The Commission’s statement of federal tax law is incorrect. Section 382 of the Internal Revenue Code does not apply to a merger of a wholly-owned subsidiary into its parent. Because of constructive ownership rules, no change in ownership is deemed to occur. Moreover, Section 382 does not prevent an NOL from passing to the surviving company in a merger; it simply limits the extent to which the NOL can be used. Although it is true that the limitation is zero for years in which the merged company’s business is discontinued, the NOL is not destroyed. If the parent later sells assets received from the subsidiary that had built-in gain at the time of the merger, the loss can be used to offset the gain.

Discussions that we have had with the Commission after the decision came out indicate that the Commission had [...]

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New York ALJ Rejects Retroactive Application of Statute

by McDermott Will & Emery | Sep 8, 2014 | Constitutional Issues, Income Tax, New York, Procedure

State courts generally have allowed legislatures a fair amount of flexibility in adopting retroactive statutes, but a recent New York case held that, under the circumstances presented, the retroactive application of a statute was unconstitutional. In Matter of Jeffrey and Melissa Luizza (DTA No. 824932) (Aug. 21, 2014), Mr. Luizza agreed to sell all of the stock of an S corporation to an unrelated buyer in a transaction governed by Section 338(h)(10) of the Internal Revenue Code. Under Section 338(h)(10), Mr. Luizza’s sale of his stock was ignored for income tax purposes and the transaction was treated as if the corporation had sold its assets and distributed the proceeds to Mr. Luizza. Under the Subchapter S rules, the liquidation was essentially tax-free. The corporation’s gain was passed through to Mr. Luizza as the sole shareholder. Mr. Luizza was a nonresident of New York and under the law in effect when the sale occurred (March 2008) it appeared that a nonresident shareholder was not taxed on the gain in a 338(h)(10) sale because the transaction was treated as a sale of stock.

In 2009, the State Tax Appeals Tribunal confirmed that although a 338(h)(10) transaction was treated as a sale of assets by the corporation for federal income tax purposes, it was in fact a sale of stock and, since nonresidents are not subject to New York State income tax on gains from the sale of stock, even of a corporation doing business in New York, a nonresident selling stock of an S corporation in a 338(h)(10) transaction cannot be taxed by New York State on the resulting gain. In Matter of Gabriel S. and Frances B. Baum, et al., (DTA Nos. 820837, 820838) (Feb. 12. 2009) (McDermott Will & Emery filed an amicus brief supporting the taxpayer’s position in that case.)

The State Department of Taxation and Finance was not happy about the result of this litigation. It convinced the legislature to reverse that result by amending the statute to provide that a shareholder’s share of the corporation’s gain in a 338(h)(10) transaction would be treated as New York source income that was taxable to nonresidents. The legislation was adopted in 2010 and was made effective retroactively to all years open under the statute of limitations.

Mr. Luizza objected to the retroactive application of the statute to him, and the administrative law judge agreed that, on his facts, the retroactivity was so harsh as to be unconstitutional under the Due Process Clause of the United States Constitution. The ALJ pointed out that the taxpayer relied on the law as it existed in 2008 and that at the time of the sale the prevailing authority was that the transaction was not taxable. Mr. Luizza was advised by his tax advisors that there would be no additional New York tax due. Because of his reliance, he did not have an opportunity to seek a higher sale price or to require the buyer to indemnify him for any additional taxes resulting from [...]

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Massachusetts Early Mediation Program Changing the Tax Appeals Landscape

by Catherine A. Battin, Richard C. Call and Scott M. Susko | Aug 4, 2014 | Massachusetts, Procedure

The Massachusetts Department of Revenue’s new Early Mediation Program (EMP) is off to a very promising start. The EMP expedites the normal appeals process and offers hope to taxpayers that desire to resolve tax disputes without prolonged litigation. The Department indicated at a recent Boston Bar Association meeting that eight of the first 11 cases have resulted in settlements. Commissioner Amy Pittner announced publicly earlier this year that the Department’s goal is that one-third of all eligible disputes will be mediated.

Only controversies with $250,000 or more of tax at stake are currently allowed into the program (this is down from the original $1 million threshold). Either the taxpayer or the Audit Division may suggest participation in the EMP. Early mediation can be initiated any time a controversy has been fully developed in the course of the audit, but in no event later than 30 days after the issuance of a Notice of Intent to Assess. A taxpayer interested in the EMP must either submit a joint application with the Audit Division or one on its own. The Department retains discretion to determine that the EMP is not appropriate.

Once accepted into the EMP, the parties need to reach a resolution within four months or they must reenter the normal appeals process. The way the program works is that both the taxpayer and the Department must exchange position papers on the issues in controversy and submit them to the mediator (a representative of the Office of Appeals) prior to the mediation. Any supplemental information needs to be provided prior to the mediation. At the mediation, the parties present oral arguments on the issues and the mediator helps facilitate a settlement. The mediation is not binding on either party. The key to the success of the program is that both parties are required to have a person with settlement authority present at the mediation.

New York’s Revised Nonresident Audit Guidelines: A Tool for Taxpayers?

by McDermott Will & Emery | Jul 21, 2014 | Income Tax, New York, Procedure

The New York State Department of Taxation and Finance recently revised its Nonresident Audit Guidelines, updating the guidelines that had been in place since 2012. Included in the revised guidelines are changes to the Department’s views on both domicile and statutory residency audits. Individuals and practitioners involved in residency audits should be aware that certain of the revisions are taxpayer-friendly and can be employed favorably in audits and litigation.

Read the full article.

Missouri DOR Burden of Proof and Notice Requirements Remain Uncertain After Veto

by McDermott Will & Emery and Eric D. Carstens | Jul 10, 2014 | Missouri, Procedure

The Missouri General Assembly passed several tax-related bills at the end of the legislative session in mid-May that would have altered the Department of Revenue’s (Department) burden of proof and changed its notice requirements. While none of these bills ultimately passed due to vetoes by Governor Jay Nixon, the General Assembly is scheduled to review the vetoed legislation during their September 10 veto session. Given the near-unanimous support for each of these bills in the legislature, there is a legitimate possibility that one or more of these vetoes will be overridden.

Burden of Proof

Three of these bills, H.B. 1455, S.B. 829 and S.B. 584, would have vastly expanded the number of tax disputes where the Director of Revenue (Director) is statutorily assigned the burden of proof. The amendments would have removed a net worth limitation for any partnership, corporation or trust challenging their state tax liability and this would have vastly expanded the number of businesses eligible for the favorable burden. In addition, the legislation removed a clause that prohibited the burden of proof from falling on the Director with respect to the applicability of tax exemptions. All in all, the burden of proof legislation would have significantly expanded both the number of taxpayers and the number of types of disputes for which the burden of proof fell on the Director. As discussed further below, the Governor vetoed these bills. The Legislature will review the vetoes in September.

The statute that was being amended (Mo. Rev. Stat. § 136.300) strictly construes tax laws and liability determinations against the taxing authority in favor of taxpayers. The statute was originally enacted in 1978 and subsequently amended in 1999. The statute assigns the Director the burden of proof with respect to any factual issue relevant to a taxpayer’s liability if three elements are met. The first two elements are that the taxpayer must (1) have produced evidence that there is a reasonable dispute with respect to the issue and (2) provide the department of revenue with access to adequate records of its transactions. These elements are unchanged in each of the amending bills being considered.

The bills passed last month would remove the third and final element: the burden of proof does not rest with the Director if the taxpayer is a business taxpayer with either a net worth in excess of $7 million or more than 500 employees, regardless of the other two elements. This limitation incentivizes the Department to impose artificially high tax assessments on excluded taxpayers. These taxpayers are at a disadvantage because they would bear the burden of proof regarding factual questions, regardless of the detail of the Department’s audit. The vetoed legislation would have removed this limit and discouraged the Department from making artificially high assessments that would have been difficult to prove.

In addition to the subtraction of an element, the three bills passed in mid-May would have expanded the scope of the section to apply to disputes over exemption applicability, which are currently excluded along [...]

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How to Negotiate a Settlement Agreement

by McDermott Will & Emery | May 22, 2014 | Nationwide Importance, Procedure

Settlements of tax audits are typically memorialized in closing agreements between the department of revenue and the taxpayer. Negotiating these agreements can be an important part of any settlement.

The department of revenue may have standard printed form closing agreements, and the taxpayer should determine the extent, if any, to which the standard form can and should be changed. If department representatives are reluctant to change the printed form, one possibility would be to add an appendix that elaborates on—and even contradicts—the provisions of the form.

The agreement should indicate whether it is effective with respect to similar issues in future years. Part of the settlement may be an agreement as to how certain items will be treated in future years; if so, this should be explicitly stated. On the other hand, if the intent is that the agreement will not govern the treatment of settled items in future years, this too should be explicitly stated. We have had cases in which this was not made clear, and, when the taxpayer in future years departed from the agreed treatment of certain items, the auditors said that the taxpayer was reneging on a deal. When the taxpayer pointed out that the agreement specifically said that the settlement was not to apply to future years and did not necessarily reflect the opinions of the parties as to the proper tax treatment of any item, the auditors backed down, but they were still somewhat resentful. The best approach is to pin down precisely the effect, if any, of the agreement on future years.

The department of revenue may want to provide that it can reopen the audit years if it discovers tax avoidance transactions. While the auditors are thinking about abusive tax shelters, their suggested language is often broad and can apply to routine business transactions where tax considerations have been taken into account. One government draft closing agreement that recently crossed our desks would have allowed the department to reopen the audit in the case of any “scheme, product, or transaction structured with the intent of evading or avoiding federal or state taxes.” This language could apply to the most routine business transactions where taxes were taken into account, such as a decision to sell a business in a tax-free reorganization as permitted by section 368 of the Internal Revenue Code (the Code) rather than in a taxable sale. Taxpayers should try to limit any such provisions to objectively determinable tax shelters such as “listed transactions” within the meaning of the Code or comparable state law. While the desire of state tax officials to be able to challenge abusive transactions is understandable, the typical closing agreement occurs only after an audit has gone on for some time and the taxpayer’s books have been carefully checked, so there is no reason why any significant transaction should not have come to light. The department should not be allowed to reopen an audit or address routine business transactions just because they [...]

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National Conference of State Legislatures to Tackle Key State Tax Policy Questions

by Arthur R. Rosen, Diann Smith, Jane Wells May and Stephen P. Kranz | Mar 7, 2013 | Constitutional Issues, Nationwide Importance, Procedure

The National Conference of State Legislatures’ (NCSL) Executive Committee Task Force on State and Local Taxation has expanded its scope to include all significant tax policy issues facing the states. As part of its expanded scope, the task force has met with industry representatives to identify tax policy topics that would benefit from the task force’s consideration. Companies with a multi-state presence and concern about state tax policy have found participation in task force meetings beneficial to assisting legislator understanding of complex tax issues.

Read the full article.