As with all tax matters, state and local taxes and incentives offer the opportunity to choose to plan ahead or to choose to not plan ahead. Planning ahead usually results in the better outcome.
Below are several of the planning opportunities that state and local tax professionals are addressing during the life of a business or individual, and which we are seeing in audits and appeals, when not properly addressed early on.
Issue: Sales Tax on Software Development
Problem: The Nebraska Department of Revenue won’t recognize that custom software developed by outside firms for a company is exempt from sales tax, unless the software development agreement meets a three-factor test for the developers to be treated as “temporary employees” of the company for sales tax purposes. NDR Rev. Rul. 1-2-1.
What to Do: If a company very precisely includes the three factors for temporary employees in its software development agreement, it may avoid Nebraska sales tax on that development. Audits and appeals usually center around proving the agreement complies and that various contract terms or company practices don’t contradict this. The three-factor test is actually a “safe harbor,” which enables other factors and legal grounds to apply if this safe harbor is not met.
Issue: Tax on Cloud Computing
Problem: The Nebraska Department of Revenue has, in multiple matters we have been asked to help resolve, alleged that sales tax is due on a part of cloud computing charges. The department’s contention was that otherwise tax-exempt cloud computing was protected by certain levels of otherwise taxable security measures.
What to Do: If cloud service contracts are carefully drafted, a company may reduce or eliminate the portion of cloud computing charges that the department alleges are subject to the sales tax on security services. On audit or appeal, we are addressing the legal position that security is an integral part of the cloud service and should not be parsed and taxed.
Issue: Nebraska Residency for Income Tax Purposes
Problem: The Nebraska Department of Revenue routinely follows individuals who move outside of Nebraska to attempt to classify these persons as still being taxable residents.
What to Do: If your client intends to move out of state to nonresident status, the 12 principal factors for determining a person’s resident or nonresident status should be addressed and documented during the move. Frequently, individuals will want to retain certain Nebraska connections (such as home or business ownership) which the Department of Revenue uses against you. On audit or appeal, we usually find the taxpayer hasn’t met all of the 12 factors or kept the documents to best prove this, so this often becomes a matter of legal positioning and settlement.
Issue: Nebraska Tax for Trusts Administered Elsewhere
Problem: Nebraska’s statutes impose tax on trusts created by a Nebraska resident. This may not be constitutional for trusts administered outside Nebraska.
What to Do: If a trust’s only contact with Nebraska was the residence of a grantor, the trust may not be subject to Nebraska income tax. This is best handled when the trust is set up or results in a legal analysis upon audit or appeal.
Issue: Qualification for Nebraska’s Capital Gain Exclusion
Problem: The Nebraska Department of Revenue has challenged the qualification for this exclusion in a number of situations, including when corporate stock is first placed into an LLC, partnership, or trust or when stock is sold in a deemed asset sale under Sec. 338(h)(10) of the federal tax code.
What to Do: The selling owner needs to meet the statutory requirements at the time of sale. If an owner wants to transfer stock into an LLC, partnership, or trust, the potential disqualification needs to be addressed before the stock is transferred. The case law provides debatable positions for audit or appeal when the ownership isn’t clean.
Issue: Optimizing Imagine Nebraska Incentives
Problem: Most state tax incentive programs, including Nebraska’s, have certain requirements to qualify for and optimize the available incentives. These can relate to the level of new investment and jobs, the type of business, the level of compensation, the locations, the corporate structure, and the type of property being acquired. We typically review more than 25 factors in preparing Imagine Nebraska Applications.
What to Do: Under the Imagine Nebraska Act, the project application needs to occur ahead of project commencement to optimize results. There are 20 main critical legal criteria that need to be addressed in the planning stage for these projects. Ideally, potential issues are dealt with in advance with the Nebraska Department of Economic Development or the Nebraska Department of Revenue before the project commitments are in place. Under this Act, a project agreement is entered into with the state of Nebraska. This is a contract. The project application is part of this contract. So, both the application and the agreement need to be addressed with the same level of legal review and care as with all contracts. Options for appeal exist for issues that are not resolved, either during the project application process or during the project’s audits.
Issue: Wayfair Changes the Rules on Sales Tax Collection
Problem: In the recent Wayfair decision, the U.S. Supreme Court eliminated the traditional physical presence rule, which held that a company must have physical presence in a state to be required to collect tax in that state. This means that companies may need to collect sales tax in a state even if they are not physically located in that state.
What to Do: Wayfair is a game changer. This reversal of the physical presence rule means that all companies selling products or services in multiple states need to determine whether they now have a sales tax collection requirement. Failure to determine this accurately can result in under collection (with tax due upon audit) or over collection (with in effect a noncompetitive overcharge). Companies must also align their purchasing practices to be sure they are not inadvertently paying a use tax on purchases where the seller has stepped up its tax collections.
Issue: A Business Buyer’s Liability for the Seller’s Unpaid Taxes
Problem: Nebraska tax law can, in certain cases, require the purchaser of a business to pay the unpaid taxes of the predecessor owner.
What to Do: This can be largely addressed in the drafting of the purchase agreement, along with the due diligence process. In addition, if a company properly plans and requests clearance from the Nebraska Department of Revenue, it may avoid taxes of a predecessor.
Issue: Bundled Transaction Rules
Problem: An improperly structured purchase transaction, in which a purchaser receives multiple goods or services for one, non-itemized price, can cause tax to be imposed on the purchase of otherwise nontaxable goods or services.
What to Do: If a company plans its purchase or sale transactions to avoid classification as a bundled transaction, it may avoid unnecessary sales or use tax. On audit or appeal, we can also address whether this is actually one nontaxable transaction, not to be broken into taxable and nontaxable portions.
Issue: Classification as Taxable Goods or Nontaxable Services
Problem: It is not always clear whether a purchase transaction is for taxable goods or nontaxable services. The answer to this drives whether the transaction is subject to sales and use tax.
What to Do: If a company structures its transactions in light of the Nebraska Department of Revenue’s six-factor test for distinguishing nontaxable services from taxable goods, it may reduce its ultimate sales tax cost on the transaction to zero. When this reaches audit or appeal, we usually need to bring both the department’s test as well as applicable “principal object” case law into play.
Issue: Qualification for Alternative Apportionment
Problem: Within the last few years, Nebraska amended its statutes to add new apportionment rules that, in general, better reflect the relative economic activity of many companies in Nebraska. However, for some companies, the statutory apportionment rules do not fairly represent its Nebraska activities.
What to Do: If a company receives an alternative apportionment ruling, it may apportion its income to Nebraska using a test appropriate for its business model. This now needs to be applied for before the tax year. This is subject to appeal if not granted.
This article has examined some of the various planning opportunities that can occur “Before an Audit.” In our next two articles, we’ll look first at certain best practices “During an Audit” and then “After an Audit” (i.e., the appeal). These are also highlighted in our publication, The Anatomy of Resolving State Tax Matters.
Nick Niemann and Matt Ottemann are partners with McGrath North Law Firm. As state and local tax and incentives attorneys, they collaborate with CPAs to help clients and companies evaluate and defend tax and incentive positions with the appropriate state or local agency, including the Nebraska Department of Revenue. Learn more at www.NebraskaStateTax.com. For a copy of their complete publication, “The Anatomy of Resolving State Tax Matters,” please visit their website or contact Niemann or Ottemann at (402) 341-3070 or at email@example.com or firstname.lastname@example.org, respectively.