State Tax Highlights

A summary of developments in litigation.

Published biweekly by the Federation of Tax Administrators
Also available at the FTA Member website at:

March 8, 2019 Edition


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Decision Issued

BNSF Railway v. Loos, U.S. Supreme Court Docket No. 17-1042. Decision issued March 4, 2019. The Court, in an opinion penned by Justice Ginsburg, held that a railroad company’s payment to an injured worker for lost wages after an on-the-job injury falls within the definition of compensation under the Railroad Retirement Tax Act (RRTA). The Court found that the definitions of compensation in the RRTA and wages for social security purposes are similar. The decision reversed the U.S. Court of Appeals for the Eighth Circuit’s decision that compensation only applies to an employer’s payment to an employee for active service. The Court held that compensation includes payment for periods of absence from service, regardless of whether the employer chooses to make it or is legally required to do so. Justice Gorsuch, joined by Justice Thomas, dissented from the majority opinion.

Cert Denied

Farr v. Commissioner, U.S. Supreme Court Docket No. 18-6781. Petition denied February 25, 2019. The lower court had determined that the petitioner had engaged in excess benefit transactions, using her the checking account of her nonprofit, the Association for Honest Attorneys, to pay her personal expenses. See the FTA’s legal database for a discussion of the U.S. Tax Court’s decision in this matter.



Sentence Upheld in Cigarette Tax Fraud Case

The U. S. Court of Appeals for the Sixth Circuit affirmed the sentences of several individuals involved in a long-term scheme to sell tax-free cigarettes. The scheme defrauded federal, state, and local governments of over $45 million in tax revenue.

The four individuals in this case took part in a decade-long scheme to sell tax-free cigarettes. The federal government eventually uncovered the scheme and charged them with 34 counts of various crimes, including conspiracy to commit mail or wire fraud in violation of 18 U.S.C. § 1349, conspiracy to launder money in violation of 18 U.S.C. § 1956(h), and conspiracy against the United States in violation of 18 U.S.C. § 371. One of the defendants, John Maddux, pleaded guilty to 29 counts. The other three all went to trial, and a jury convicted each of them on various counts. The three challenged their convictions on several grounds. Maddux and two of the three also challenged their sentences, arguing that the district court erred when calculating their recommended sentences under the Sentencing Guidelines. The court rejected all their arguments and affirm the lower court. United States v. Maddux Jr. et al., U.S. Court of Appeals for the Sixth Circuit, No. 16-6368; No. 16-6370; No. 16-6371; No. 16-6726. 2/26/19

IRS Third-Party Summons Quashed

The U.S. Court of Appeals for the Ninth Circuit affirmed a district court order that quashed an IRS summons issued to a state court for documents in its audit of an elderly couple. The court agreed with the district court that the IRS didn’t provide the couple reasonable notice in advance that it would contact the court as required under section 7602(c)(1) before issuing a summons to a third party, finding that the notice supplied by IRS Publication 1, “Your Rights as a Taxpayer,” did not meet the section 7602(c)(1) requirement. The court held that reasonable notice must provide a taxpayer with a meaningful opportunity to provide the records sought to avoid third-party contacts.

The Internal Revenue Code (IRC) provides that before the Internal Revenue Service (IRS) summons a taxpayer's financial records from employers, financial institutions, or other third parties, the IRS must provide the taxpayer with “reasonable notice in advance.” The court noted that the Ninth Circuit had yet to determine what notice amounts to “reasonable notice in advance.” The IRS argued that a “general notice,” like its “Publication 1,” sufficed in every circumstance, but the lower court found that the advance notice procedure could not be satisfied by the transmission of a publication about the audit process generally. The court, however, concluded that “reasonable notice in advance” means notice reasonably calculated, under all the relevant circumstances, to apprise interested parties of the possibility that the IRS may contact third parties, and that affords interested parties a meaningful opportunity to resolve issues and volunteer information before third-party contacts are made.

The taxpayers here are an elderly married couple living in northern California. The husband is an attorney who accepts appointments from the California Supreme Court to represent indigent criminal defendants in capital cases. On July 25, 2013, the taxpayers received a letter in the mail from the IRS, indicating that they had been “selected at random for a compliance research examination,” an audit that was part of the IRS's National Research Program (NRP), which randomly selects taxpayers for exhaustive audits to help the IRS “better understand tax compliance and improve the fairness of the tax system.” The IRS letter instructed the taxpayers to contact a revenue agent at the IRS to discuss items on their 2011 tax return, as well as the examination process, and enclosed a two-page notice entitled “Your Rights as a Taxpayer,” which the IRS referred to as “Publication 1.” Page 2 of the publication warns that although the IRS will generally deal directly with the taxpayer or the taxpayer’s authorized representative, the IRS will sometimes talk with other persons if it needs information that the taxpayer is unable to provide or to verify information that the IRS has received. In September 2013, the IRS requested documents from the taxpayers, and they asked the IRS to excuse them from the NRP audit because of the husband’s poor health and the couples' advanced age and provided a doctor's declarations to the IRS showing that the NRP audit would worsen the husband’s hypertension and contribute to hypertensive retinopathy, a deteriorating eye condition, as well as his serious hearing loss. The IRS refused the couple's request for an exemption, and the taxpayers filed a separate suit to stop the audit in the Northern District of California in May 2015. The IRS continued with its NRP audit and in September 2015, the IRS issued a summons to the California Supreme Court seeking “copies of billing statements, invoices, or other documents . . . that resulted in payment to” the husband for the 2011 calendar year. The taxpayers did not learn about the summons until after the fact and in
October 2015, the couple filed a timely petition to quash the summons in the Northern District of California.

The district court evaluated the taxpayers’ petition under Powell v. United States, 379 U.S. 48 (1964), which sets forth four requirements that the IRS must satisfy to enforce an administrative summons. Under Powell, the IRS must establish a prima facie case of good faith by showing that: (1) the underlying investigation is for a legitimate purpose, (2) the inquiry requested is relevant to that purpose, (3) the information sought is not already in the government's possession, and (4) the IRS followed the administrative requirements of the IRC. A court may quash a summons if the resisting party disproves any of the four
Powell elements or successfully challenges the summons on “any appropriate ground.”
The district court concluded that the government had satisfied the first three steps of the Powell test, but did not satisfy the fourth requirement, finding that the IRS
had not provided sufficient notice to the taxpayers that it would contact the California Supreme Court, in violation of I.R.C. § 7602(c)(1)'s requirement that the IRS provide “reasonable notice in advance” to the taxpayer.

In this appeal, the court said it must determine the meaning of the phrase “reasonable notice in advance.,” and began by reviewing the text of the statute and found that the phrase was not ambiguous. The court noted that the Supreme Court has interpreted “notice” to mean “notice reasonably calculated, under all circumstances, to apprise interested parties” and “afford them an opportunity to present their objections.” See, e.g., Jones, 547 U.S. at 226. I.R.C. § 7602 is an exception to the general rule that the IRS must keep taxpayer records confidential and the court construes § 7602(a) narrowly in favor of the taxpayer and § 7602(c) broadly as a protective measure. I.R.C. § 7602(c)(1)'s notice requirement also complements other notice requirements in the IRC, including I.R.C. § 7609(a)(1), which instructs the IRS to provide the taxpayer with a copy of any summons it serves on a third party. While § 7609 gives the taxpayer an opportunity to quash the summons in a federal district court, § 7602(c)(1), in comparison, protects the taxpayer's reputational interest. It gives the taxpayer a meaningful opportunity to resolve issues and volunteer information before the IRS seeks information from third parties, which would be unnecessary if the relevant information is provided by the taxpayer himself. The court found that the exceptions to I.R.C. § 7602(c)(1)'s notice requirement further demonstrate that Congress meant for the advance notice provision to provide the taxpayer with a meaningful opportunity to produce information to avoid third-party contacts. The court found that when the IRS uses Publication 1 as it was used here, mailed with an introductory letter and divorced from any specific request for documents, it was not reasonable for the IRS to fear that a person who received the publication would have enough information to spoil a criminal investigation or retaliate against a potential third-party source.

The court concluded that the IRS does not satisfy the pre-contact notice requirement, § 7602(c)(1), unless it provides notice reasonably calculated, under all relevant circumstances, to apprise interested parties of the possibility that the IRS may contact third parties, and that affords interested parties a meaningful opportunity to resolve issues and volunteer information before those third-party contacts are made. The court noted that this standard requires a balancing of the “interest of the State” in administering an effective auditing system against “the individual interest” in receiving notice of the potential third-party contact and an opportunity to respond. The court noted that in the present case, Publication 1 did not accompany a specific request for documents, nor was there any evidence that the IRS revisited the notice later in the audit when it knew that the taxpayers had requested an exemption from the research audit and had not provided documents for the audit. More than two years elapsed between when the IRS sent Publication 1 to the taxpayers and when the IRS subpoenaed the billing records and invoices from the California Supreme Court. The court said that nothing about the audit required the government to move quickly. The IRS issued the summons to the California Supreme Court as part of its National Research Program audit, not an audit in the normal course. The IRS had no reason to believe that the taxpayers might evade its review, hide assets, or abscond, nor was the California Supreme Court going anywhere soon. The court found that the lack of urgency was further reflected in the IRS's willingness to wait two years between requesting the documents from the taxpayers in September 2013 and issuing the summons to the California Supreme Court in September 2015. The court also found that the IRS should have known that it was requesting information from a particularly sensitive source, sending the summons to the husband’s employer, not a remote third party. J.B. et al. v. United States, U.S. Court of Appeals for the Ninth Circuit, No. 16-15999. 2/26/19

Abused Wife Granted Relief

The U.S. Tax Court held that an individual is entitled to relief under section 6015(f) from joint tax liabilities with her former husband for tax years 2006 through 2009. The court found that she would face economic hardship if not granted relief and that she was abused by her former husband, making her unable to participate meaningfully in the filing of their joint returns.

The taxpayer was married in 2000 and during her marriage she stayed home and took care of their two children. Her husband owned and operated a sole proprietorship construction company, which was the only source of income during the marriage. In 2010 she filed for divorce, and on October 5, 2011, the divorce became final. During their marriage, the couple acquired by warranty deed a property the court called Lot 12. Before their marriage the husband acquired an ownership interest in the lot next to Lot 12 (Lot 13). On May 10, 2004, the couple applied for a loan to build a home on Lot 13, but the loan was denied because the husband did not have clear title to Lot 13. During this process the wife learned that her husband was still married to another woman by common law, and his common law wife's name was also on the deed to Lot 13. Almost five years after marrying the wife, the husband obtained a divorce decree from his common law wife, and the decree granted Lot 13 to the husband. The husband subsequently transferred a one-half interest in Lot 13 to the wife.
During the marriage the husband abused the wife, documented by police reports. On October 14, 2010, the wife obtained a temporary restraining order against the husband for two weeks.
The wife received custody of the couple's two minor children in the divorce and the decree included a protective provision for the wife and minor children, but even with the protective provision in place, the wife had to call the police regarding the ex-husband’s continuing abusive behavior. At the time the divorce became final in October 2011, the decree distributed to the wife as her separate property a one-half interest in Lot 12 and a one-half interest in Lot 13. The divorce court awarded her an additional $127,050. If the husband failed to pay the awarded amount on or before September 2012, the decree allowed for judicial foreclosure on his one-half interests in Lots 12 and 13 to satisfy the judgment. After failing to make the payment, the husband transferred his one-half interests in Lots 12 and 13 to the wife. Before the divorce was final and before the property was transferred, a notice of lien was filed and recorded against the husband’s property and assets in Lincoln County on the basis of liabilities from a substitute return the IRS had prepared using his 2008 income. A complaint was subsequently filed seeking foreclosure on the two properties.

The IRS began an audit for the husband’s 2008 and 2009 tax years and on January 4, 2013, he filed his 2008 and 2009 tax returns claiming head of household status. On March 5, 2013, the couple filed amended joint returns for 2008 and 2009 and later filed joint returns for 2006 and 2007. During interactions with the IRS, the wife tried to ask the IRS agent questions because she did not understand why she had to file joint tax returns with her ex-husband, nor did she understand the amounts reported on the returns or why she had to sign a 2008 return for a year already in collection in District Court. The IRS agent declined to respond and redirected her to counsel paid for by her ex-husband. She made handwritten notes on the 2006 and 2007 tax returns next to her signature, stating “as to form”. At the time of signing the joint returns petitioner's minor children still lived at home and the protective provision remained in place.
The taxpayer knew her ex-husband had financial difficulties but believed her ex-husband would pay the liabilities as he had previously paid all tax liabilities. At the time of signing the return she had been divorced from him for almost 17 months and did not have knowledge of his current income or employment. During the marriage she did not have nor could she obtain access to his construction records because she was not named as a principal in the construction business. He conducted his business without her assistance or involvement.

While the taxpayer has some education that allowed her to work part time in a medical office after the divorce from 2013 to 2015 for $8 per hour, she has not worked since that time, relying on child support payments to meet her basic living needs. Her ex-husband has been making child support payments sporadically and was still in arrears. On December 27, 2013, petitioner submitted a Form 8857, Request for Innocent Spouse Relief, requesting relief for 2006 through 2009, declaring that she signed the returns under duress and was a victim of spousal abuse. On January 12, 2016, the IRS issued a final appeals determination denying the taxpayer’s request for innocent spouse relief for 2006, 2007, 2008, and 2009 and she filed a petition for review of the determination. Section 6015(f) grants the Commissioner discretion to relieve an individual from joint liability, where relief is not available under section 6015(b) or (c), if, taking into account all the facts and circumstances, it is inequitable to hold the individual liable for any unpaid tax or deficiency. The Commissioner has prescribed procedures to determine whether a requesting spouse is entitled to equitable relief from joint and several liability, set forth in Rev. Proc. 2013-34.

The requesting spouse must meet seven threshold requirements to be considered for relief under section 6015(f), including that no assets were transferred between the spouses as part of a fraudulent scheme, the only threshold requirement in dispute here. The IRS contended that Lots 12 and 13 were transferred between the couple as part of a fraudulent scheme, but the wife argued that the assets were transferred pursuant to a court-ordered divorce decree judgment subject to the IRS liens of record and were therefore not part of a fraudulent scheme. The court noted that the transfer was made to satisfy a judicial foreclosure due to the ex-husband’s failure to pay the wife monies awarded in the divorce decree. The court said the transfer was made with the assistance and guidance of the wife’s divorce attorney and was recorded publicly and was subject to public inspection. The court found there was no intent to misrepresent, conceal, or hide this transaction from the IRS.

If the threshold requirements are satisfied, Rev. Proc. 2013-34, sec. 4.02, sets forth three requirements that a requesting spouse must satisfy to qualify for a streamlined determination by the Commissioner granting relief under section 6015(f): (1) the requesting spouse is no longer married to the nonrequesting spouse on the date the IRS makes its determination, (2) the requesting spouse will suffer economic hardship if relief is not granted, and (3) in the case of an underpayment, the requesting spouse did not know or have reason to know that the nonrequesting spouse would not or could not pay the tax reported on the joint return as of the date the return was filed or the date the requesting spouse reasonably believed the return was filed. The court concluded that the wife met all three requirements and was entitled to relief from joint and several liability under section 6015(f) under a streamlined determination. Laura Denise Contreras v. Commissioner, U.S. Tax Court, No. 7713-16; T.C. Memo. 2019-12. 2/26/19

Claim for Unreasonable Detention by Police Dismissed

The U.S. District Court for the Southern District of California held that qualified immunity applies in an IRS employee’s suit against police officers who detained him after the owner of an auto shop reported him for a tax scam. The court found that he had not been unreasonably detained.

The plaintiff was an Internal Revenue Service (IRS) employee, who filed a § 1983 claim as well as state law claims for damages based on his detention by San Diego Sheriff's deputies following a citizen report of a tax scam. The incident was initiated by a citizen complaint at an automotive shop on September 22, 2017 to which the defendant police officers responded. The shop's owner alleged that plaintiff was claiming to be an IRS agent and was demanding money from him. The deputies arrived at the owner's office at 3:03 p.m. and detained the plaintiff while they conducted an investigation to confirm whether or not the plaintiff worked for the IRS. He was released soon after 4:44 p.m.

Throughout the investigation, the court said that facts emerged that increased the deputies' suspicions that plaintiff was perpetuating a scam. He showed his IRS identification, but would not give possession of it to the deputies until one took it from him. He also provided a Florida license though he lived in California.1 In addition, to the deputies he appeared to be “extremely nervous,” his voice shook, he was visibly shaking, and he rarely made eye contact. Plaintiff explained that his training officer was at the location earlier with him, but had already left, and that he drove his own vehicle to the location rather than the usual IRS vehicle. The owner told the deputies that plaintiff told him “to go to the bank and get cash out and bring it to him.” The plaintiff asserted that he never demanded to be paid in cash, but that he did inform the owner that cash payment was an acceptable option. The owner explained that he was suspicious of plaintiff because he did not have tax debt and he had been receiving phone calls “from someone claiming to be from the IRS and threating if he did not pay $14,000 immediately, things would get worse.” In addition, after these calls, the owner said he received a letter from the plaintiff demanding payment. The deputies were unable to verify on the internet the IRS address on documents the plaintiff provided, the plaintiff's name did not appear to belong to an domain email, and his name did not appear in a database which was supposed to contain a complete list of federal employees. At approximately 4:14 p.m., the deputies received the contact information for the plaintiff’s supervisor and reached out to him and he ultimately confirmed that the plaintiff was an IRS employee and plaintiff was released.

The plaintiff filed suit on February 5, 2018, asserting that the defendants subjected him to an unreasonable seizure, were negligent, and falsely arrested him. Defendants filed a motion for summary judgment, arguing that their detainment of plaintiff was reasonable and that the deputies who detained Plaintiff were entitled to qualified immunity. Under case law, “qualified immunity shields a police officer from suit under § 1983 unless (1) the officer violated a statutory or constitutional right, and (2) the right was clearly established at the time of the challenged conduct.” The court said that while the plaintiff argued that he was subjected to an unreasonable detention, he did not identify a case where an officer, acting under similar circumstances, was held to have violated the Fourth Amendment, nor could the court identify a case where an officer acting under similar circumstances was held to have violated the Fourth Amendment. The court noted that the deputies pursued multiple means of investigation that would confirm or dispel their suspicions that plaintiff was not an IRS employee and while the investigation proceeded, the deputies uncovered facts that increased their suspicions that he was not an IRS employee. The court also found that it could not conclude that defendants' detention of plaintiff was an “obvious” violation of his constitutional rights. Citing case law, the court said that in assessing whether a detention is too long in duration to be justified as an investigative stop a court must examine whether the police diligently pursued a means of investigation that was likely to confirm or dispel their suspicions quickly, during the time it was necessary to detain the defendant. The court found that the current case does not present an “obvious” violation of plaintiff's constitutional rights, pointing out that the deputies pursued multiple means of confirming or dispelling their suspicions that Plaintiff was not an IRS employee and, throughout the investigation, uncovered facts that required further investigation. Under these circumstances, the court said it could not conclude that plaintiff's rights were obviously violated, and the defendants were entitled to qualified immunity as to the plaintiff’s claims.

The court also addressed whether the deputies violated plaintiff's constitutional rights under the Fourth Amendment, which allows officers to conduct a brief investigatory stop if there is a reasonable, articulable suspicion supporting the action. The court considered whether the detention was reasonable under the Fourth Amendment, noting that there is no rigid time limitation on investigative stops. The court considered the detention as a whole and concluded that the investigatory stop was reasonable. The court declined to exercise supplemental jurisdiction over the plaintiff's state law claims. Glenn Rosado v. County of San Diego et al., U.S. District Court for the Southern District of California, No. 3:18-cv-00265. 2/21/19




Sales and Use Tax Decisions

Assessments Affirmed

The Illinois Appellate Court, First District, affirmed a restaurant owner's tax assessment, determining that the taxpayer offered no evidence to prove the hypothetical weakness in the Department of Revenue's (DOR) audit method.

The taxpayer is the sole proprietor of a carryout-only Chinese restaurant located in Chicago.
DOR conducted a business tax audit of the business for the period from January 1, 2008, through December 31, 2010 and found that the taxpayer fraudulently underreported his total sales during this period. DOR issued corrected tax returns and Notices of Tax Liability. The taxpayer filed a protest and requested an administrative hearing. At the administrative hearing DOR submitted audit records into evidence and the ALJ determined that they established DOR’s prima facie case. The taxpayer testified at the hearing that he prepared his sales tax returns by calculating total daily sales and reporting those figures along with his expenses to his bookkeeper on a monthly basis but did not provide any of the physical sales receipts.
He submitted into evidence copies of his tax returns for 2008, 2009, and 2010. The copies were signed by a preparer but did not bear the taxpayer’s signature. He commented that he did not understand the tax forms and just signed what his accountant had prepared.

He also submitted a copy of the restaurant's menu representing the prices charged during the audit period. He also gave rough estimates about the percentage each type of item accounted for from his total sales, with fried rice at 50%, seafood entrees at 30%, and other meat entrees at 20%. He estimated his average sales revenue to be $300 per day for Monday through Thursday, around $600 to $700 on Fridays and Saturdays, and that his profit margin for sales averaged 25%. He was questioned about a previous hearing he had against DOR regarding a sales tax audit for the period of January 1, 2005, through December 31, 2007. He denied that he had received notice or was informed by his accountant about the need for cash register tapes after the first audit. After the hearing DOR submitted an Audit Narrative prepared by the auditor, describing the process used by the auditor in determining the deficiency.

The ALJ prepared a 12-page recommendation for disposition in which he found that the NTLs admitted into evidence established DOR’s prima facie case and noted that the taxpayer did not have books and records available for audit as required by state law. The ALJ concluded therefore that the container method employed by the auditor to determine the unreported tax liability and related penalties was a “reasonable” method to estimate revenue and the related sales tax. The ALJ also found that the record failed to establish, by clear and convincing evidence, that the taxpayer filed his returns with an intent to defraud and recommended that the fraud penalty that had been assessed be abated. The DOR Director ordered finalization
of the NTLs issued as they were originally entered but believed that the record supported a fraud penalty and entered additional findings of facts and conclusions of law in accordance with her opinion. The taxpayer filed an appeal to the circuit court.

The circuit court held that the statute and case law established DOR’s prima facie case was proven by the certified exhibits but agreed with the taxpayer that the auditor's methods were “opaque at best” because she did not give a formal accounting or mention the exact prices used in her calculations. While the court expected to see a more thorough work-up in the audit in light of the large assessment, it could not rule that DOR failed to meet a minimum standard of reasonableness. The court concluded that the taxpayer could not prove that there was a better way to calculate the estimated sales receipts where no books and records existed.
The court did, however, overrule the director's decision finding that there was no clear showing of the prerequisite intent to fraud. The parties filed an appeal.

The court noted that when an appeal is taken to the appellate court following entry of judgment by the circuit court on administrative review, it is the decision of the administrative agency, not the judgment of the circuit court, which is under consideration and an administrative decision will be set aside as clearly erroneous only when the reviewing court is left with the definite and firm conviction that a mistake has been committed. The taxpayer challenged the admissibility of the auditor’s narrative arguing that it did not constitute competent evidence because the auditor did not testify and contended it was unfair for the ALJ and Director to draw conclusions based on the narrative, which was not presented during DOR’s case-in-chief. The court found that the plain language of the statute clearly negates the taxpayer’s challenge to the auditor's narrative as competent evidence. The court determined that the auditor's narrative was prepared as a memorandum of DOR detailing the procedures of the audit, certified by DOR’s director, and properly admitted into evidence by the ALJ. The court also rejected the taxpayer’s claim that DOR failed to present a prima facie case, finding that it was also negated by the statute.

The taxpayer further argued that DOR’s prima facie case was not substantiated with “sufficient and probative documentary proofs” and, therefore, the auditor should have testified to explain and justify the amounts he was alleged to owe in tax. In lieu of the auditor’s testimony, DOR submitted the narrative she had typed up and submitted regarding her procedures and findings. The court said the narrative supported DOR’s argument that the audit was performed under a minimum standard of reasonableness. The auditor's method of calculation included scheduling the containers purchased by the taxpayer, calculating the average menu prices for items, and estimating gross sales revenue based on the number of containers used multiplied by the average sales price for that size container. This method was selected because the auditor believed that a significant number of purchase orders for higher priced items were missing. The court noted that the narrative also discussed a second method of calculation in which the auditor reviewed the guest checks provided for June 2010 but concluded that these guest checks were unreliable because there was no control for the guest checks, they were not in numerical order, and guest checks would be stapled to carryout bags and given to customers. The court concluded that DOR did not employ arbitrary or unreasonable methods to calculate the sales tax owed. The court also noted that previous cases recognized DOR is not required to produce the auditor to prove up DOR’s prima facie case.

The court also rejected the taxpayer’s contention that he factually rebutted DOR’s corrected assessment when he submitted his income tax returns and through his testimony. The taxpayer argued that the submitted income tax returns and his credible testimony were sufficient to overcome DOR’s prima facie case, but the court found that the returns had little probative value as the taxpayer could not testify that they were correct, and he related that the returns were prepared by his accountant based on monthly summaries that he generated himself. His testimony further revealed that his accountant did not have access to the source material on which the summaries were based. A taxpayer's failure to produce their records permits a negative inference that if the records had been produced, they would have reflected unfavorably on the taxpayer. The court found that the taxpayer’s testimony and offered evidence amounted to no more than a bare assertion that DOR’s corrected returns were incorrect and noted that the court has consistently found that a taxpayer's oral testimony without sufficient corroborative evidence will not rebut a prima facie case. The court did, however, find it appropriate to reverse the fraud penalties. Hau v. Beard, Illinois Appellate Court, First District, 2019 IL App (1st) 172588. 2/27/19

Use Tax Assessment Affirmed

The Michigan Court of Appeals held that the Michigan Tax Tribunal (MTT) properly found that terminals sold by a credit and debit card service provider were subject to use tax at the time of purchase.

The taxpayer is a provider of credit card and debit card processing services. Its customers are merchants, and the taxpayer provides them with card readers or card processing terminals that communicate with it over a data line. The taxpayer takes a percentage of each credit card transaction, and a third party performs the actual processing. Most of the terminals provided by the taxpayer are “placed for free,” and the taxpayer retains ownership of the terminal.
The taxpayer also sells some of its terminals outright. All terminals are “locked” when deployed so the merchant is not able to alter a terminal's programming or put it to other uses. If a merchant purchased a terminal outright, the taxpayer would “unlock” the terminal upon request and the merchant could then use the terminal with other services. The taxpayer maintains its inventory of terminals at its headquarters in the state and has no way to track whether any particular terminal will eventually be sold or placed for free until the terminal is actually withdrawn from inventory for deployment. Approximately 90.13% of the taxpayer’s total equipment was deployed outside of Michigan. Whether a terminal was sold or placed for free, the taxpayer invoiced the terminal transactions separately from its service agreements.

According to taxpayer’s tax manager, the present policy was to self-assess use tax on the terminals and pay the tax as the taxpayer purchased them. However, his predecessor had apparently not paid those taxes, which resulted in an audit by the Department of Treasury (Department). The taxpayer does not contest that it owes use tax on terminals placed for free in the state but contended that it does not owe use tax on any of the terminals deployed outside of Michigan, and that it should not pay any tax on any terminal until that terminal is withdrawn from inventory, because until that time every terminal has the potential to be sold.
The Department argued that the taxpayer was the consumer of the terminals, so it owed use tax at the time it purchased those terminals and the MTT agreed, reasoning that even though the taxpayer did sell some of its terminals, those sales were fundamentally intertwined with the sale of services, so it was not truly engaged in sales at retail. The taxpayer filed this appeal.

The court concluded that MTT’s finding that despite making some sales of terminals, the taxpayer’s business was the provision of services was clearly “supported by competent, material, and substantial evidence on the whole record.” The court said that the evidence established that even though it was possible to purchase a terminal without a service agreement, there was essentially no reason why anyone would purchase a terminal without a service agreement, and the testimony strongly implied that the taxpayer’s witnesses had no idea whether such a standalone transaction had ever occurred. The court noted that the taxpayer advertised itself as a provider of services and “free equipment,” not as an equipment retailer. The court said that the evidence was clear that although terminals were frequently sold outright, no such sales occurred without also entering into service agreements. The court also concluded that the taxpayer’s failure to maintain separate books or to treat the sold terminals in any distinguishable manner profoundly undermined its argument that the Department should treat the sold terminals in any distinguishable manner. The court found that MTT properly concluded that the taxpayer’s terminals were not truly “purchased for resale,” because only a minority were actually sold, because none of those sales were independent of the taxpayer’s services, and because all of the sales were merely incidental to its services. The court rejected the taxpayer’s argument that the majority of its terminals are deployed outside of Michigan, and as a consequence they are not subject to the use tax, pointing to case law for the proposition that the definition of use in the statute does not encompass the withdrawal of inventory and subsequent distribution of such items in another state. The court said that because the taxpayer did not purchase the terminals for resale within the meaning of the Use Tax Act, the terminals were not exempt from the use tax at the time of their purchase. N. Am. Bancard Inc. v. Dep't of Treasury, Michigan Court of Appeals, No. 344241; LC No. 16-003703-TT. 2/28/19

Personal Income Tax Decisions

Excess Capital Gain Deduction on Farmland

The Iowa District Court affirmed a couple's income tax assessment issued by the state Department of Revenue (DOR). It found that the taxpayers took an excess capital gain deduction for a sale of agricultural real estate located in the county.

The taxpayers filed a joint state income tax return for calendar year 2006, reporting the sale of agricultural real estate, and included a capital gain tax deduction on the tillable land. The facts show that they did not claim a capital gain deduction on the prior sale of the acreage. DOR audited their return and determined that they had taken an excess capital gain deduction and assessed tax, interest and penalty. The taxpayer paid the assessment under protest. An administrative law judge (ALJ) upheld the assessment and the Director of DOR adopted the ALJ’s proposed order. The taxpayer filed this appeal.

The wife’s father owned a 96-acre ranch and when he died in 1989, she and her brother inherited the real estate. They retained a 3-acre parcel with a house and garage for their personal use and rented out the remainder of the property. The building site was sold in 2005 and the two parcels of tillable land were sold to the two tenants in 2006. During the period from 1989 through 2006, neither the wife or her brother lived on the farm and none of the parties were ever engaged in farming as their principal occupation. The farm leases included a provision requiring the tenants to care for the land in a good and farm-like manner and to keep the premises free from brush and burrs, thistles and noxious weeds. The tenants decided what crops would be raised, provided all crop inputs, labor, and services. The rent charged was based upon an agreed, fixed rate per acre and was not related to production results or profitability. The landlords assumed no risk from the farming operation and had no investment in the crops.

The state income tax statute gives taxpayers a deduction for net capital gain income from taxable income from the sale of certain business property, including farm property, if the taxpayer materially participates in the business for at least 10 years. The sole issue in this case was whether the taxpayers materially participated in the business. DOR adopted administrative rules to assist in determining whether a taxpayer can meet the material participation test. One of the seven tests set forth in the rules includes cash farm leases and provides that a farmer who rents farmland on a cash basis will not generally be considered to be materially participating in the farming activity and places the burden on the landlord to show there was material participation in the cash-rent farm activity. The court concluded, based on its review of the record, that the agency determination that the type, duration, and significance of the participation provided by the taxpayers in the rental activities of the property fell short of the requirements was supported by substantial evidence in the record. Christensen v. Iowa Dep't of Revenue, Iowa District Court for Winneshiek County,
Case No. EQCV026248. 1/14/18

Corporate Income and Business Tax Decisions

Franchise Tax Refunds Barred

The Louisiana Court of Appeal, First Circuit, ruled that taxpayers that voluntarily paid Louisiana corporation franchise tax but were not subject to the tax were not entitled to refunds. The court found that the taxpayers must make claims against the state to recover the overpayment, holding that La. R.S. 47:1621(F) prohibits refunds of overpayments based on misinterpretation of the law by the state Department of Revenue (DOR).

The taxpayers are foreign corporations, organized under the laws of Delaware, and conducted no business in Louisiana during the pertinent tax periods. The taxpayers filed state corporation income and franchise tax returns for the years at issue here and subsequently filed amended returns claiming they were not subject to the state corporate franchise tax, based on the decision in UTELCOM, Inc. v. Bridges, 2010-0654 (La. App. 1st Cir. 9/12/11), 77 So. 3d 39, 48-50, writ denied, 2011-2632 (La. 3/2/12), 83 So. 3d 1046, which held that passive ownership interests in entities operating in the state were not sufficient to give out-of-state corporations nexus with the state for purposes of the franchise tax. The decision held that the franchise tax regulation LAC 61:1.301(D) was promulgated based on a mistake of law due to DOR’s misinterpretation of the corporate franchise tax law and the regulation was declared the invalid.

By letters dated April 4, 2012, DOR denied the taxpayers' refund claims, asserting that the amounts paid by the taxpayers were not refundable under any provision of Louisiana law and advised the taxpayers that they could file written petitions in the Board of Tax Appeals (BTA) regarding the denial of their refund claims. The taxpayers filed their appeal with the BTA and while the claims were pending, they entered into settlement agreements with DOR that stipulated they taxpayers had made overpayments of franchise taxes. The BTA issued recommendations that the legislature, at the next session, appropriate funds to pay the taxpayers the overpayment amounts at the earliest possible dates, thereby settling the taxpayers' claims. The legislature failed to appropriate funds to pay the overpayment amounts in the claims.

DOR then filed a motion for summary judgment, arguing that La. R.S. 47:1621(F) precluded the issuance of a refund to the taxpayers. That provision states that “[t]his Section shall not be construed to authorize any refund of tax overpaid through a mistake of law arising from the misinterpretation by the secretary of the provisions of any law or of the rules and regulations promulgated thereunder.” The section further provides that if a taxpayer believes DOR has misinterpreted the law, his remedy is to pay the tax under protest and file suit to recover or appeal to the BTA. DOR argued that since there had been a determination in UTELCOM that DOR misinterpreted the corporate franchise tax law, La. R.S. 47:601 through the promulgation of LAC 61:1.301, and the taxpayers' overpayments were based upon that misinterpretation of law, the statute applies to prohibit the issuance of a refund. The BTA found for the taxpayers and DOR filed this appeal.

Initially, the court found that the taxpayers had a right of action to seek a refund of franchise taxes via the Overpayment Refund Procedure in La. R.S. 47:1621-1627 and the BTA properly overruled DOR’s exception of no right of action, and the issue before the court was whether La. R.S. 47:1621(F) precluded the issuance of a refund to the taxpayers. The court reviewed the rules of statutory construction. The court noted that under the facts of the case, the taxpayers' Overpayment Refund Claims were based solely on the UTELCOM decision, i.e., “a mistake of law arising from the misinterpretation by the secretary of the provisions of any law or of the rules and regulations promulgated thereunder” under section 47:1621(F). The taxpayers did not pay their franchise taxes under protest and their only possibly remedy to recover a refund of voluntarily paid taxes would, therefore, be “an appeal to the Board of Tax Appeals in instances where such appeals lie.” The court agreed with DOR that the phrase “instances where such appeals lie,” refers to La. R.S. 47:1625 and is not binding on either the BTA or this Court.” The court found that it was constrained by the first sentence of La. R.S. 47:1621(F), which prohibits the authorization of any refund of overpayment based on DOR’s misinterpretation of tax law. Recognizing that statutes providing for tax refunds must be strictly construed against the taxpayer, the court held that Section 1621(F) is clear and unambiguous and must be applied as written. The taxpayers voluntarily paid taxes and are not entitled to a refund of taxes overpaid based on DOR’s misinterpretation of tax law as recognized in UTELCOM. The court noted that the enactment of La. R.S. 47:1484(C) in 2016 demonstrated the legislature's recognition of the potential for a substantial number of refund claims and material budgetary issues resulting from the UTELCOM decision and its attempt to provide relief to UTELCOM claimants with settled Claims Against the State. That section provides that when the BTA has approved a claim against the state for erroneous payments of corporate franchise tax, and the claim is not paid pursuant to Subsection A of the section within one year of the date the board's approval of the claim becomes final, the secretary of DOR and the claimant may agree that the payment of the claim may be taken as an offset against state corporate income or franchise tax liability of the claimant. Bannister Properties, Inc. v. State of Louisiana, Louisiana Court of Appeals, First Circuit, 2018 CA 0030. 11/2/18

Note: The Louisiana Supreme Court recently declined to review this appellate decision.

Property Tax Decisions

Exemption for Charter School Denied

The Arizona Court of Appeals held that a nonprofit corporation was ineligible for the charter school property tax exemption for 2015. The court found that the school ceased operations in May 2015, before the assessment period for the 2015 tax year was complete.

The state statute provides that property owned by a § 501(c)(3) nonprofit organization that operates as a charter school is exempt from taxation if the property is used for education and not used or held for profit. A qualifying nonprofit corporation owned three parcels of real property in the county where it operated nonprofit charter schools. The nonprofit filed for bankruptcy protection in April 2014, and the property became part of the bankruptcy estate. One of the nonprofit’s creditors sought leave from the bankruptcy court to pursue a sale of the property and the court granted the limited stay relief but ordered that the schools could continue to operate until May 29 and that no sale could be completed before that date. As part of this process, the taxpayer here was appointed as receiver with respect to the property. The schools ceased all operations on May 29, 2015. The County Assessor had classified the property as tax exempt under the charter school exemption and had applied the exemption through the 2014 tax year but did not apply the exemption for the 2015 tax year. The taxes went unpaid, and the first installment became delinquent as of November 2, 2015. The property was eventually sold to a third-party on April 28, 2016 and in conjunction with the sale the nonprofit paid the full amount of the 2015 taxes owed on the property. The taxpayers subsequently filed a tax claim in superior court, asserting that the property remained entitled to the charter school exemption for the 2015 tax year, and requesting a refund of the monies paid for that year. The taxpayers concurrently filed a petition for a refund with the County Board of Supervisors (Board), invoking a special administrative procedure provided by the charter school exemption statute. After the Board denied the petition, the taxpayers amended their tax court complaint to add a special action claim seeking a writ of mandamus directing the Board and the County Treasurer to refund the 2015 tax payment. The tax court dismissed the taxpayer’s complaint and this appeal was filed.

The county argued that the property lost its exempt status for the 2015 tax year when the charter schools ceased operations on May 29, 2015. The court noted that statutes granting exemptions are strictly construed, albeit not so strictly as to destroy the legislative purpose underlying the exemption. All ambiguities are construed against exemption, and the taxpayer bears the burden to establish that the exemption applies. The court pointed out that the exemption at issue here exempts property and buildings from taxation if owned by a nonprofit organization that operates as a charter school and uses the property for education purposes.
The property in this case was used for education only through May 29, 2015 and the court concluded that because the property was no longer used for education after that date, and before the assessment period for the 2015 tax year was complete, the property lost a necessary condition for entitlement to the charter school exemption. The court rejected the taxpayer’s argument that because the property was exempt for the first five months of the year, it was entitled to the exemption for the entire tax year, pointing to case law that addressed and rejected this same argument in the context of another tax exemption. R.O.I. Props. LLC v. Ford, Arizona Court of Appeals, Docket No. 1 CA-TX 18-0001. 2/21/19

Exemption to Hospice Care Center Denied

The Illinois Appellate Court, First Division, confirmed the Department of Revenue's (DOR) denial of an inpatient hospice care center's charitable property tax exemption application for the 2013 tax year. The court found that the taxpayer failed to prove that it utilized its facilities for exclusively charitable purposes.

The taxpayer operates a large end-of-life care facility in the state. In 2008, it operated a palliative care center on a 4.1-acre parcel of property in order to provide palliative care for patients and provide services to their families. The property was designated as tax exempt after DOR entered into an agreement with the taxpayer granting it a 91.9% charitable property tax exemption for the property. In 2011, the taxpayer began the construction of an inpatient hospice center pavilion on the same property as the palliative care center and subsequently filed an application for a charitable property tax exemption for the 2013 tax year for the property that houses both the palliative care center and the hospice care pavilion. DOR found that while the palliative care center remained property-tax exempt, the hospice care pavilion was not and, therefore, denied the application. The taxpayer appealed and an administrative hearing was held.

For income tax purposes, the taxpayer is classified as a 501(c)(3) organization and its bylaws provide that its purposes are “exclusively charitable,” and its articles of incorporation provide that its earnings cannot benefit any person. The articles of incorporation further provide that Midwest cannot discriminate against protected classes in conducting its operations and that it must admit patients that meet the applicable admission criteria without regard to the prospective patient's ability to pay. As part of its mission, the taxpayer provides adult bereavement services, counseling and support services to children, and a camp for grieving children and teenagers. It trains volunteers to provide vigil support and companionship to families and patients, and its volunteers provide comfort services and goods for suffering patients. It also trains medical students, free of charge, in providing hospice services which it claims helps to supply appropriately-trained physicians for palliative and hospice patients in the area. At the administrative hearing, the taxpayer pointed out that its hospice care pavilion was on the same plot of land as the tax-exempt palliative care center, was owned by the same entity, and operated under the same charitable principles. The ALJ concluded that the taxpayer had not demonstrated sufficient evidence to warrant an exemption for the facility and the recommendation was adopted by DOR. The taxpayer filed this appeal.

The court noted that there was no dispute that the taxpayer is a charitable institution and the issue was whether the property, the hospice care pavilion, was being used for a charitable purpose in 2013. The legislature is limited by the state constitution in its power to grant property tax exemptions, and when a party seeks a charitable use exemption, the property must be used exclusively for charitable purposes. The court cited Methodist Old Peoples Home v. Korzen, 39 Ill. 2d 149 (1968), in which the state supreme court set forth the accepted framework for deciding whether property can be considered to be used exclusively for charitable purposes and therefore exempt from property taxation.

In reviewing the financial data submitted, the ALJ observed that.4% of the taxpayer’s operating revenue came from charitable contributions and noted that 94% of the revenue it generated was from billing patients, exchanging medical services for payment, as a business. The ALJ found was not devoting a substantial portion of its operating income to an identifiable charitable need and he was unable to conclude that the revenue received by the taxpayer was devoted to the general purpose of charity. ALJ observed that the taxpayer’s primary purpose was not to provide charity, but to serve paying customers and the taxpayer did not reduce the burdens on the government as many charitable endeavors do. The ALJ took note of the community-based benefits the taxpayer offered, like bereavement counseling and training medical students, the ALJ did not find the activities to be charitable acts sufficient to justify a property tax exemption, instead finding that they actually served to benefit the taxpayer as a business and not a charity. The ALJ noted that there was no specific testimony introduced at the hearing regarding either the number of patients receiving charity care or the dollar amount of the taxpayer’s charitable expenditures for the 2013 exemption year. The ALJ concluded that the less than 1% expenditure for charitable care on the property represented an incidental act of beneficence that is legally insufficient to establish that the taxpayer exclusively uses the Marshak Pavilion for charitable purposes.

The court concluded that DOR did not clearly err when it found that the taxpayer failed to meet its burden to demonstrate by clear and convincing evidence that its hospice pavilion was used exclusively for charitable purposes in 2013, finding that the evidence introduced at the administrative hearing showed that almost none of the taxpayer’s revenue came from charitable contributions, and almost none of the revenue it generated was expended on providing charitable services. Instead, the court found that the taxpayer generated revenue almost exclusively by performing services to patients for pay. The court said that just because an institution is a non-profit and performs good deeds does not mean that the institution is using its real property exclusively for charitable purposes as that term is used in the Illinois Constitution. The court found that the evidence showed that the taxpayer almost exclusively served people that did not need charitable care. The taxpayer argued that there was no reason for treating the hospice care pavilion differently from the palliative care center for property tax purposes, but acknowledged that the two divisions were, in fact, separate. The court said that they can be treated differently for tax purposes as each entity seeking a tax exemption must carry its burden to demonstrate its entitlement to an exemption. The court said that while DOR entered into a settlement agreement with the palliative care center, stipulating to its charitable status, there was nothing binding DOR to treat the hospice care pavilion in the same manner. The taxpayer also argued that the hospice care pavilion might qualify for a charitable tax exemption on the basis that it is an extension of the tax-exempt palliative care center, but the court found that the taxpayer failed to meet its burden to demonstrate that the hospice care pavilion is reasonably necessary for carrying out the mission of the palliative care center. Midwest Palliative Hospice & Care Ctr. v. Beard, Illinois Appellate Court, First Division, 2019 IL App (1st) 181321; No. 17 L 50714. 2/25/19

Other Taxes and Procedural Issues

No cases to report.




The State Tax Highlights is a publication of the Federation of Tax Administrators for its members. If you have any comments on this publication, please send them to Linda Tanton at [email protected]