CPAs need to be aware of current developments in key states in order to properly advise companies doing business in multiple jurisdictions. This article will examine recent tax developments in California, Ohio, and Tennessee.
California Rules in Favor of Taxpayer Not “Doing Business”
On January 12, 2017, the California Appellate Court reaf-firmed the judgment of Swart Enterprises, Inc. v. California Franchise Tax Board (Cal. Super. Ct., Nov. 14, 2014). In Swart, the court held that an out-of-state corporation was not “doing business” in California and was therefore not subject to California’s franchise tax. Swart Enterprises, Inc., headquartered and incorporated in Iowa, operated in Kansas and had no property or employees in California. Swart’s sole connection with California was its 0.2% ownership interest in a California-based LLC, Cypress Equipment Fund XII, LLC, with no right of control over the business affairs of Cypress.
The California Franchise Tax Board (FTB) argued that Swart was doing business in California and therefore subject to California’s franchise tax because Cypress was doing business in California, as the activities of a partnership can be attributed to a general partner. The FTB and the California Attorney General also argued that a foreign business entity should be considered to be doing business in California using a broad interpretation that would include Swart’s passive investment. In addition, the FTB argued that when an LLC elects to be treated as a partnership for federal income tax purposes, all members of the LLC must be treated as general partners.
The court rejected the FTB’s position and held that Swart’s passive 0.2% interest was not sufficient to conclude that Swart was doing business in California. The court also held that there is no authority under either California or federal law to support the claim that members of an LLC treated as a partnership for federal income tax purposes should be treated as general partners. The court further stated that “this interest closely resembles that of a limited, rather than a general, partnership” for the following reasons: 1) Swart had no interest in the particular property of Cypress LLC; 2) it was not personally liable for the obligation of Cypress LLC; 3) it had no right to act on behalf of or to bind Cypress LLC; and 4) it had no ability to participate in the management or control of Cypress LLC. In February 2017, the FTB issued Notice 2017-01 announcing that it would not appeal Swart and would follow the court’s decision in situations with the same facts.
CPAs should be aware that the court held that a member’s passive ownership interest in an independently managed LLC where the member had no right to control the business affairs of the LLC does not constitute doing business in California for franchise tax purposes. Therefore, the member is not required to pay the minimum tax. CPAs may suggest that LLC members owning a passive interest in an LLC doing business in California file a refund claim.
As more and more businesses expand into new geographic areas without establishing a physical presence in those areas, state and local govern ments will come to see these enterpris es as a source of tax revenue.
Ohio Affirms Economic Nexus Presence
The Supreme Court of Ohio recently ruled that the commerce clause of the U.S. Constitution does not prevent Ohio from imposing its commercial activity tax (CAT) on Internet retailers and that the statutory $500,000 sales receipt threshold satisfies the commerce clause requirement of substantial nexus. The court decided a commerce clause challenge to the Ohio CAT brought by three out-of-state retailers with no physical presence in Ohio: Crutchfield, Inc., Newegg, Inc., and Mason Companies, Inc. Each retailer brought a separate challenge to the Ohio CAT on commerce clause grounds; the challenges were consolidated on appeal (see Crutchfield Corp. v. Testa, Slip Opinion No. 2016-Ohio-7760).
The challenge was rooted in the following background: In Complete Auto Transit, Inc. v. Brady [430 U.S. 274 (1977)], the U.S. Supreme Court established the rule that a state is precluded by the commerce clause from imposing a tax on any business that does not have “substantial nexus” with the state. In 1992, in Quill Corp. v. North Dakota [504 U.S. 298 (1992)], the Supreme Court ruled that the “substantial nexus” threshold established in Complete Auto Transit required a taxpayer to have physical presence in the taxing state to be subject to a sales/use tax.
In 2005, Ohio enacted a gross receipts tax, commonly referred to as the CAT, on any business having more than $500,000 of Ohio gross receipts. The CAT statutes do not require that a taxpayer have a physical presence in Ohio to be subject to such tax. The three retailers sold their products to customers in Ohio; however, none of the taxpayers maintained any facilities or had any employees or representatives in Ohio. The taxpayers’ Ohio business operations consisted solely of shipping goods to Ohio consumers using the United States Postal Service or common carrier delivery services. Relying on Quill, the taxpayers challenged the imposition of the CAT on them arguing that 1) the taxpayers did not have “substantial nexus” with Ohio, and 2) a physical presence is required to subject a taxpayer to a gross-receipts type tax.
The court rejected the taxpayers’ arguments, holding that 1) a physical presence standard is not required for imposing a gross-receipts tax, and 2) the $500,000 sales receipts threshold complied with the substantial nexus requirement established in Complete Auto Transit. The court also held that Quill has not been and should not be extended beyond the sales and use tax context.
The current state nexus rules are extremely complex, and more states have adopted and are adopting an economic nexus threshold for imposing their taxes. Given the differing rules and fast-changing state tax landscape, CPAs should ensure that they understand the doing business rules in jurisdictions in which they have clients.
Tennessee’s Business Tax
In addition to its well-publicized excise and franchise taxes, Tennessee also imposes a gross receipts tax known as the “business tax.” Many taxpayers conducting business in Tennessee, however, are not aware of it. Tennessee’s business tax is a gross receipts tax on businesses that sell goods or services in the state. Effective for tax periods beginning on and after January 1, 2016, this tax is imposed, using economic nexus rules, on any business that derives at least $500,000 from sales to Tennessee customers during the current tax period. Accordingly, an out-of-state business with no physical presence in the state could potentially be liable for the business tax. The tax is imposed on a “location-by-location” basis, whereby taxpayers are required to register, file a return, and remit payment for each location, unless they receive permission to file a combined return for multiple locations. Businesses with no physical location in Tennessee, however, must consolidate their returns and treat their Tennessee sales as arising from a single location for purposes of the business tax.
Business tax rates vary from 0.02% to 0.30%, based on the taxpayer’s specific business classification. A business classification is determined based on the taxpayer’s “dominant business activity” at a particular location. A “dominant business activity” is defined as the business activity that is the major and principal source of taxable gross sales of the business. A business entity that generates gross receipts of less than $10,000 is not subject to Tennessee’s business tax and is not required to file a return; however, a business entity that generates more than $3,000 at a particular location must still pay a minimal activity license fee of $15.
Tennessee’s business tax is not imposed on the following employment activities:
- Sales made to wholesalers for resale;
- Occasional and isolated sales or transactions by a person not routinely engaged in business;
- Certain services within the fields of law, accounting, human and veterinary medicine, animal boarding, domestic services, public utilities, banking, insurance, engineering and architecture, building management, farming, nonprofit, education, religion, and charity.
Moreover, Tennessee has authorized its localities (i.e., towns, cities, and counties) to impose a similar tax that is state administered. Needless to say, CPAs with clients doing business in Tennessee need to be cognizant of these new filing requirements.
The Cost of a Shrinking World
As more and more businesses expand into new geographic areas without establishing a physical presence in those areas, state and local governments will come to see these enterprises as a source of tax revenue. It therefore behooves CPAs to keep abreast of the rapid developments in this area of tax policy.