The new tax bill passed by Congress is expected to be signed into law by President Trump in the next few days.  Based on the changes that will take place as of January 1, 2018, there are several items that taxpayers should consider implementing prior to December 31, 2017.

Please note that each taxpayer’s situation is different and each suggestion below should be discussed with the taxpayer’s tax and financial advisors to determine what steps, if any, should be implemented now or deferred until next year or whether it should be implemented at all depending on the taxpayer’s business and tax attributes.

Items to consider:

  • Prepay real estate property taxes if you have amounts due for 2018 (cannot prepay NJ or NY state income taxes)
  • Prepay home equity interest (no deduction after this year)
  • Make charitable contributions this year, especially if not itemizing deductions in 2018
  • Accelerate business deductions
  • Medical expense deduction floor reduction to 7.5% only lasts through 12/31/18, so incur medical expenses if possible before then
  • Delay or accelerate Roth conversion
  • Defer or accelerate income*
  • If you are a US person with foreign businesses, potentially converting to an S corporation before year end could be beneficial due to a “deemed repatriation” of profits in the new bill
  • If you have children in private elementary, junior high or high schools and have not already been funding 529 plans, consider use of 2017 annual exclusions not otherwise exhausted to fund 529 plans

 

*Deferral of income until 2018 could save taxes for some taxpayers because of the lower marginal rates, while acceleration of income could save taxes for others due to the limitation on deductions of state and local taxes.  Whether or not a taxpayer is subject to AMT also plays a role.  Again, each taxpayer should consult his or her own tax and financial advisors for specific advice.

Beginning January 1, 2018, the IRS will begin implementing Section 7345 of the Internal Revenue Code to certify tax debt to the State Department.  This will allow the State Department to revoke or withhold the issuance of passports to delinquent U.S. taxpayers.

To warrant IRS certification to the State Department, the IRS debt has to be deemed “seriously delinquent tax debt.”  This is defined as: (a) an amount exceeding $50,000, as adjusted annually for inflation and including penalties and interest; (b) a levy or notice of federal tax lien has been issued by the IRS; and (c) all administrative remedies, such as the right to request a collection due process hearing, have lapsed or been exhausted.  This only relates to Title 26 of the United States Code and does not include other tax-related penalties, such as FBAR penalties.

The IRS will be required to notify the taxpayer in writing at the time it issues a tax debt certification to the State Department. Before denying a passport, the State Department will hold a passport application for 90 days to allow the taxpayer to resolve the tax debt or enter into a payment alternative with the IRS.

It is also possible to seek relief in U.S. Tax Court or District Court.  The court can order the IRS to reverse the certification if it was erroneously issued, or was required to be reversed but the IRS failed to do so.

The certification will not apply or will be reversed in the following scenarios:

  • The debt is paid in full. (The IRS will not reverse the certification if the taxpayer pays down the debt to an amount below $50,000.)
  • The taxpayer enters into an installment agreement with the IRS to pay off the debt.
  • The IRS accepts an offer in compromise to satisfy the debt, or the Justice Department enters into a settlement agreement with the taxpayer to satisfy the debt.
  • Collection is suspended based on a request of innocent spouse relief, or for collection due process based on a notice of levy, but only if the request is with respect to the debt underlying the certification.
  • The debt becomes unenforceable based on statute of limitations.

The law affects expatriates living abroad and individuals traveling regularly overseas for work.  If the taxpayer finds himself or herself traveling or living outside of the country with a revoked passport, the Secretary of State has the discretion to limit the existing passport, or issue a limited one, for return travel to the United States.

It is not clear if this statute will ultimately pass constitutional challenges.  In the meantime, starting January 1, 2018, you may be at risk of having your U.S. passport revoked if you travel outside of the U.S. without first addressing delinquent tax debts exceeding $50,000 through any administrative remedies and/or collection alternatives available to you.

We are seeing an uptick in audit activity by state tax authorities of closely held businesses, particularly in the area of sales and use tax, to generate much needed revenue for meeting budget shortfalls and funding services and entitlement programs.  A go-to audit technique is to examine whether a company has “nexus” with its state.

The question of whether your company has “nexus” with other states can lurk in the background of its normal multi-state activities, until all of a sudden it explodes in an audit.  A company that has failed to file returns and pay tax where there is nexus may face an audit for the past six to eight years generating substantial tax liability.  In the case of a trust fund tax (such as sales tax) there is also personal liability to a company’s owners and officers that is not a dischargeable debt in bankruptcy.

Definition of Nexus

An out-of-state (“foreign” or “nonresident”) business with significant physical presence in another state will have nexus with this other state.  The reason is that such business will be considered to avail itself of the state’s benefits and privileges (this assumption is automatic for resident businesses) and, in turn, the state will have jurisdiction to impose “privilege” taxes, of whatever specific kind, on the nonresident business.

Physical contacts in the state, beyond outright ownership or leasing of property, may include in-state deliveries (other than by common carrier) and banking activities in the state.  For sales tax purposes, such contacts also include solicitation of sales, whether by employees, independent contractors or other agents.  In addition, states have become increasingly aggressive and have asserted “economic nexus” based on non-physical contacts with the state, such as “click-through” nexus / internet referrals, licensing a trademark, and banking and financial services.

The two most common types of tax imposed by states on out-of-state businesses through nexus are income tax and the obligation to collect sales and use tax from customers.

Income Tax

State income tax is generally imposed on a nonresident business on income sourced within the state.  However, income derived from solicitation activities is protected by federal statute, 15 USC § 381 (commonly known by its 1959 enacting legislation, “P.L. 86-272”).  Under P.L. 86-272, a state cannot impose corporate tax on a foreign business, even when there is nexus, if the tax is based on, or measured by, the business’ gross or net income if: (1) all such income is derived from solicitation of sales of tangible personal property, and (2) orders are approved and shipped from out of state.

Note that P.L. 86-272 does not protect: (a) income derived from solicitations of sales of services, real estate or intangibles, and (b) non-income franchise tax calculated based on gross receipts, apportioned capital, net worth and other non-income measures.  For example, Washington State is notorious for targeting out-of-state companies with tenuous business activities in the state for failure to pay its Business and Occupancy Tax.  Other types of such non-income taxes that have been known to reach companies “doing business” out of state include Michigan Business Tax, Texas Margin Tax, and Ohio Commercial Activities Tax.

Sales and Use Tax

P.L.86-272 only protects solicitation activities from income tax.  For sales tax purposes, solicitation of sales by subsidiaries, agents or affiliates, who are residents of a state, on behalf of a foreign business will create nexus.

In fact, many states have made nexus automatic (and also not purely based on physical nexus), through a rebuttable presumption that a foreign company’s in-state referral sources are soliciting sales, by internet or otherwise, to generate their commissions.  The burden of proof shifts to a company having to prove the opposite: that a referral arrangement with a resident does not cause such resident to solicit sales, by internet or otherwise, generating a sales tax collection obligation.  New York’s highest court has upheld this type of statutory presumption (referred to variously as “click-through nexus,” “commission-agreement provision” or “Amazon law”) against constitutional challenge by online retailers Amazon.com and Overstock.com.

Nexus Study / Diagnostic Check

In light of the potential tax pitfalls facing a business with regular ties to various states—direct or indirect, physical or economic—every multi-state business should periodically perform a state-by-state diagnostic check, or nexus study, of its activities, such as:

  • Ownership or leasing of real property (store, warehouse, office) or personal property (machinery or equipment).
  • Inventory maintained in a warehouse or by sales representatives.
  • In-state deliveries to customers in company-owned vehicles.
  • Local media advertising (e.g., phone directory or telemarketing service).
  • Employees attending trade shows, or conducting training or seminars.
  • Active solicitation of orders for sales (for sales and use tax purposes).
  • Solicitation activities beyond the protection of P.L.86-272, such as solicitation of sale of services, real estate or intangibles (for income tax purposes).
  • Installation, repair, or maintenance services.
  • In-state order approval, receipt of payment, merchandise returns and customer complaint resolution.
  • Affiliate referral programs, internet-based or otherwise.
  • License, royalty or other fee arrangements.

Once a company completes a nexus study questionnaire, and personnel interviews, regarding its specific activities in various states, this information is analyzed in light of current law by state and area of tax.  A confidential attorney-client privileged memo summarizing the nexus study results is then provided to the business.  The company can then make informed decisions with its tax counsel on how to minimize its multi-state tax exposure.  The business may choose to alter its business practices to eliminate nexus in one or more states.  If that is not possible, it may choose to make voluntary disclosures through available state programs to potentially obtain a limited look back period and waiver of penalties.

Conclusion

In the wake of dramatic budget shortfalls and deficits, states are eager to wage nexus audits on out-of-state businesses, generating significant payments of income tax, sales and use tax, interest and penalties.  If your company operates in a multi-state market, is not registered to do business in other states and is not paying income tax or collecting sales tax, it is critical that you engage a tax attorney—that has the benefit of a confidential-attorney client relationship—to conduct a state-by-state nexus study.  Failing to do so may cause your company to be blindsided by what could be substantial (in some cases multimillion dollar) tax liability that may also be a personal debt for its owners and officers.