The top state and local tax issues of 2022

February 7, 2023 9:00 AM

At the beginning of 2022, the hope was that the year would be a time for everything to return to normal from the perspective of recovering from the pandemic, in the state and local tax landscape as well as the rest of the culture.

"While getting back to a new normal in many respects became a goal and then a reality during the past year, the pandemic has changed behavior that is continuing to affect SALT outcomes for businesses, individuals and state and local governments," observed Jamie Yesnowitz, SALT national leader in Grant Thornton LLP's Washington National Tax Office.

"States are still reacting to federal legislation. We expect that activity will continue, as states keep busy responding to recent federal legislation," he added.

Each year, Yesnowitz and his team consider the developments of the past year and rank the most important SALT stories in order of perceived importance. For the second year in a row, the development of pass-through entity tax regimes led the list, although many other late-breaking issues potentially will have considerable impact, he indicated.

The following are the 10 most important SALT stories of 2022.

1. Continued adoption of pass-through entity taxes

"States continue to adopt pass-through entity taxes as a work-around to the $10,000 federal deduction limitation," Yesnowitz said. "Although the number adopting PTE taxes was less than those that did so in 2021, there is now a clear majority of states that offer the option to PTEs and their owners."

The trend this past year was seeing states, and even New York City, do this in a distinctive manner, according to Yesnowitz. "There is a lack of uniformity between jurisdictions," he said. "The timing of the election varies across states, and several allow retroactive elections. And we are beginning to see state tax authorities provide significant guidance on calculation and on how to make the election."

Under the typical regime, the PTE is permitted to deduct state and local income taxes paid at the entity level for federal income tax purposes, followed by a deduction for the PTE tax on the distributive share of the PTE owners' income. The owner then claims a corresponding tax credit against their personal tax liability or an exclusion on the portion of the owner's pass-through income subject to the entity tax, Yesnowitz explained.

The possibility that Congress will change or eliminate the SALT deduction limit is very unlikely at this point, Yesnowitz remarked.

2. Maryland digital ad tax invalidated

Welcome to Maryland Sign

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A state trial court invalidated Maryland's digital advertising services tax, finding it to be unconstitutional. Lawsuits were filed contesting the tax in both state and federal court, with the federal case now suspended.

The state now wants to appeal the decision directly to the Maryland Supreme Court (formerly the Maryland Court of Appeals), according to Yesnowitz. "It's difficult to predict how a state supreme court would act in this instance," he said. "If the new tax regime applies to only a limited number of taxpayers, it does have constitutional issues."

3. Tax rate reductions

The word "Taxes" is seen on the facade of the Internal Revenue Service headquarters in Washington, D.C.

Andrew Harrer/Bloomberg

Many states were in a surprisingly strong fiscal position in 2022, with tax receipts significantly exceeding projections. In addition, the American Rescue Plan Act provided federal funds to states to combat the effects of the pandemic. This has led many states to reduce their corporate income tax and individual income tax rates.

"There's a question as to whether this strong fiscal position will continue in 2023, given the uncertain economy and the fact that most of the ARPA funds have already been used by the states," said Yesnowitz.

4. ARPA tax mandate litigation

In the wake of the American Rescue Plan Act's "tax mandate" provision saying states couldn't lower their taxes if they had received federal aid, a number of states sued the Treasury, arguing that the mandate was unconstitutional.

"So far, there's been no formal effort by the Treasury to 'claw back' ARPA funding due to tax rate cuts," Yesnowitz noted. "There has been litigation, and currently we're seeing a split as to whether Treasury has the ability to claw back these funds. States are arguing that they should have the sovereignty to pursue their own tax policies and that the federal government and Treasury are overreaching based on the tax mandate provision. The expectation is that given the conflicting results in federal courts, the U.S. Supreme Court will be called upon to consider whether the tax mandate provision passes constitutional muster."

5. Sales tax inventory nexus litigation

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In recent years, several states have asserted inventory nexus for remote sellers participating in the Fulfillment by Amazon program prior to the Wayfair decision in 2018 and the marketplace facilitator laws that followed, explained Yesnowitz.

"Under the FBA program, as a means to facilitate transport of a remote seller's inventory to the ultimate customer, the inventory may be temporarily relocated to an intermediate state without the seller's knowledge," he said. "Relocating the inventory can give retailers physical presence in a state where they may not be registered to collect sales tax, resulting in states asserting nexus and sales tax collection and remittance obligations based on such tangential physical presence."

The most interesting decision in 2022 was in Pennsylvania, according to Yesnowitz: "The court held that sellers under the FBA program would not be subject to Pennsylvania sales and use tax just because their inventory had tangential presence in the state due to moving inventory into the state temporarily."

"This was the first decision to rule against a state based on the merits of an inventory nexus case," he said. "Now there is the potential for a split across jurisdictions in the coming months which could increase the likelihood of the U.S. Supreme Court considering the matter."

6. State reaction to the MTC’s take on P.L. 86-272

In August 2021, the Multistate Tax Commission adopted an updated statement on Public Law 86-272, the 1959 federal law that limits the state taxation of income from sales of tangible personal property, if the taxpayer's only business activities in the state are the solicitation of orders that are approved and shipped from outside the state. The revised statement includes a list of 11 different activities conducted by internet businesses and explains whether they are protected or unprotected for P.L. 86-272 purposes.

"California and New York were the first states that reacted to this, but they did it in different ways," Yesnowitz noted. "California conforms to this through administrative relief, whereas New York reacted by a draft regulation that has not yet been finalized. The New York draft regulation includes the 11 examples provided in the MTC's statement and, like California, reaches the same conclusions regarding whether each transaction is protected by P.L. 86-272."

7. Market-based sourcing developments

The Sirius XM Holdings Inc. application is displayed for a photograph on an Apple Inc. iPhone in Washington, D.C., U.S., on Sunday, Jan. 28, 2018. Sirius XM is expected to release earnings figures on January 31. Photographer: Andrew Harrer/Bloomberg

Andrew Harrer/Bloomberg

There have been numerous apportionment sourcing developments during the past 15 years, as many states changed from a cost-of-performance method focused on the location of activities performed by a service provider, to a market-based sourcing method in which the sale is sourced via a representation of the marketplace, according to Yesnowitz. "There were several very important cases in 2022," he said.

The Sirius case in Texas involved the sourcing of receipts from satellite radio subscriptions for Texas franchise tax apportionment purposes. The Texas comptroller determined that Sirius should have sourced its subscription receipts using the location of its subscribers, but the Texas Supreme Court determined the most natural reading of the state statute supports locating the performance of the service at the place where the taxpayer's personnel or equipment is physically located.

"Likewise, in Florida, a circuit court ruled in Target Enterprises Inc. that a taxpayer's use of the cost-of-performance method to source service revenue for purposes of the Florida corporation income tax was correct," said Yesnowitz.

8. Gain sourcing litigation

Cases in California, Massachusetts and New York addressed the sourcing of gains from sales by out-of-state entities, according to Yesnowitz.

"In Metropoulos Trust, the California Court of Appeals held that a nonresident shareholder's California source income from an S corporation's sale of intangible property, specifically goodwill, was partially from California sources and not sourced entirely to the shareholders' states of domicile," he said.

"In VAS Holdings & Investments LLC, the Massachusetts Supreme Judicial Court held that the state did not have statutory authority to tax an out-of-state S corporation on the capital gain it received from selling its 50% membership interest in an in-state limited liability company," he continued. "And the New York Supreme Court Appellate Division affirmed a decision of the New York City Tax Appeals Tribunal that the capital gain from a Delaware corporation's sale of its minority interest interest in an LLC conducting business in the city was subject to the city's general corporation tax, even though the Delaware corporation itself had no other presence in the city."

9. The MoneyGram case

The U.S. Supreme Court took up this case by original jurisdiction, observed Yesnowitz; it involves a dispute between Delaware and 30 other states over which state is entitled to escheat $300 million in uncashed checks issued by MoneyGram Payment Systems.

"It appointed a special master to hear the facts from both parties and come up with recommendations. It's interesting that the special master has changed its view on how the court should rule a couple of times," said Yesnowitz. "So we await the decision, which should come in the first three to six months of 2023."

10. Colorado’s retail delivery fee

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The Colorado delivery fee is an example of a new levy on businesses that addresses the increase in deliveries in part as a result of the pandemic, Yesnowitz indicated. "It's designed to help alleviate some of the pollution and environmental concerns caused by the delivery. The fee is imposed on certain retail motor vehicle deliveries to a Colorado location with at least one item of tangible personal property subject to state sales tax. The fee itself is somewhat complicated from a compliance perspective, and we expect the Department of Revenue to clarify some of the rules in effect," he said.