Key takeaway: In a one-two punch, the TCJA and Wayfair delivered a significant wallop to the state and local tax landscape.
Key takeaway: In a one-two punch, the TCJA and Wayfair delivered a significant wallop to the state and local tax landscape.
Wayfair turns one
It has been a little over a year since the U.S. Supreme Court delivered its historic decision in South Dakota v. Wayfair, which enabled states to require out-of-state sellers to collect and remit sales tax solely based on their economic connection to their state. While the historic physical presence requirement is still a relevant consideration, for the first time in the 50 years, it is not the only consideration. This game-changing decision has already had a huge impact over the past year and it promises to make waves for at least the next few years.
State responses to Wayfair
As expected, the states responded to the Wayfair decision quickly by enacting economic nexus legislation of their own. Today, all but two of the states that impose a sales tax have expanded their nexus statutes to include sales thresholds and/or number-of-transaction thresholds tests. The majority of states adopted the same $100,000 of sales and 200 transactions thresholds used by South Dakota. Florida and Missouri proposed economic nexus legislation but they failed to pass before their legislative sessions ended. We expect these remaining states to have economic nexus statutes in the near future.
We are already seeing consequences of the rushed responses from states. Economic nexus laws in California, Iowa, North Dakota and Washington originally included a number-of-transactions test, but the legislatures have since repealed them. California, Connecticut, Georgia, New York and Oklahoma already changed the dollar thresholds — either increasing or decreasing them.
Another emerging trend is the simplification of local sales tax rates. Alabama, Louisiana and Texas offer a simplified sales tax collection method for remote sellers that allows these sellers to charge a single blended rate for all sales made into their states.
Marketplace facilitators and nexus
The latest tool that states are using to expand sales tax compliance is in the area of marketplace facilitators. Generally, a “marketplace facilitator” is defined as a marketplace that contracts with third-party sellers to promote the sale of certain tangible property and digital goods and services through the marketplace. Examples include Amazon and eBay and, lately, this concept spread to food delivery services, including Uber Eats and Grubhub. States have created legislation that require these marketplace facilitators to collect sales tax on behalf of their third-party sellers’ transactions. States see this as a way to collect all the required sales tax from one company as opposed to thousands of smaller companies. Also, these facilitators collect tax from all companies regardless of how small the amount of sales or number of transactions. As of Oct. 1, more than 30 states have marketplace facilitator statutes.
What the future is likely to bring
As a natural response to the massive influx of companies registered for and collecting sales tax, we expect sales tax audits to increase dramatically in the coming two to four years. Taxpayers could start being audited wherever they are registered, which increases the likelihood of having multiple state audits simultaneously.
Impact on international companies
Wayfair’s challenges are not limited to U.S.-based businesses. The decision could potentially have significant impact on the administrative burdens of foreign companies as well. A foreign company selling tangible personal property or taxable digital goods or services into the U.S. from outside of the country could be required to register in a state and collect/remit sales tax if its sales or annual transaction exceeds the applicable economic thresholds in a given state. International tax treaties will only apply to state income taxes once adopted by the state. As such, foreign companies with U.S. customers could be subject to state sales tax compliance obligations, regardless of whether or not they have a permanent establishment. While the issue is still evolving, arguments may be made and practical considerations taken into account regarding whether a state can enforce collection against non-U.S. entities.
Impact on other taxes
While clearly addressing sales and use tax when confirming the idea of economic nexus, Wayfair effectively implicitly endorsed the previous assertions by numerous states that physical presence was not a requirement for the imposition of income taxes and other entity-level taxes. States currently impose economic nexus for other types of taxes by broad economic nexus or bright-line or “factor presence” economic nexus. We anticipate states will continue to use these standards for income and/or gross receipts taxes. While states adopted economic nexus-based provisions for income tax purposes, P.L. 86-272 (the Interstate Income Act of 1959) continues to prohibit states from requiring a company file a net income tax return if the company’s activities in a state are limited to the solicitation of orders for the sale of tangible personal property and the orders are approved and filled from outside the state.
The TCJA’s impact isn’t limited to federal taxes. Every state has had to decide which provisions of federal law it would conform to or if it would set up its own rules to deal with business interest expense limitations, repatriation and the voluminous other changes made under the TCJA.
Business interest limitation under IRC section 163(j) developments and trends
One of the more substantial changes to come from tax reform is the limitation on the federal deduction for business interest expense. Since many states conform to federal income tax provisions, this limitation affects state tax liability as well.
Just how much a taxpayer’s state income tax liability is influenced by the new regulation is unclear, not only because it depends on a number of state-specific factors, including conformity rules, “taxpayer” definition and return filing methodology, but also because the majority of states have yet to publish specific guidance for taxpayers.
Arkansas, California, Georgia, Indiana, Mississippi, New Hampshire, South Carolina, Texas, Virginia and Wisconsin decoupled from section 163(j) and did not adopt the interest limitation. However, states have differing treatments in handling the decoupling modification. Case in point: Virginia has partially decoupled with a mechanism permitting a 20% subtraction modification for any federal interest expense limitation that is included in the state’s starting point, which is federal taxable income. Generally, the decoupling mechanisms will require some adjustment to the amount deducted for federal tax purposes with remaining amounts carried forward to a future tax year. This necessitates separate state interest expense schedules to be maintained along with federal.
In states such as Nevada, South Dakota, Washington and Wyoming, adopting or decoupling from the interest expense limitation is not relevant since they do not have an income tax.
The remaining states have adopted the limitation either by adopting the entire IRC as of a date after the TCJA was effective or by specifically adopting section 163(j). Of the many adopting states only a few, including Alabama, Minnesota and Pennsylvania, have specific implementing guidance. In fact, Pennsylvania’s guidance is unique in that it applies the limitation to only corporations and pass-through entities but not individuals.
In states where the federal limitation and carryforward provisions are adopted, the value of the carryforward in a subsequent year can be impacted by the change in apportionment factor in the year of limitation to the year of carryforward. For example, if a taxpayer’s limitation was $100 and their apportionment factor was 50%, they would forgo $50 of interest expense to that state in the year of limitation. Fast forward to the subsequent year and the entire $100 is carried forward in the federal taxable income but the taxpayer’s apportionment factor is now 25%. This would result in a permanent loss of $25 of carried forward interest limitation on this particular state without taking into consideration the potential increase in apportionment in other states.
GILTI inclusion/deduction and FDII deduction developments/trends
Section 951A is an anti-deferral regime for all controlled foreign corporations (CFCs) earning global intangible low-taxed income (GILTI). For any year a U.S. person is a CFC shareholder, the shareholder must include in gross income the shareholder’s GILTI inclusion amount for such tax year. However, section 250 mitigates the impact of the GILTI regime by allowing C corporations deductions of 50% of GILTI income and 37.5% of foreign-derived intangible income (FDII).
Many states that adopted the IRC subsequent to TCJA have implicitly included GILTI in their state starting point (generally U.S. Form 1120 line 28 or 30). Assessing whether the state permits a 100% or a lesser subtraction of the GILTI inclusion via a state modification is the next level of inquiry.
If the inclusion of the GILTI income remains in the state base due to the lack of a subtraction modification, it is time to determine whether a state adopts the 50% GILTI and the 37.5% IRC section 250 FDII deductions. For the most part, GILTI-inclusion states that begin with federal line 30 will adopt both of the section 250 deductions, but it is recommended the adoption of these deductions be verified independently.
The impact on apportionment of a GILTI inclusion should be considered when preparing state income tax returns. However, our experience has been only a handful of states may require the sales factor numerator or denominator be adjusted for GILTI-inclusion purposes.
Trust income taxation developments
Please see our alert: Supreme Court issues trust-friendly state income tax nexus decision.
SALT cap pass-through entity workaround
The TCJA limits deductibility of state and local taxes to $10,000 for individual taxpayers. In response to this limitation cap, some high-tax states (Connecticut, Wisconsin, Oklahoma and Louisiana) enacted workaround legislation subjecting pass-through entities (PTEs) to an entity-level income tax. Other states (Michigan, Minnesota, New Jersey, New York and Rhode Island) have proposed workaround legislation, and Massachusetts’ DOR recently issued a directive on the application of the income tax credit related to the Connecticut PTE tax to Massachusetts’ resident taxpayers.
For PTEs, this state entity-level income tax is fully deductible when computing federal taxable income. To avoid double taxation, PTE owners either receive an offsetting credit for taxes paid by the entity or the ability to exclude income from their individual returns that the entity has already paid taxes on. Federal regulations issued June 11, 2019, addressed and disallowed workarounds related to government-created charitable funds for a variety of programs in which donors can receive a state tax credit in exchange for donations. However, no formal response has yet been provided from the IRS on state PTE workarounds, but the IRS is likely developing proposed rules on the application of the $10,000 cap on the state and local tax deduction to PTE. Some believe the guidance being developed will seek to invalidate an emerging PTE SALT cap workaround.
In most instances, a voluntary disclosure program can be a tax-efficient way to remediate historic liabilities due to the limited lookback of tax periods — as long as a taxpayer is not under audit, not currently filing returns or has not been contacted by a state. If the taxpayer does not qualify for a voluntary disclosure program, they should consider any available amnesty programs to remediate any past exposures. For instance, Illinois will provide such a tax amnesty for delinquent taxpayers between Oct. 1, 2019, and Nov. 15, 2019. Other states may have amnesties in the near future.
Our recommendation is to consult with your tax professional on the availability/efficacy of amnesty versus voluntary disclosure programs to remediate historic tax liabilities you may have in various jurisdictions.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.