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How Will States Respond to Pandemic-Related Revenue Shortfalls?

Posted on Dec. 21, 2020
Michael A. Cottone
Michael A. Cottone
Stephen J. Jasper
Stephen J. Jasper
Michael D. Sontag
Michael D. Sontag

Michael D. Sontag, Stephen J. Jasper, and Michael A. Cottone are attorneys at Bass, Berry & Sims PLC and are part of the firm’s state and local tax law practice group.

In this installment of Bass Tax, the authors examine how states may respond to revenue shortfalls resulting from the COVID-19 pandemic, such as pushing income tax burdens onto out-of-state taxpayers and broadening the base of gross receipts and sales and use taxes through more aggressive enforcement.

Copyright 2020 Michael D. Sontag, Stephen J. Jasper, and Michael A. Cottone.
All rights reserved.

For many states, the COVID-19 pandemic is expected to cause serious budgetary difficulties. In fact, average state tax collections for the first six months of the outbreak were already more than 6 percent lower than in 2019, which is especially troubling because pre-pandemic projections anticipated state revenues rising 2 to 3 percent.1 Some states have already responded by enacting deep spending cuts and canceling plans to reduce taxes.2 But these measures will likely be insufficient to address budget shortfalls in every state, and some states will need to find new ways to raise revenue.

Anyone who was working in state and local tax in 2008 knows what to expect. State revenue departments will start enforcing their tax laws more aggressively to raise the missing money. That much seems fairly certain. Less certain, however, is exactly which laws will be the focus of the states’ efforts. As discussed below, we believe the states will seek to address their budgetary gaps by returning to the tried-and-true playbook of pushing their income tax burdens onto out-of-state taxpayers and broadening the base of gross receipts and sales and use taxes through more aggressive enforcement. States will likely find this basic approach to raising revenue the safest and surest way to close their budgetary gaps in these unusual circumstances. Also, states are likely to take a closer look at their credits and incentives and find ways to limit the application of those benefits to future taxpayers and to taxpayers that may believe they have qualified for the benefits. As a last resort, states may increase tax rates but will likely only do so for taxes with limited applicability.

I. States Will Aggressively Pursue Corporate Income Tax for Out-of-State Businesses

Raising revenue is often easier said than done because state officials do not want to be seen as raising taxes on residents.3 Usually, states avoid imposing more tax on individuals and, instead, attempt to collect additional revenue from businesses.4 Because in-state businesses generally exercise more political influence than out-of-state businesses, a state typically looks for ways to focus the additional tax burden on businesses that lack a large physical presence in the state. This is no less true during a pandemic. For these reasons, states looking to raise revenue lost as a result of the pandemic have a strong incentive to vigorously pursue corporate income tax issues that mostly affect large, out-of-state taxpayers with minimal operations in the taxing state. Taxpayers can expect states to focus their efforts on these issues, including the examples discussed below.

An obvious example of a corporate income tax issue that affects out-of-state businesses is Public Law 86-272. By the statute’s terms, P.L. 86-272’s protections apply only to companies with minimal business activities in the taxing state.5 P.L. 86-272 prohibits a state from imposing income tax on businesses whose activities in a state are limited to the solicitation of orders for tangible personal property and de minimis amounts of other activities.6 Taxpayers that rely on P.L. 86-272 should prepare for states to take a closer look at the statute and aggressively limit their interpretation of the circumstances in which the statute’s protections apply. In fact, many states began this process before the pandemic, with those efforts resulting in the Multistate Tax Commission’s expansive new proposed information statement on P.L. 86-272.7 In its current form, the MTC’s statement takes a number of positions that seek to drastically reduce the scope of activities protected under P.L. 86-272. For instance, the MTC’s statement claims that a company loses the protection of P.L. 86-272 if it responds to post-sale questions from a customer through email or places information regarding job openings on its website, unless the openings are limited to sales positions.8 Under the MTC’s statement, nearly every business with a website would lose P.L. 86-272 protection in any state where a customer accesses that website. During ordinary economic times, many states would be cautious about taking such aggressive positions, but the current budgetary shortfalls might lead states to join the MTC’s statement when they otherwise would not.9 For this reason, states are likely to strictly interpret the scope of P.L. 86-272 in an attempt to raise revenue from out-of-state taxpayers that never would have considered paying the states’ income taxes in prior years.

Like P.L. 86-272, nexus issues primarily affect businesses with little presence in the taxing state. Many states have clarified that a company will not be required to file and pay corporate income tax simply because an employee works remotely from a location in the state because of COVID-19.10 There have, however, been a few notable exceptions. For example, the Michigan Department of Treasury has informally said it will not waive nexus requirements related to telecommuting.11 Similarly, Colorado and Montana have reminded taxpayers that there has been no change to their corporate income tax nexus laws related to COVID-19.12 Kentucky has taken a more neutral approach, saying it will continue reviewing income tax nexus “on a case-by-case basis.”13 Several other states have been silent on this issue. These states may attempt to impose corporate income tax requirements on businesses with employees working remotely from a location in the state during the pandemic. But even states that provide nexus relief for telecommuting during the pandemic have been careful to say that other nexus principles will not change.14 In actuality, given the financial circumstances, it should be expected that states will increase their attempts to find nexus for income tax purposes. There appears to have already been an uptick in states sending nexus questionnaires to companies, and those efforts should be expected to continue. If a taxpayer has registered to do business but is not paying corporate income tax in any state, it should be on alert for a possible audit.15

Finally, states have often used combined reporting to impose greater tax burdens on businesses with limited presence in the taxing state. Several states have recently adopted mandatory combined reporting,16 and taxpayers should be on the lookout for increased enforcement efforts in this area as well.

II. States Will Broaden the Sales and Use and Gross Receipts Tax Bases Through Aggressive Enforcement

States will also likely look to raise revenue through other taxes. In the past, states have attempted to increase sales tax, hotel occupancy tax, or other consumption taxes on tourists and the industries that serve them. With tourism and travel down significantly, states are unlikely to take this approach to cope with budget shortfalls.17 As an alternative, states will likely focus on strictly enforcing sales and use and gross receipts taxes more generally.

States may take this approach for several reasons. First, it is often administratively easier for states to assess taxpayers for sales and use and gross receipts taxes. Revenue departments can often quickly issue “rough justice” sales and use tax assessments using relatively basic sales data. Moreover, audits for gross receipts taxes can be completed at the same time as sales and use tax audits, and auditors often use the same sales data for both purposes, even if it does not precisely match the requirements of the gross receipts tax. Finally, in most instances, businesses are legally or practically unable to collect past liability for sales and use and gross receipts taxes from their customers. This means the average voter will not be affected — or more accurately stated, will not know she is affected — by increased enforcement of sales and use and gross receipts taxes.

In addition, sales and use taxes provide another opportunity for states to impose their tax burdens on out-of-state businesses. Following the Wayfair decision,18 most states have adopted economic nexus and marketplace facilitator rules to impose sales and use taxes on businesses with little presence or activities in a state.19 A state can generate significant revenue by successfully auditing a remote seller or marketplace facilitator that has not been collecting and remitting sales and use tax because the resulting assessment would include all sales the entity made or facilitated to customers in the state. For these reasons, budget shortfalls have made the states more likely to vigorously enforce economic nexus and marketplace facilitator rules, and taxpayers should expect states to focus substantial efforts on auditing companies for compliance with these rules.

Out-of-state businesses will not be the only ones affected by a state’s increased enforcement of sales and use taxes. Taxpayers should be aware that states that have not previously required strict technical compliance with sales and use tax rules and regulations will likely begin doing so. For example, many state departments of revenue have allowed dealers to rely on resale or exemption certificates received from customers during an audit, rather than at the time of the sale. It would be unwise to expect this practice to continue considering significant budget deficits. Taxpayers should prepare by reviewing and, if necessary, improving their documentation and other technical compliance practices.

III. States Will Aggressively Limit Credits and Incentives

Before the pandemic, many states were reworking their tax credit and incentive programs to more narrowly target types of economic development and maximize their return on investment. For example, Tennessee recently revamped one of its lesser-used tax credits to encourage more development activity in economically distressed areas.20 Pandemic-related budgetary concerns have caused states to accelerate these kind of efforts to narrowly interpret or revise their credits and incentives to ensure they are providing the precise benefit the states want to receive.

Moreover, in response to revenue shortfalls, states are likely to entirely repeal numerous tax credits and incentives. Regardless of the actual effect on taxpayers, reducing or eliminating tax credits and incentives is not generally viewed as raising taxes. For that reason, almost any credit or incentive could be on the chopping block in states with severe budget shortfalls. One exception may be tax credits that benefit lower- and middle-income residents, like the earned income tax credit. Earlier this year, Colorado expanded its version of the credit from 10 percent of the federal credit to 15 percent, although this was less than the increase to 20 percent initially planned.21 Nonetheless, when budgets are tight, states are more likely to view other types of credits and incentives as unnecessary or unaffordable. Even if a state does not eliminate a particular credit or incentive, it may create tougher standards for taxpayers to qualify or require more proof that a project is creating jobs or otherwise driving economic development.

In addition, taxpayers that have entered incentive agreements with states or have recently claimed state tax credits on their returns should be aware that states are beginning to take much more aggressive enforcement positions than they have in the past. In some states, taxpayers that have already bargained to receive incentives are experiencing difficulties with officials claiming technical noncompliance and refusing to provide previously agreed-upon funds. Several states are reportedly examining tax credits closely during routine audits and raising arguments that the credits were not deserved. These actions represent a break with past practice and are concerning. In many instances, agreed-upon incentives and generally available tax credits encouraged in-state investment, and the states already received the benefits of that investment in prior years. Taxpayers that have received incentives or taken credits should be careful to meet all technical requirements and maintain any necessary documentation.

IV. States Will Enact Rate Increases for Some Taxes as a Last Resort

As discussed above, state officials are hesitant to raise taxes, and enacting higher tax rates is certainly seen as a tax increase, assuming offsetting deductions or reductions to the tax base are not also enacted. For that reason, states are likely to take other measures to raise revenue before increasing tax rates. Nonetheless, budget shortfalls in some states are so dire that raising tax rates seems inevitable, although this is generally seen as a last resort.22

When lawmakers raise tax rates, they generally avoid broad-based rate increases. Instead, rate increases tend to focus on specific activities or small groups of taxpayers.23 That trend has continued during the pandemic. States that have recently proposed or enacted increased rates have done so for “vice” taxes on alcohol and for individual income over $1 million.24 Other states can be expected to take similar steps and avoid broad-based rate increases if possible.

V. Conclusion

Because of the ongoing epidemic, many states are experiencing severe budget shortfalls that will require them to significantly raise tax revenues. To attempt to cover these shortfalls, states likely will take aggressive positions and increase enforcement efforts regarding corporate income tax, sales and use and gross receipts taxes, and tax incentives and credits. Many states have already done so. Some states will be forced to raise tax rates, but states will avoid broad-based rate increases if possible. In preparation for potential audits, taxpayers should be aware of potential state enforcement priorities — especially issues primarily affecting out-of-state taxpayers like P.L. 86-272 and economic nexus and marketplace facilitator rules — and work to improve their technical compliance and recordkeeping practices.

FOOTNOTES

1 Center on Budget and Policy Priorities, “States Grappling With Hit to Tax Collections” (Nov. 6, 2020).

2 Id.; see also National Conference of State Legislatures, “State Actions to Close Budget Shortfalls in Response to COVID-19” (Nov. 6, 2020).

3 See David Brunori, State Tax Policy 3-4, 41-42 (2016) (discussing the “politics of antitaxation”).

4 A few states have proposed or adopted personal income tax increases on income over $1 million. See A.B. 1253, 2019-2020 Leg. (Cal. 2020); and Janelle Cammenga, “Seventh Time’s the Charm: New Jersey Passes Millionaires Tax,” Tax Foundation (Sept. 30, 2020).

5 See 15 U.S.C. section 381(a).

6 See Wisconsin Department of Revenue v. William Wrigley Jr. Co., 505 U.S. 214, 223-32 (1992). P.L. 86-272 provides that a state cannot impose any net income tax on any person or company whose only in-state business activities are: “(1) the solicitation of orders by such person, or his representative, in such State for sales of tangible personal property, which orders are sent outside the State for approval or rejection, and, if approved, are filled by shipment or delivery from a point outside the State; and (2) the solicitation of orders by such person, or his representative, in such State in the name of or for the benefit of a prospective customer of such person, if orders by such customer to such person to enable such customer to fill orders resulting from such solicitation are orders described in paragraph (1).”

15 U.S.C. section 381(a).

7 Multistate Tax Commission, “Statement of Information Concerning Practices of Multistate Tax Commission and Signatory States Under Public Law 86-272” (Feb. 20, 2020 proposed revision). The information statement is founded on the dubious idea that the meaning of P.L. 86-272 should be informed by the U.S. Supreme Court’s decision in South Dakota v. Wayfair Inc. — even though that decision had nothing to do with the statute or its language. See id. at 2. In fact, there is little justification for a constitutional decision nearly 60 years removed from the enactment of P.L. 86-272 to inform the statute’s interpretation. See Bostock v. Clayton County, Georgia, 140 S. Ct. 1731, 1738 (2020) (“This Court normally interprets a statute in accord with the ordinary public meaning of its terms at the time of its enactment.”).

8 Multistate Tax Commission, supra note 7, at 8-9.

9 See id. at 2 (noting that, for the information statement to apply in a member state, the state must affirmatively adopt or indicate support for the statement).

10 See, e.g., District of Columbia OTR Tax Notice 2020-07 (Sept. 3, 2020); South Carolina Information Letter No. 20-24 (Aug. 26, 2020); Rhode Island Advisory No. 2020-24, (May 28, 2020); Indiana Department of Revenue, “Coronavirus Information: COVID-19 FAQs” (last updated Sept. 4, 2020); and Mississippi Department of Revenue Notice 2020-01 (Mar. 23, 2020).

11 See email from Michigan Department of Treasury to Checkpoint Catalyst (May 19, 2020).

12 See email from Colorado Department of Revenue to Checkpoint Catalyst (May 19, 2020); correspondence from Montana Department of Revenue to Checkpoint Catalyst (May 19, 2020).

13 See Kentucky Department of Revenue, “COVID-19 Tax Relief: Frequently Asked Questions” (July 16, 2020).

14 See, e.g., Massachusetts Technical Information Release No. 20-10, (July 21, 2020); and Georgia Department of Revenue, “Coronavirus Tax Relief FAQs” (last updated Oct. 1, 2020).

15 Some states take the position that merely registering to do business in the state will create nexus for income tax purposes. See, e.g., Conn. Gen. Stat. section 12-214; Conn. Agencies Regs. section 12-214-1(b)(2); Mass. Gen. Laws ch. 63, section 39; and Vt. Stat. Ann. tit. 32, section 5811(15).

16 See Ky. Rev. Stat. Ann. section 141.201; N.J. Rev. Stat. section 54:10A-4.8; and N.M. Stat. Ann. section 7-2A-8.3.

17 See U.S. Travel Association, “COVID-19 Travel Industry Research” (last updated Nov. 20, 2020); and António Guterres, “It Is Imperative That We Rebuild the Tourism Sector,” United Nations.

18 South Dakota v. Wayfair Inc., 585 U.S. ___, 138 S. Ct. 2080, 2095 (2018).

19 See, e.g., Ala. Admin. Code section 810-6-2-.90.03; Ariz. Rev. Stat. Ann. section 42-5043(A)(2); Colo. Rev. Stat. section 39-26-102(3); D.C. Code Ann. section 47-2001(w); Ga. Code Ann. section 48-8-2(8)(M.3); Haw. Rev. Stat. section 237-2.5; Ind. Code section 6-2.5-2-1(d); Ky. Rev. Stat. Ann. section 139.340(2)(g); Mich. Comp. Laws Ann. section 205.52c; Miss. Code Ann. section 27-67-4(2)(e); and Tenn. Code Ann. section 67-6-501(f), (g).

20 See, e.g., Tenn. Pub. Ch. 606 (Mar. 12, 2020) (revising Tennessee’s brownfield tax credit).

22 See, e.g., Peter Hancock, “Illinois Budget Forecast: Ballooning Deficits and Backlogged Bills,” Peoria Journal Star, Nov. 16, 2020.

23 See Brunori, supra note 3, at 49.

24 See A.B. 1253, 2019-2020 Leg. (Cal. 2020); Cammenga, supra note 4; “Maryland Lawmakers Propose Alcohol Tax Hike for Health Plan,” WTOP, Sept. 16, 2020; and Julie Sherburne, “Maine Pandemic Budget Gap Plan Announced,” News Center Maine, Sept. 10, 2020. Virginia has also enacted a new tax on some gambling machines. Lauren Loricchio, “Virginia Legislature Approves Tax on ‘Electronic Skill Games,’Tax Notes Today State, Apr. 28, 2020.

END FOOTNOTES

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