In our work with various departments of revenue around the country, we have the opportunity to see first hand how Nebraska’s Department of Revenue compares. As states grapple with their budget issues, many state departments of revenue have become much more aggressive and less reasonable to work with.
The Nebraska Department, by contrast, has remained approachable and reasonable to work with. It has a culture which aims to strike the right balance between doing their jobs to aggressively enforce the State’s tax laws to secure the State’s fiscal needs and being willing to consider reasonable approaches and settlements (on tax appeals, tax incentive projects and ruling requests).
Many of the state tax and incentive matters we handle involve fact or legal interpretation issues on which reasonable minds can differ, sometimes simply because the issue hasn’t yet been addressed authoritatively in Nebraska. These differences are inherent in the practice of state tax legal matters. We settle most cases during informal discussion and debate with the Department while taking others through the formal administrative hearing and litigation processes when the Department is not willing to reach the result we believe should occur.
Unfortunately, several cases we have handled involve situations where either the taxpayer’s or advisor’s earlier actions or inactions (e.g. during the audit or in drafting a protest) worked to the disadvantage of the taxpayer. Therefore, we thought it would be helpful to share a selection of some of the state tax and incentive issues we have been addressing or challenging with the Department. This may offer both some insights and some precautions.
Sales and Use Tax
- Is It A Service Or Property? The line between whether a transaction is a purchase of nontaxable services or the purchase of taxable property can be unclear. Several states, including Nebraska (e.g. Rev. Rul. 1-08-6), have applied various tests. This is important both for sales/use tax purposes (as to whether the transaction is exempt) and for income tax purposes (by affecting apportionment).
- In Which States Must I Report And Pay Taxes? One of the most important, yet most confusing, tax issues that multi-state companies deal with is whether that company must file tax returns and/or collect sales tax in various states. A company must pay and collect tax in a state if that company has “nexus” in the state, which generally means that it has enough contacts with the state to enable the state to constitutionally exercise its right to tax you. Most companies make sales of property or services into multiple states. The amount of property and employee contact or other economic activity within a state, as well as the company’s corporate structure, determines whether that state can tax you (for both sales and income tax purposes). An understanding of the ground rules can help you reduce your tax exposure.
- What If I Buy Software And Load It On A Server Outside Nebraska? What If I Utilize Software-As-A-Service? With innovations such as cloud computing, external data centers, and software-as-a-service becoming the new norm, fundamental tax questions must be re-addressed. For example, if I load software on a server in Kansas, but use it in Nebraska, do I owe Nebraska or Kansas tax on the software? Is “software-as-a-service” taxable as a software purchase or a tax-free service?
- Am I Taxed On Software Development? The Department has issued a ruling (Rev. Rul. 1-02-1) which states that if a company’s agreement with a software developer contains three provisions – dealing with control, liability, and ownership – then the company’s payments to that provider will be treated as payments to a temporary employee and are not taxable. In practice, agreements are often unclear if they haven’t been carefully drafted with these provisions in mind. In addition, some auditors disregard this ruling and simply assess all software development transactions (letting it be resolved on appeal). What happens if the software development occurs outside Nebraska and the software is then moved to Nebraska? Will the Department’s 3 factor ruling still apply? When is the IRS 20 factor test applied instead? How does your Nebraska sales tax position impact your payroll tax and employee benefit plans?
- What If The Department Decides I Am Not Really Engaged In Manufacturing? Nebraska’s manufacturing machinery exemption is a powerful economic development incentive. However, the Department has interpreted it narrowly. The Department has attempted to limit the equipment used by manufacturers that is eligible for the exemption by limiting who it considers to be a manufacturer and by not reflecting the integrated plant nature of the statute, among other issues. An initial negative response is often worth challenging.
- When Is Sales Tax Due If I Purchase Or Sell A Business? Nebraska has enacted an “occasional sale” exemption which often exempts the sale of an entire business from Nebraska sales tax. To qualify, a buyer must be able to demonstrate that the seller had paid (or was originally exempt from) sales tax on the initial purchase of the business assets. If this evidence is not obtained during the acquisition due diligence process, the buyer will likely owe the tax on its purchase of the business unless other alternative evidence can be established. A variety of state tax issues need to be addressed in every sale or purchase of a business.
Business Income Tax
- As A Service Business, How Do I Qualify For Special Apportionment? Nebraska’s income tax apportionment rules for Nebraska-based service businesses generally require those businesses to pay Nebraska tax on 100% of their income (based on their costs of performance). If the statutory method does not fairly represent the income attributable to Nebraska and produces incongruous results, Nebraska law allows companies to request a more reasonable apportionment method from the Department (allowable in the discretion of the Tax Commissioner).
- In A Sale Of Intangible Assets, Where Is My “Cost of Performance”? If a company sells intangible assets (such as contract rights or the stock of a subsidiary), does this need to be apportioned to Nebraska based on the regular “cost of performance” rule. Not necessarily, depending on the underlying source of income from those assets.
Personal Income Tax
- What If I Claimed Nebraska’s Special Capital Gains Exclusion But Made A 338(h)(10) Election? The LB 775 tax incentive program includes an exclusion for the sale by a business owner of his or her corporate stock. This was intended to help incent entrepreneurs to stay in Nebraska rather than retiring to a state that imposes no income taxes. Prior to 2010, the Department had agreed the full gain is excluded, even when a 338(h)(10) election is made to treat the transaction as an asset sale. In 2010, the Department issued a challengeable revenue ruling (Rev. Rul. 22-10-1) to the contrary and began retroactively assessing tax.
- What If The Department Claims My Stock Ownership Did Not Have Economic Substance So I Am Not Eligible For Nebraska’s Special Capital Gains Exclusion? To qualify for the special capital gains exclusion, the Nebraska corporation at issue must have at least 5 shareholders, with at least 10% owned by persons not related to the other 90%. Some companies have issued stock on the eve of sale to meet these tests. If these ownership tests were just met within 12 months before the sale, the Department has been retroactively challenging these situations under the Federal “economic substance” doctrine. This doctrine, if applicable, requires (according to the Department) a close review of both the business purpose and the economic substance of the stock ownership.
- Can The Nebraska Capital Gain Exclusion Be Met If The Stock Is Held By An ESOP, Trust, LLC or Partnership? This depends on the interaction of the pass-through ownership rules to this exclusion.
- What State Tax Issues Are Being Created By New “Virtual Worlds”? Second Life and Zynga are just two of the hundreds of companies which have developed new business models which are thriving in the new “virtual economy” as millions of individuals participate in “virtual persistent worlds”. Several state sales and income tax issues arise within these virtual worlds as participants purchase avatars, apps, virtual real estate, and other virtual items with virtual currencies. State income tax guidance is scarce regarding income characterization, recognition, apportionment and nexus. Some state sales tax guidance exists. While states generally do not impose sales tax on services, many states are now taxing digital goods and services, however, no clear guidance exists for sourcing these sales, giving rise to the risk of multiple taxation as more than one state asserts taxing jurisdiction.
- Is Tax Increment Financing Ever Available Outside Of A City? Tax increment financing is normally used within cities to redevelop their blighted and substandard areas. A special Nebraska rule allows communities to TIF rural, noncontiguous projects outside the city limits for an agricultural processing facility (which can also be combined with LB 775/LB 312 benefits).
- How Are The Number Of Employees Determined For LB 312 Nebraska Advantage Projects? The required number of new employees is determined under an FTE calculation, based on the total hours paid by a company divided by normal workweek hours in a year. If you plan to contend that salaried personnel should be counted as working more than a 40 hour week, this needs to be documented in the corporate policies which apply for hourly personnel.
- Can I Tailor The Scope And Description Of My LB 312 Nebraska Advantage Project? Yes and very often you should, in order to fairly optimize your tax results. Don’t be lulled to inaction by the Department’s pre-printed fill-in-the-blank form.
Tax Appeal Procedure
- Do I Need To State Specific Legal And Factual Grounds When I File A Protest Or Refund Claim? The protest petition (to appeal a sales or income tax notice of deficiency) or a refund claim (to seek an overpaid tax or an incentive) is equivalent to filing the initial pleading in litigation. This is because if the appeal or claim goes to formal hearing at the Department of Revenue or on to District Court, the initial protest or claim sets the parameters for your entire case. It’s important not to handicap the taxpayer. So, the protest or refund claim should detail the specific legal and factual grounds (which may be further impacted by the rules of evidence and the scope of applicable legal precedents). Equally important is the factual record made during the initial audit and any later hearing, so CPAs need to be very careful, again so the case is not handicapped.
- When Does The Formal Legal Process Begin? It begins when a protest petition or refund claim is filed with the Department of Revenue. Everything said or given to the Department by the taxpayer or its advisor is evidence (even when submitted by the non-attorney advisor during an audit or well before a formal Hearing is ever started).
- Do I Need To Request A Hearing Upfront Or Lose This Right? A Hearing is a formal legal proceeding in which evidence in the form of documents and testimony is introduced and arguments are presented before a Hearing Officer (appointed by the Tax Commissioner). Following the Hearing, both the Department and the taxpayer will submit legal briefs (under Nebraska’s briefing rules) to the Hearing Officer. The Hearing Officer will then issue a recommended decision to the Tax Commissioner, who will be the final decision maker for the Department. An appeal of the Tax Commissioner’s decision may be made to the Lancaster County District Court (based only on the record made at the Hearing). Absent a Department Hearing, the entire factual record will be based on the scant (and usually inadequate) record filed with the protest or refund claim. The Nebraska Supreme Court recently confirmed that the failure by the taxpayer’s advisor to request the Hearing upfront resulted in the loss of any right to later present evidence (which ended up losing the case for the company).