Dave Cain: Welcome to unsuitable on Rea Radio, the award-winning financial services and business advisory podcast that challenges your old school business practices and the traditional business suit culture. Our guests are industry professionals and experts, who will challenge you to think beyond the suit and tie, while offering you meaningful modern solutions to help enhance your company’s growth. I’m your Host, Dave Cain.
Dave: We’re enjoying the calm before the storm here at Rea & Associates. In just about a month, it will be all hands on deck for accountants everywhere. While most of us are still buzzing about federal tax bills, midterm elections, and future tax planning strategies under the Tax Cuts and Jobs Act, our State and Local Tax Team is looking at this upcoming tax season from another angle.
Dave: Joining us on today’s episode of unsuitable is Luke Lucas from Independence, Ohio, Rea’s offices located in that location. He is Overseas Income and Franchise Tax Manager for the Firm on Rea’s State and Local Tax Team. Luke is here to help us understand how our state taxes could be impacted this year by Federal Tax Reform by the Wayfair v. South Dakota decision and the recent Commercial Activity Tax sales sourcing rules.
Dave: Welcome to unsuitable, Luke.
Luke Lucas: Thanks, Dave. I’m glad to be here.
Dave: Thanks for making the trip down 71-
Luke: Definitely, it’s just a-
Dave: … from Browns Country.
Luke: … short two-hour drive.
Dave: How many games the Browns gonna win this year?
Luke: Not looking too good. Not looking too good.
Dave: I don’t know. Great. Great for a number one draft pick.
Dave: That’s what we’re after. So, hey, a lot going on, on the tax side … lot of times on unsuitable we’re talking about Federal Tax Reform. Course, we’ve had several, different episodes on the Wayfair case. That’s impacting a lot of companies that we deal with. So let’s start talking about state tax impact that’s, I guess, morphed from the Federal Tax Reform.
Luke: Obviously, most of our listeners have heard plenty about Federal Tax Reform. What people might not think of right away is that there’s a trickle down effect to state taxes, especially state income taxes. Now, it’s been about a year since Federal Tax Reform has been in place. All of the states have had time to have their legislative sessions react to the Federal Tax Reform and, now, we’re finally starting to get some clarification on what it’s gonna look like going forward.
Dave: So we’re right. The calm is before the storm, once the states figure out how to attack this.
Luke: Right. Well-
Dave: I understand that you were at the session in Washington, D.C.-
Luke: I was-
Dave: … at the Supreme Court-
Dave: … for the Wayfair case.
Luke: That’s correct. Joe wrangled our department up. We went down there, I think it was Friday … No … Whatever night it was, but anyways-
Dave: They all run together when you’re in Washington, D.C. Huh?
Luke: We got down there one night. We woke up at 3:00 a.m. the next morning and got in line at 4:30 and waited in line, outside in the cold, ’til 9:00 a.m. Then, we got to see the hearing. So it was a pretty awesome experience.
Dave: So, pretty crazy.
Luke: Right. Definitely.
Dave: So, anyway, let’s go back again. You know, we talk a lot, on the podcast, about business risk and trying to mitigate risk. Is this state issue, if it goes undetected or you don’t have a plan, is that gonna increase the risk within my business?
Luke: Oh, definitely. Well see, a lot of times, we’ll have clients. They might hire a contractor in another state. They might have employees traveling to another state for business purposes and they really don’t recognize the risk that they’re exposing themselves to.
Luke: With the Wayfair case, it just gives the states another option to look at them and get ’em.
Dave: So, it’s coming. 2019, 2020 … what are you thinking, here? Where’s it gonna hit the fan?
Luke: Well, for the Wayfair stuff, the states are all responding on the sales tax piece. It’s important to remember that Wayfair is a sales tax case. Historically, states have derived their income tax laws around another sales tax case, landmark U.S. Supreme Court Sales Tax Case. That was Quill Corp. versus North Dakota. Basically, that was in 1992, before the internet was born. I wasn’t born much before that.
Dave: Way to rub it in.
Luke: Anyways, back then, they said you can only impose your taxes on a business who has a physical location in the state. With Wayfair, the Supreme Court said … The world has changed a lot since 1992. We have the internet, all the e-commerce software. It’s really easy to do business across the United States, and even the world. What they said is, “You no longer need a physical presence to impose a sales tax on an out-of-state business.” Now, where income tax comes into play is, like I said, states have historically derived their income tax Nexus laws around these sales tax Supreme Court cases.
Dave: Okay. Well, let’s go back and, kind of, redefine physical presence. You and I, kind of, talked this off-mic, but the old traditional physical presence mean I had a storefront. I had a warehouse. I had employees. I, maybe, had some inventory within a state. That was, supposedly, the physical presence test, but now they’re testing more than that. Explain that to me.
Luke: Traditionally, for physical presence, like you said, you got the employees living in the state or your brick and mortar business in the state on Main Street, maybe some inventory in a warehouse in another state. Now, people are traveling all across the country for business work. So, just traveling to another state can create what they call, “physical presence.” Really, most of the time, if you’re there a day or two, that’s enough to exceed their threshold and allow them to impose their tax on you.
Dave: Okay. So are we talking about just sales tax, or does that sprinkle over into income tax?
Luke: That is for both, sales and income, taxes.
Dave: Okay. So, again, this Nexus or physical presence … all these tests … we’re testing two things, sales tax and income tax and, maybe, other state taxes that are in existence.
Luke: That’s correct.
Dave: So, are there any states I should stay out of? I’m going off the grid. Where should I go?
Luke: Well, I wouldn’t go to California or Washington. They seem to be two of the more aggressive states out there.
Dave: So, stay out of the… Now, again, there’s a good message there. If we’re located in Ohio, and we have some activity, some sales or other activities out in California or Washington, we’d better take a look at that.
Luke: Right. You know, it’s ironic that I brought those two states up because those are two of the states that have this income tax Nexus Bright-Line threshold. That goes back to Wayfair, where they said, in the Wayfair case, if you have x-amount of sales sourced to this state, then they can impose their taxing jurisdiction on you, even if you never step foot into the state.
Dave: Another state that we need to keep an eye on … We need to keep an eye on all of ’em, but what are some of the more aggressive states? New York?
Luke: New York’s one. They also have the bright-line threshold, which is, kind of, justified by Wayfair. Ohio actually has it, as well, but the majority of our listeners, we’re already in Ohio, and have the physical presence in Ohio. So we don’t really see that affecting us.
Dave: Define “bright-line.” There’s a couple different definitions out there. Clear that up for us. What’s that mean?
Luke: When you’re looking for Nexus relief on a permanent basis, you’re looking at apportionment … not to get too far into detail, but you use apportionment factors to prepare and accurately divvy up income between states and pay taxes in those states. So, you normally look at three of the factors. Either you look at the sales factor, the property factor, or the payroll factor within those states. The bright-line really comes into play with the sales factor, which is what, once again, with the Wayfair case, said is allowed to happen.
Luke: Actually, Ohio was the first state to bring in this bright-line factor for income tax as well. … taxes. That’s with the CAT tax, which we’re all familiar with.
Dave: I’m glad you got technical there, for a minute, because that just proves how difficult this is. It’s very difficult to do that without the technology and the understanding of, not just Ohio rules, but … You guys … I don’t know how you do it. You have to track every state.
Luke: You know, we run into an issue, sometimes, with some of our less sophisticated clients with, maybe, older software. They might get an audit notice from California or Pennsylvania for eight, or so, years ago, and they just don’t have the software to be able to track their sales by state. So it makes the audit process really difficult when that happens.
Dave: I know, in the name of confidentiality, we need to talk at a high level of some of the cases we’ve run across but I
‘ve heard some staggering numbers of some audit findings for, I would call ’em, medium-range clients. They’re not large clients but, when the State comes in, they come in for multiple years.
Luke: Right. Something we always tell our clients, whenever we’re talking to them, there is no statute of limitations for failure to file a tax return when you’re supposed to.
Dave: Say that, again, now?
Luke: No statute of limitations for failing to file a tax return when you should have. In simpler terms, that means a state can go back as far as they would like if you did not meet your obligations.
Dave: In other words, grab your ankles if they catch you.
Luke: Right. Right. What’ll happen is, if we figure out that a client should’ve been filing in a state, there’s options that we can take to help them and not worry about those eight, or so, years ago, but they have to be willing to do it.
Dave: So, worse case scenario, you could be on the hook multiple years, plus interest, plus penalty.
Luke: That’s correct.
Dave: Okay, walk me through a scenario. Let’s say you and I are having a discussion and, at the end of the discussion, I tell you, “Oh, gee. I forgot to file in Tennessee,” or “I forgot to file in California.” I wanna come clean on this. What do I do?
Luke: Sure. What we’ll do in that scenario, if the client would like to come clean, and the states encourage this, we can enter, with our client, with a state, what’s called a Voluntary Disclosure Agreement with the State. So, basically, we will reach out to the State, on an anonymous basis, explain the facts, and the State will review that application, and they’ll let us know whether or not they are allowed to enter into the Voluntary Disclosure Agreement. The benefit of the Voluntary Disclosure Agreement is the State will limit a look-back period. Normally, they’ll let you go back three or four years of back-tax filings … where, say, if you should have been filing them for eight years, that cuts off four or five years of tax filings that you, now, don’t have to do, or don’t have to worry about being caught.
Luke: Additionally, they will do you a favor of waiving any penalties for those past filings.
Dave: So that’s a good thing-
Luke: Great thing.
Dave: … little amnesty, mini-amnesty.
Luke: Right. Right.
Dave: So, I suppose if I say, “Hey, look. I don’t have records past five years. My insurance company told me that I didn’t need to keep records that far.” Is that a legitimate defense?
Luke: It is not. If you can’t prove, beyond the benefit of the doubt, that your sales aren’t sourced to “X” State, there’s really not much you can do. That’s why, if you’re in that situation, and you can’t produce the records back that far, it’s really good to enter into a VDA.
Dave: “Hey, Luke. I don’t have a problem, here. I certainly didn’t pay tax in California. I paid it in Ohio. So, no problem … I’ll just file California and get a refund from the State of Ohio for that sales tax.” Am I on the right track or SOL?
Luke: It doesn’t quite work that way.
Luke: I mean, it can. It can, but-
Dave: I’m out of money. Aren’t I?
Luke: Yeah, plus fees, plus compliance fees.
Dave: Plus, on their radar, most likely, for years to come.
Dave: So, in the cases that you’ve run across … We try to get a feel for this from other guests on our show … from your State and Local Tax Team, your SALT Team. When you go out and, let’s say, you look at 10 different cases or 10 of our clients, how many of those are you finding that there are deficiencies in state tax filings?
Luke: I would say a very large majority of our clients.
Dave: Gimme a number. Go for it. It can’t be tracked.
Luke: I’ll throw out 90%-
Luke: 90% … whether it’s-
Dave: That seems pretty consistent.
Luke: … whether it’s income or sales tax, chances are they have something that they should’ve been doing and just don’t know about it.
Dave: Now, bit of clarification … As we go through this process, I don’t think that there’s a … It’s not a double taxation. It’s just that, hey, if we had to pay tax in Illinois or Indiana, or California, that means we shouldn’t have been paying it in Ohio.
Luke: Right. There’s really not a double taxation. Like I said, it goes back to that apportionment factor that states make you use. It divvies up you net income across all of the states. Then you pay tax based on those states’ rules.
Dave: So, you’d mentioned apportionment. Is that something that’s readily available in my accounting records? What exactly am I looking for? I’m a business owner. I’m on the sales side. I have no idea what apportionment is.
Luke: Apportionment, like I said, it’s a calculation, a formula, and all states … they can be different, but most of them are pretty similar. You look at the property. So you look at your fixed assets or inventory in a state. We would average out the beginning and ending amounts to figure out your property. You look at payroll. So, your payroll filings. You look at your payroll filings in that state versus everywhere … your percentage. Then you look at your sales, as well. So your sales source to that state divided by your sales everywhere.
Dave: So, a couple of things I’m taking from our conversation. One is I’d better make sure my team … they’re keeping records long enough to support some of these things if an audit does exist ’cause, if not, we’re in deep trouble. We’re writing a check.
Luke: Definitely. From my experience, clients usually take their position where states, sort of, take a back seat to federal issues. Back to the Federal Tax Reform, looking at your net income calculations, for Federal Tax Reform, they brought in the 100% bonus depreciation. They disallowed DPAD. So, there’s some stuff that benefits your taxable income and is a liability towards your taxable income. Really, for corporate purposes, the big savings amount is the reduced tax rate, and that doesn’t affect the states. So what happened was-
Dave: I don’t like where you’re going with this.
Luke: … what happened was EY and COST, which is a governmental agency called, “Council of State Taxation” … they did some joint report analyzing all the changes, what they had predicted the states were gonna do with the changes. At the end of the day, they determined that the average state tax base is gonna increase 12%. So, at the end of the day, states are more of an issue than they have been before.
Dave: Sure. So, I think what you just told me is that my federal taxes are going down. My state taxes, most likely, are going up.
Luke: That’s correct.
Dave: And, as states are looking for revenue, especially with internet activity, the states are gonna look harder and faster.
Luke: Yep. And something that I think people don’t realize, either, is that the majority of the states are actually required to maintain a balanced budget. Whereas, the Federal Government is not.
Dave: Imagine that. Huh?
Luke: So, based-
Dave: Isn’t that a novelty idea? Balanced budget … how ’bout that?
Luke: What is comes down is the states are gonna look for any way they can to get their income from you.
Dave: You’d mentioned CAT, or Commercial Activity Tax. Are there changes going on with that? That’s the tax that replaced the Personal Property Tax, several years ago.
Luke: Yeah. So the CAT replaced the Personal-
Dave: Back when you were in grade school, we used to file Personal Property Tax.
Luke: That’s correct. The CAT replaced the Personal Property Tax, as well as the Ohio Corporate Franchise Tax, back in 2005. Obviously, the CAT is going to be relevant to a large majority of our clients and. Also, a by-product of all these Wayfair discussions is sales sourcing discussions. That can get quite complex, depending on your business type but, back to CAT, there have been a couple developments, within the past year, where it takes an advanced look at sales sourcing and the State have followed the taxpayers and there’s been a decision.
Luke: In one case … I think it was Greenscapes versus Testa … Greenscapes Lawn & Garden … They are a lawn and garden company down in Georgia, actually. What happened is they would, sometimes, have customers pick up the product in Georgia, bring it back to Ohio. So Greenscapes argued that that was a Georgia-sourced sale, and maybe Georgia’s laws might say that, actually, but what Ohio found out is they were picking this product up in Georgia, bringing it back to Ohio. Ohio said, “That’s an Ohio-based sale because that’s the ultimate destination of the product.” So Ohio ruled that it was an Ohio sale, at the end of the day. That’s not very favorable for the taxpayer. In my opinion, it’s a situation where, maybe for out-of-state taxpayers, ignorance is bliss. Maybe they don’t wanna know where that product’s gonna end up.
Dave: Sure. In the example you used, I don’t have to pay tax in both states. Do I?
Luke: Depending on the State’s rule, you might have to source that sale to both of those states, unfortunately. Now, you’re not necessarily paying tax in both states, but you’re sourcing the sale and divvying up the income twice.
Dave: Again, gotta go back the accounting records. What if my accounting staff doesn’t know exactly what kind of records to keep, can you guys help us out with that?
Luke: Yeah. That’s something, like I said, depending on their business model, we can have those discussions and help them be prepared if out-of–state tax departments come knocking.
Dave: So you can help train-
Dave: … you can help train audit defense. I get a letter. Can your team help me navigate through that?
Luke: Yeah. We’ll handle everything for the client, with the audit … work with the auditor. They’re generally pleasant to work with. Believe it or not. At the end of the day, whenever the auditors give us their findings, we’ll also review their findings and make sure there’s no misunderstandings, make sure they’re assessing the right amount of tax.
Dave: Now, with the states, if we’re caught … and, eventually, if you’re in this business long enough, you’re gonna get a letter. I don’t wanna say, “caught,” but you’re gonna get a Letter of Inquiry. Will you help me negotiate a settlement?
Luke: Yeah. We can do that if it comes down to it. That happens more on the sales tax side. There’s a lot of stuff that goes into that, but, on the income tax side, there’s really not a lot of gray area for a settlement.
Dave: As 2018 comes to a close, and we start 2019, what are some things that, maybe, we can do as a business, in my business, to get off on the right foot so we have correct filings for the states?
Luke: Well, as a business, we’re always happy to talk. We give our clients a higher-level discussion … give them some rough ideas of where they might have a filing obligation. We always point out that, that’s a general rule. There are general rules across all the states, but all the states happen to have their quirky rules. You really wanna take a look at the code to make sure we’re not telling them to file if they don’t need to or telling them not to file when they should.
Dave: And, to your point, we may be filing in some states we don’t have to. On the other side, we probably should file in more states. The goal, here, is not to file in 50 states and every township and municipality that we’re in. The goal is, “Let’s take a look and get a fair representation, and minimize our risks.”
Luke: Definitely. We can also work with the client to strategize where they’re going, where they’re shipping their product from, where they’re shipping it to, to help minimize their out-of-state tax exposure.
Dave: That’s the education process.
Dave: Good. Good. So, again, I think we’ve covered a lot of territory … very technical, very complex. You think the Wayfair case is gonna raise its ugly head, big time, in ’19 or do we got a year to get our act together?
Luke: Well, for sales tax purposes, a lot of the states are moving pretty quickly, there. So those rules are already in place. People do expect, and I agree, that there’s going to start to be more income tax bright-line threshold put in place because of that.
Dave: Sure. So, actually, with the 2018 filings, this is a real good time to get that right and get a springboard for going forward.
Luke: Yeah, a very busy time for our department … client calls every day. Clients are interested in this. They wanna see how it affects them, and we’re happy to help in anyway we can.
Dave: You gonna be able to take a little time off around the holidays or you’re gonna be working on CAT Tax, and Nexus, and bright-line, and whatever else you’re working on?
Luke: Planning on taking some time off … actually taking the week after Thanksgiving off, for deer season.
Dave: There you go. Perfect. Our guest, today, has been Luke Lucas with Rea & Associates, located in Independence, Ohio, talking about state tax concerns. If they’re not keeping you up at night, they probably should. There’s a lot of risk out there. Thanks, again, for joining us today, Luke.
Luke: ‘preciate it, Dave.
Dave: You’ve certainly given us a lot to think about. I’m sure listeners will put your advice to good use. That being said, if you have any state and local tax questions, get ’em in now. Contact us at reacpa.com, and we’ll put you in touch with a member of our SALT Team, which also is our State and Local Tax Team.
Dave: Did you enjoy today’s episode? Let us know. Like it, comment on it, or share it, and don’t forget to check out videos of our podcasts on YouTube. Until next time, I’m Dave Cain, encouraging you to loosen up your tie and think outside the box.
Disclaimer: The views expressed on unsuitable on Rea Radio are our own and do not necessarily reflect the views of Rea & Associates. The podcast is for informational and educational purposes only, and is not intended to replace the professional advice you would receive elsewhere. Consult with a trusted advisor about your unique situation so they can expertly guide you to the best solution for your specific circumstance.