Today we hear a lot of debates in political circles where someone on the political spectrum is contending that an action by the Executive Branch (typically the President) is not constitutional. These debates are most often not whether a statute is constitutional, but whether the action by the Executive Branch is unconstitutional in how it exercises the authority under statute. We are not weighing in on these debates. Instead, the purpose of this article is to highlight how we are often able to identify where a state department of revenue or county board taxing authority has applied a statute in an unconstitutional way.

As tax attorneys, we collaborate with a company’s internal tax and legal teams, and their external CPAs, to resolve state and local tax audits and appeals. To help resolve many of these engagements, we have deployed what we refer to as constitutional “guardrail” defenses. Our objective is not to create new points of contention, but rather to utilize these defenses strategically to help achieve more favorable settlements in a shorter timeframe.

We use these defenses most commonly to show how the taxing authority is applying a statute or regulation in a manner that violates constitutional principles (i.e.,

it is acting outside of the constitutional “guardrail” and is out of bounds). This approach serves to curtail overly broad or aggressive interpretations by the taxing authority. It helps ensure the statute is applied within constitutional bounds. In doing so, we are not attempting the difficult task of invalidating a statute (though at times we have also taken that on). Rather, we are simply insisting that the statute be applied in a lawful and constitutionally compliant manner.

The following is a summary of some of the most frequently used and impactful constitutional “guardrail” defenses relevant to state and local tax matters.

Equal Protection Clause: U.S. & Nebraska Constitutions

The 14^th Amendment to the U.S. Constitution establishes that “No state shall … deny to any person within its jurisdiction the equal protection of the laws.” A similar provision exists in Nebraska’s Constitution (Article I, Section 3).

These provisions prohibit states from making unreasonable classifications. To be constitutional, the law (and how it is applied) must have a rational relationship to a legitimate legislative purpose. While that may seem to be simple enough, some distinctions can run afoul of this “guardrail.”

For example, in the case Natural Gas Pipeline Co. v. State Bd. of Equalization, 237 Neb. 357 (1991), the Nebraska Legislature had exempted railroad cars, but not pipelines, from personal property taxation. The Nebraska Supreme Court held this violated the Equal Protection Clause, stating: “The Legislature’s stated justification is illusory. We fail to see any real and substantial difference between personal property used … by one type of business and the same … personal property used by another type of business.”

Dormant Commerce Clause: U.S. Constitution

The Dormant Commerce Clause (also called the Negative Commerce Clause) is a legal doctrine that is taken from the Commerce Clause in Article I, Section 8 of the U.S. Constitution. That clause, as written, specifically grants the federal government the power to regulate interstate commerce. The Dormant Commerce Clause is a judicially created doctrine that prohibits states from enacting legislation or from adopting rules or practices that discriminate against or unduly burden interstate commerce. This prohibition applies even when Congress has not passed a law on a given subject.

As applied to state and local taxes, the U.S. Supreme Court has developed a four-part test that a tax statute (and how it is applied) must meet to be allowed under the Dormant Commerce Clause:

1. The tax must be applied to an activity that has a substantial connection to the state.
2. The tax must be fairly apportioned to activities in the state.
3. The tax must not discriminate against interstate commerce.
4. The tax must be fairly related to services provided by the state.

An example of state action in this context is how it applies the income apportionment rules.

Special Legislation Clause: Nebraska Constitution

Article III, Section 18 of the Nebraska Constitution specifies that: “The Legislature shall not pass local or special laws in any of the following cases:  … Granting to any corporation, association, or individual any special or exclusive privileges, immunity, or franchise whatever.”

The Nebraska Supreme Court has interpreted this to mean that: “A legislative act constitutes special legislation if (1) it creates an arbitrary and unreasonable method of classification or (2) it creates a permanently closed class.”

Nexus: U.S. Constitution

The U.S. Supreme Court has stated that there must “be some definite link, some minimum connection between a state and the person, property, or transaction it seeks to tax.” This link is commonly referred to as “nexus.” If a person or company does not have nexus in a state, the state cannot subject that person or company to tax (or require them to collect tax).

As established in the U.S. Supreme Court case Wayfair v. South Dakota, nexus can be both from physical presence or economic presence in a state. So, while nexus may now be easier for states to establish, nexus is still a significant “guardrail.”

The nexus “guardrail” is the basis of Public Law 86-272. This federal statute prevents a state from imposing a net income tax on a company’s income derived within the state from interstate commerce if:

a) the only business activity performed in the state is the solicitation of orders of tangible personal property;
b) such orders are sent outside the state for approval or rejection; and
c) the orders, if approved, are filled by shipment or delivery from a point outside the state.

Given the Public Law 86-272 protections, we will review the applicability of the Public Law 86-272 “guardrail” whenever we confront the claim by a state taxing authority that a nonresident company selling tangible personal property owes state income tax.

Privileges & Immunities Clause: U.S. Constitution

This constitutional “guardrail” prohibits a state from imposing higher tax rates, or additional taxes, on nonresidents than the state imposes on residents. Courts have, in the past, used this “guardrail,” for example, to prohibit a “commuter income tax” which applied only to nonresidents working in the state or to prohibit the application of a property tax credit to only farms owned by residents.

Uniformity & Class Definitions in Property Tax: Nebraska Constitution

Property taxes in Nebraska have additional constitutional “guardrails” that should be considered.

Article VIII, Section 1 of the Nebraska Constitution establishes that taxes must be levied uniformly on real property in Nebraska: “Taxes shall be levied by valuation uniformly and proportionately upon all real property and franchises as defined by the Legislature except as otherwise provided in or permitted by this Constitution.”

There are certain exceptions to this general rule, of course. Article VIII, Section 2 of the Nebraska Constitution establishes certain exemptions for real property. In addition, Article VIII, Section 1 establishes that “agricultural and horticultural land” shall constitute a “separate and distinct class of property for purposes of taxation.” This provision allows for agricultural and horticultural land to be assessed at 75% of its fair market value.

For personal property, Article VIII, Section 1 of the Nebraska Constitution establishes: “Tangible personal property … shall all be taxed at depreciated cost using the same depreciation method with reasonable class lives, as determined by the Legislature, or shall all be taxed by valuation uniformly and proportionately.” Article VIII, Section 2 of the Nebraska Constitution again establishes exemptions for certain types of personal property, including “household goods and personal effects,” livestock, and business inventories.

When evaluating a property tax case, we review whether Nebraska’s constitutional “guardrails” for property tax are being interpreted and applied properly. If the application of Nebraska’s law by the taxing authority goes outside of these property tax “guardrails,” we will adopt a defense accordingly.

At the invitation of the Nebraska Chamber of Commerce, we presented a program on Nebraska tax policy to our state’s business leaders, tax advisors, and legislative leaders. As part of that presentation, we highlighted key “guardrail” defenses to preserve the state’s tax integrity. To learn more, view the presentation video on McGrath North’s website (mcgrathnorth.com) under the State and Local Taxation and Incentives practice area, or watch it directly at https://youtu.be/aUHmA9vjixI.