The top issues in state tax for 2019
Wayfair and the TCJA continue to dominate in 2019
By Roger Russell
Any way it’s measured, 2018 was a momentous year in state tax developments. State tax professionals experienced a “Super Bowl and Olympics” in the form of the Supreme Court decision in Wayfair and the state and local tax implications of federal tax reform in the Tax Cuts and Jobs Act, according to Jamie Yesnowitz, principal and SALT national tax office leader at Top Six firm Grant Thornton. “Cleary the top two developments of 2018 were Wayfair and the implications of federal tax reform,” he said. “With respect to Wayfair, there’s the decision itself to analyze, South Dakota’s response to Wayfair, and then, of course, other states’ responses by providing their own economic nexus statutes.”
Here are the top state tax developments of 2018, according to Yesnowitz and the Grant Thornton SALT national tax office.
The impact of Wayfair and South Dakota’s response
The U.S. Supreme Court’s June 21, 2018, ruling in Wayfair concluded that states can impose sales tax-collecting requirements on out-of-state retailers, even those that do not have a physical presence in the state.
The court addressed South Dakota’s direct challenge to Quill, the 1992 decision that established the physical presence test for sales and use tax nexus. South Dakota’s challenge lay in the enactment of an economic nexus test that requires remote sellers, without a physical presence in the state, to collect sales tax if certain gross revenue or transaction thresholds were met — more than $100,000 of goods sold or 200 transactions within a year. “Wayfair really changed the core of how you deal with sales tax,” said Yesnowitz. “Now remote sellers have to consider whether their markets are large enough to be required to collect and remit sales tax in places they have not envisioned before.”
“South Dakota’s response to Wayfair was particularly interesting because of its inclusion of marketplace providers and facilitators. On or after March 1, 2019, certain marketplace providers will be required to collect and remit sales tax on behalf of sellers using their services, when certain conditions are met,” said Yesnowitz. “The constitutionality of this was not addressed by the court in Wayfair, since the law at issue before the court did not impose these rules on marketplace providers and facilitators.”
“One of the major challenges companies are facing is the non-uniform treatment of the new rule with different thresholds, tax bases etc.,” he added. “For many this is a giant tracking exercise.”
State responses to Wayfair
In addition to the remote-seller legislation inspired by Wayfair, the states are expanding the sales tax base through taxability of digital goods and additional types of services, Yesnowitz observed.
“Wayfair has provided these states with an opportunity, through legislation, to expand the sales tax base. Our sense is that in 2019 we will see continued legislation regarding Wayfair, particularly in the area of marketplace providers and facilitators,” he said. “We will start to see some state court decisions that reference Wayfair and pre-Wayfair nexus, for controversies that occurred prior to Wayfair, and we should begin to get a sense of how the courts will rule.” There will be repercussions on the income tax side as well, according to Yesnowitz: “States were beginning to consider how to implement expansive economic nexus provisions on the income tax side.”
The next frontier: Sales tax on cloud-based sales post-Wayfair
Through 2018, 17 states imposed a state-level sales tax on software as a service, and 26 states imposed a state-level sales tax on digital goods and products, Yesnowitz noted.
“However, with the changing nexus landscape, as decided in Wayfair, along with the continued growth in the digital economy, it is likely that we will begin to see states more broadly tax internet and cloud-based sales. As states have adopted economic nexus provisions, many have [expanded] their definition of what makes up gross or taxable sales — subject to economic nexus thresholds. Digital products, items transferred electronically, intangibles, and sales over the internet are examples of the types of transactions being targeted by many states in a concerted effort to expand the sales tax base.”
The expansion of definitions and taxability of goods and services, especially those in the realm of digital and software services, is being pursued in tandem with the new economic nexus provisions, Yesnowitz noted. “Given the developments in Iowa, Rhode Island and the District of Columbia [all of which took action in this area in 2018], it is fair to conclude that the states will continue to reach for the next frontier of sales taxability. Issues to watch in the coming year that go beyond pure compliance with Wayfair standards include how broadly services may become part of the sales tax base, and whether states will be able to align definitions in the realm of digital goods and beyond.”
State responses to federal tax reform
“This issue was what we thought would be the story of the year prior to Wayfair,” said Yesnowitz. “We think states will be spending time reacting to federal provisions in the coming year. Much of the state action in the past year related to state treatment of IRC 965, the deemed repatriation provision, as the income from that provision hit taxpayers’ 2017 taxes. States took various approaches to Section 965 and released guidance throughout the year. As a result, taxpayers had to consider to what extent a state allowed a dividends received deduction, and if includible, how it would be treated for sourcing purposes. Some states that conformed to Section 965 allowed less than a 100 percent dividends received deduction through an offset or a reduced deduction.”
During the past year. states had to deal with the effects of the federal 100 percent bonus depreciation, and began to consider the effects of some of the more material tax reform provisions, including the interest deduction limitation, the Section 179 expensing threshold, and the potential effect of the Section 199A pass-through deduction, Yesnowitz observed. “Many of these provisions will be hitting taxpayers’ 2018 returns and as a result, 2019 state legislative sessions will focus on whether to adopt or decouple from all of these provisions. In many cases, by doing nothing and simply conforming to the federal code, state corporate income tax bases following tax reform are likely to rise, leading to increases in tax. Expect a fair amount of nonconformity between the states with respect to which provisions they will decouple from or conform to. Approaches will vary from state to state, which will make for a very complicated tax filing on state returns in the years ahead.”
Major tax reform enacted by some states
“Wayfair and federal tax reform provided the states with a significant opportunity to engage in their own state-specific tax reform,” Yesnowitz suggested. “While many states enacted legislation in response to federal tax reform, states such as New Jersey, Connecticut, Kentucky and Missouri enacted significant state-specific tax reform that went far beyond adopting or decoupling from federal tax reform provisions.”
Texas and Michigan narrowly interpret deductions against their gross receipts tax bases
During the 2000s, several states, including Texas and Michigan, adopted gross receipts or other non-income taxes. Many taxpayer controversies arose that focus on the scope of deductions from the tax base, Yesnowitz indicated: “During 2018, both Michigan and Texas narrowly interpreted these deductions, via judicial and regulatory action, respectively.”
Continuing sales factor sourcing uncertainty
For sales other than sales of tangible personal property, many states during the past decade have changed their methodology of sourcing receipts, replacing the traditional cost-of-performance method with market-based sourcing. “In some states, however, there remains a level of uncertainty regarding the sourcing of service revenue,” Yesnowitz said. “For example, Texas is widely considered to be a cost-of-performance state, but the state comptroller has attempted to apply market-based sourcing in certain instances. And although Wisconsin is a market-based sourcing state, the Wisconsin Department of Revenue was unsuccessful in sourcing software royalty income received from original equipment manufacturers to the location where it is ultimately used, as reflected in Microsoft Corporation v. Wisconsin Department of Revenue.”
The rise of municipal-level taxes targeted toward special initiatives
A number of municipalities attempted to raise revenue for special initiatives during 2018. Several municipalities attempted to address homelessness. Seattle enacted an employee hours tax for the privilege of engaging in business in the city, only to repeal it several weeks later in response to the opposition from affected businesses. San Francisco enacted an increase in the business tax rates on gross receipts that will be directed to fund homelessness services. And the Philadelphia Beverage Tax, designed to combat obesity, sustained challenge during 2018. “Based on what we’ve seen, one of the underlying state topics for the year ahead will relate to municipal-level taxes,” Yesnowitz said. “We’ll see a fair amount of activity in this area during 2019, particularly on the West and East Coasts.”
Megadeals and taxability of incentives post-tax reform
Yesnowitz cited the competition among states for businesses to locate their expanded operations. In particular, Amazon’s HQ2 for its second headquarters generated intense competition, with over 200 proposals from jurisdictions across the country. The search was eventually narrowed to 20 potential locations. The winners, New York (Long Island City) and Northern Virginia (Arlington), and a third, smaller hub in Nashville, offered a variety of incentives, but were not the most generous of the offers.
“Despite individual locations offering up to four times the amounts offered by New York and Virginia, Amazon still chose to locate in well-established cities along the East Coast with easy access to airports,” said Yesnowitz.
North Carolina and Alabama were in a lower-profile battle for the location of a Toyota-Mazda jointly operated auto plant, with Alabama being selected. Alabama offered approximately $350 million in incentives consisting mainly of the jobs credit and an investment credit, Yesnowitz indicated. It also offered reimbursement for eligible capital costs, state sales tax abatement, a non-educational property tax abatement, and a promise that the state employment agency would build and operate a training center. In addition, the city of Huntsville offered local incentives, bringing the total incentive package to approximately $700 million.
“It will be interesting to see whether a TCJA provision amending IRC Section 118 will serve to dampen incentive megadeals in the future,” said Yesnowitz. “Amended Section 118 expands gross income for federal tax purposes to include many previously untaxed state and local incentives. This could lessen the impact of economic incentives offered to companies, or force states and localities to offer more in consideration of an immediate tax offset.”
Illinois Supreme Court decides hospital property tax case
The Illinois property tax exemption for nonprofit hospitals has been an issue since a new category of charitable exemption tailored to hospitals was created in 2012. A conflict between two districts of the Illinois Appellate had issued conflicting opinions on the constitutionality of the hospital property tax exemption statute. The Illinois Supreme Court resolved the issue in a unanimous holding that the exemption for hospitals and their affiliates is constitutional.