Stay-at-home orders sparked by the COVID-19 pandemic have resulted in mass business closures, hence, leading to dramatic reductions in state tax revenue. While the full financial impact will not be known for months or even years, we do know that state budget shortfalls are projected to be in the billions. And states will need to address their revenue shortfalls sooner rather than later.
A portion of the shortfalls may be addressed by using rainy day funds, which would have to be replenished, or through decreased government spending. However, as the shortfalls prolong and budget cuts no longer cover the declines in tax revenue, we expect states to address the lost revenue by expanding taxes through various pieces of legislation and more aggressive compliance enforcement.
It is highly likely states will most likely consider the following seven actions:
- COVID-19 Nexus Considerations
- CARES Act Conformity
- Suspension of NOL Carryovers
- “Millionaire’s” Tax
- New Revenue Streams
- Sales Tax Base Expansion
- Aggressive Tax Audits
1. Nexus Considerations
COVID-19 has created potential nexus concerns for businesses as a result of employees working remotely. While a handful of states have issued guidance that employees temporarily working remotely during an emergency declaration does not create nexus, those same employees may create nexus if they continue to work remotely after the emergency declarations are lifted. The nexus waivers also only apply to employees that did not work remotely prior to the declarations. Businesses must consider revisiting their policies regarding remote employees, as well as maintain documentation around the time employees spent working remotely during the pandemic in the event states question an employer’s activities in a future year.
We expect states will follow recent trends and expand their “doing business” standard for income and franchise taxes to include a gross receipts threshold, similar to the state Wayfair thresholds. While a handful of states have applied factor presence thresholds in the past, more states are implementing gross receipts nexus thresholds each year. Most recently Texas implemented a $500,000 nexus threshold for margin tax returns due in 2020.
>> Read “Does Your Company’s New ‘Work from Home Normal’ Create New State Tax Obligations?”
2. CARES Act Conformity
The most significant changes to the income tax base will revolve around state conformity to the CARES Act provisions, as well as“CARES Act 2.0” legislation expected by Congress sometime later in 2020. Most states’ legislature sessions adjourned prior to the IRS enacting the Cares Act on March 27, 2020. While some states have issued guidance on conformity to the CARES Act, most have remained silent. Consequently, businesses will likely not have a clear answer until state legislative sessions resume. In the interim period, businesses are forced to anticipate state action around the retroactive provisions by using existing IRC conformity rules.
3. Suspension of Net Operating Loss (NOL) Carryovers
Another instrument used by states in times of economic downturn and subsequent recovery periods is the temporary suspension or limitation of state net operating loss (NOL) usage. States are expecting businesses to suffer financial losses as a result of the pandemic and report losses on income tax returns. Suspension of NOL usage allows states to have an additional period of economic recovery after businesses have begun to financially recover. An alternative to NOL suspensions are limitations on NOL usage. For example, Pennsylvania limits the amount of NOL carryover to 30% of a corporation’s annual taxable income. Deferring or limiting NOL usage provides states a temporary replacement of lost revenue.
4. “Millionaire’s” Tax
While we do not expect across the board tax rate increases at the state level, we do foresee local governments pursuing tax rate increases as well as some states targeting wealthy taxpayers. For example, Illinois has a Constitutional Amendment on the November 2020 ballot to increase personal income taxes by nearly 3% on taxpayers earning more than $250,000 annually. New York has also proposed legislation to impose a 10.9% income tax on individuals earning more than $5 million annually, which would be a 2% tax increase. High-net-worth taxpayers may want to begin evaluating their desire and ability to reside in a state that does not impose an income tax.
5. New Revenue Streams
Oregon began imposing its largest tax hike in state history on January 1, 2020. Taxpayers with more than $750,000 of Oregon gross receipts are now subject to a corporate activity tax (CAT) on state gross receipts. Unlike Ohio’s CAT, Oregon did not replace another tax, but instead is imposing CAT in addition to their traditional taxes. Many states envy the tax regimes of Ohio, Texas and now Oregon, which are able to generate taxes independent of a taxpayer’s income.
Other states are considering the taxation of new sources of revenue. Ohio has legislation pending that would legalize and tax sports betting, as well as online gambling. New York is considering a 5% tax on businesses deriving income from the sale of data of New York residents.
6. Sales Tax Base Expansion
Prior to the COVID-19 pandemic, several states had pending legislation to expand the sales tax base. Hot topics of recent legislative sessions included digital advertising, services and digital products. We anticipate a renewed focus on these areas during 2021.
7. Aggressive Tax Audits (Wayfair)
History has shown us that state budget shortages are often addressed with additional tax audits and aggressive assessments. And, thanks to Wayfair, states have a growing pool of easy marks operating outside their borders. Many businesses have taken the stance that when they do not have a physical presence within the state they are likely not on a state’s radar, or, when their goods and services are not subject to sales tax they need not worry. Neither of these notions are true, and this line of thinking will leave many businesses exposed to growing assessments. Technology has enabled taxing authorities to broaden the net they are casting to identify non-filers. States often perform a variety of data mining activities by searching the internet, identifying non-filers during an audit of their customer or vendor, and when reviewing marketplace facilitator returns.
It is critical to be educated so you can make informed decisions around risk and compliance for your business. The first step is to consider a nexus study that examines current and historic nexus activities around both physical presence and, more recently economic presence. This evaluation will allow businesses to assess and prioritize their risk in each taxing jurisdiction based on specific activities both pre- and post-Wayfair. Informed businesses also have more control of the remediation processes that often provide opportunities for the relief of penalties and the number of tax periods assessed through state voluntary disclosure or amnesty programs. However, as you begin evaluating nexus and your sales tax obligations, do not collect sales tax in any jurisdiction until you are properly registered to remit the collected tax.
In the end, sales tax is collected from the consumer but when procedures are not in place to properly collect, the business selling taxable goods or services takes on the consumer’s sales tax liability, interest and penalties. So, while inconvenient, not tackling sales tax compliance impacts a business’ profitability if not today, at some point in the near future.
As states slowly begin the process of reopening, uncertainty abounds. Consumer spending has declined significantly during the COVID-19 pandemic as consumer habits have shifted from spend to save. The longer consumers remain in save versus spend mode, the more state budgets will be impacted. The economic recovery from the pandemic will likely take years. Businesses should expect states to use all means available to them to close budget shortfalls.
If you have significant sales to customers in states from which you do not collect sales tax, please contact a member of your service team, or contact Hannah Prengler at firstname.lastname@example.org.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.