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Howdy folks, and welcome back to another edition of the TexasTax Roundup, where we gab about all things Texas tax and perhapseven some things Texas tax adjacent. As ole T.S. once put it,"April is the cruelest month" 1—althoughmaybe not for the same reasons he had. Because instead of"breeding lilacs out of the dead land"2 orsome such, which implies at least a glimmer of hope (although thatmight be why he thought it was so cruel, him being a bit of adowner, you know), April 2023 showered us with a string of taxpayerdefeats, the one bright spot being a smackdown on a plea to thejurisdiction by the Texas Comptroller.
Plea to the Jurisdiction/Total Revenue
Hibernia Energy, LLC v. Hegar, No.03-21-00527-CV (Tex. App.—Austin Apr. 21, 2023, nopet. h.)—The Texas Third Court of Appeals affirmed thetrial court's judgment denying the Comptroller's plea tothe jurisdiction but also denying a taxpayer's/consultant'sclaim for refund for franchise taxes attributable to the inclusionin total revenue of gains from the sale of oil-and-gas leaseholdinterests.
The taxpayer, a limited liability company, acquired oil-and-gasleasehold interests in 2010, and then sold these interests in 2012and 2014 at a gain of $95,866,370 and $296,691,853 for each yearrespectively. The taxpayer included these gains in its totalrevenue for purposes of determining its franchise tax liability forthe respective franchise tax report years and paid the taxes.
In 2015, the taxpayer hired a consultant that filed a refundclaim on the taxpayer's behalf for the franchise taxes paidthat were attributable to these gains.3 The reason givenfor why the taxpayer was entitled to a refund was that it hadoverstated total revenue by including gains whose inclusion was notrequired under applicable law.
A limited liability company by default is treated as apartnership for federal income tax purposes.4 Apartnership is required to file a Form 1065, U.S. Return of Partnership Income to"report the income, gains, losses, deductions, credits, andother information about the operation of thepartnership."5
Under the Texas franchise tax, the total revenue of a taxableentity treated as a partnership for federal income tax purposes iscalculated by first adding up the amounts reportable as income onvarious lines on the entity's Form 1065:
- Line 1c (balance of gross receipts or sales over returns andallowances);
- Line 4 (ordinary income or loss from other partnerships,estates, and trusts);
- Line 6 (net gain or loss from the sale or exchange of businessproperty);
- Line 7 (other income or loss);
- Form 8825, line 17 (net rental real estate income orloss);
- Schedule K, line 3a (other gross rental income or loss);
- Schedule K, line 5 (interest income);
- Schedule K, line 11 (other income or loss); and
- any total revenue reported by a lower tier entity that isincludable in the taxable entity's totalrevenue.6
Other items not relevant here are then subtracted to determinethe taxable entity's total revenue.7
In its refund claim, the taxpayer argued that it did not and wasnot required to report the gains from the sale of the oil and gasinterests on Form 1065, Schedule K, Line 11 (and, apparently, didnot and was not required to report the gains on any other line usedto calculate total revenue).
The refund claim went through an informal review process withthe Comptroller, which resulted in a denial of the refundclaim.8 The taxpayer then requested a formaladministrative hearing in 2016, which resulted in theadministrative law judge ("ALJ") denying therefund claim.9 In 2020, the Comptroller issued adecision adopting the ALJ's recommendation to deny the refundclaim.10 The taxpayer filed a motion for rehearing,which was in turn denied.11
Flashback to 2017. In that year, the consultant purchased thetaxpayer's refund claim and obtained an assignment from thetaxpayer of all rights and interest to the refundclaim.12
After the denial of the motion for rehearing, the taxpayer fileda petition in Travis County district court seeking a refund of thetaxes issue.13 The petition listed the taxpayer as theplaintiff, and the consultant was listed as the party submittingthe petition. Later, the taxpayer and consultant amended thepetition to list the consultant as a plaintiff, with the consultantagain listed as the party submitting the petition.
The Comptroller filed a plea to jurisdiction with the districtcourt. (For those who don't know, a plea to the jurisdiction inTexas is a way to get a case dismissed on the grounds that thecourt does not have authority to hear the case. This can becauseeither the Texas Legislature has not granted that specific courtthe authority to hear that type of case—for instance, Texasstate tax cases generally cannot be brought in any other court thanTravis County district court—or the plaintiff lacks standingor has not taken certain procedural steps to get the case beforethe court. For more info, see Jason's blog post here.)
The Comptroller argued that once the taxpayer had assigned itsinterest in the refund claim to the consultant, any action it tookafter that point in connection with the refund claim was invalid.Thus, the taxpayer did not have the authority to file the motionfor rehearing, which is a statutory prerequisite for being able tobring a refund suit for Texas state taxes. Along the same lines,the Comptroller contended that after the refund assignment theconsultant became the party that was required a motion forrehearing, which it failed to do. As a result, the Comptrollermaintained that the trial court lacked the authority to hear thecase.
The court of appeals upheld the trial court's denial of theComptroller's plea to the jurisdiction. The court observed thatunder the Texas common law, an assignee of a cause of action maysue either in its name or in the name of the assignor without thetrial court being deprived of jurisdiction to hear thecase.14 The court also looked to the Texas Tax Code,which says that refund claim may be brought either by the personwho directly paid the tax or that person'sassignee.15The Code further provides that the personclaiming the refund can request a formal hearing and, ifdissatisfied with the Comptroller's decision, file a motion forrehearing.16 Thus, before the assignment the taxpayerwas the only party who could file the refund claim. After theassignment, the taxpayer continued to be the party that could filea motion for rehearing and file a tax-refund suit in districtcourt. The court held that while the consultant could have pursuedthe refund claim in its own name after the assignment, nothing inthe common law or statutes required it to do so.
On the other hand, the court of appeals also upheld the trialcourt's denial of the taxpayer's/consultant's refundclaim. The court rejected the taxpayer's argument that it didnot have to report its gain from the sale of its oil and gasinterests on line 11 of the Form 1065 despite the Internal RevenueCode and instructions to the form stating that all partnershipincome must be reported. The court also rejected the taxpayer'sassertion that it couldn't calculate its gains from the sale ofthe oil and gas interests (probably because it seems to have doneso on its original franchise tax report).
Notable Additions to the State Tax Automated Research("STAR") System
Primarily Engaged in Retail or WholesaleTrade
Comptroller's Decision Nos. 117,167, 117,168,117,169, 117,170, 117,171, 117,172, 117,173, 117,174(2023)—The ALJ determined that a taxpayer was notentitled to the reduced franchise tax rate applicable to taxpayers"primarily engaged in retail or wholesale trade." Thisrate applies to taxpayers whose activities are described in Division F (Wholesale Trade) or G (Retail Trade) of the 1987 StandardIndustrial Classification ("SIC") Manual, if:
- the total revenue from these activities is greater than thetotal revenue from its activities in trades other than the retailand wholesale trades;
- less than 50 percent of the total revenue from its activitiesin retail or wholesale trade comes from the sale of products itproduces or products produced by an entity that is part of anaffiliated group; and
- the taxable entity does not provide retail or wholesaleutilities.17
The taxpayer primarily installed flooring for others and wasinvolved in flooring materials cleaning and restoration. Thetaxpayer argued that it was classified under Division F, SIC Classification 5713 (Floor CoveringStores):
Establishments primarily engaged in the retail sale of floorcoverings. Establishments included in this industry mayincidentally perform installation, but contractors primarilyengaged in installing floor coverings for others are classified inConstruction, Industry 1752.
The ALJ found that the taxpayer did not provide sufficientevidence that 70% of its revenue came from the sale of flooring asopposed to labor or other services. The taxpayer's contractsand invoices were lump sum (in other words, they didn't set outseparate line items for labor from materials). The taxpayer alsodidn't provide source records supporting a segregation of itsrevenue streams for sales of flooring as opposed to sales oflabor/services.
Additionally, the ALJ believed that the taxpayer's customerswere purchasing both flooring and installation with neither elementbeing more important than the other, thus placing the taxpayer moreappropriately under SIC Division C, Classification 1752 (Floor Layingand Other Floor Work, Not Elsewhere Classified):
Special trade contractors primarily engaged in the installationof asphalt tile, carpeting, linoleum, and resilient flooring. Thisindustry also includes special trade contractors engaged in laying,scraping, and finishing parquet and other hardwood flooring.
As a result, the ALJ determined that the taxpayer didn'tqualify for the reduced rate applicable to taxpayers primarilyengaged in retail or wholesale trade.
Comptroller's Decision Nos. 118,220, 118,221(2023)—The ALJ ruled that a company with one to twoemployees located in Texas had nexus with the state and wastherefore subject to Texas franchise tax and sales and use tax. Thecompany was in the business of "brand strategy, creative andcontent development, engagement management, public relations,search marketing, social media, paid media, analytics, and thecompilation of monthly reports." The company used its websiteto solicit sales nationwide. The ALJ determined that the companywas selling data processing services and information services, bothof which are taxable under the Texas sales and usetax.18 The Comptroller identified the company'sin-state employees by reviewing business reports issued by theTexas Workforce Commission. The ALJ found that the companysolicited business in Texas through its website and had employeesoperating in Texas, causing the company to have constitutionalnexus with the state for purposes of Texas franchise tax and salesand use tax.19
Comptroller's Decision No. 118,232(2023)—The ALJ affirmed an assessment of sales and usetax against the sole owner of a company for a period during whichthe company continued operating a restaurant in the state after itsright to do business had been forfeited due to the company'sfailure to file its franchise tax report.20
Comptroller's Decision No. 118,151(2023)—The ALJ ruled that a fitness club didn'tqualify for the resale exemption on its "purchases of fitnessequipment, towels, member kits, and consumable items (shampoo, bodywash, etc.)." The ALJ found that there was no evidence thatthese items were transferred to club's members or, if they weresold, the amount that the club charged for the items.21The ALJ rejected the club's argument that it had detrimentallyrelied on Comptroller advice by pointing out that the club hadfailed to establish that any erroneous advice was communicated tothe club directly in a private letter ruling.22
Comptroller's Decision No. 118,989(2023)—The ALJ found that the purchase of menstrual padsand feminine hygiene products did not qualify for exemption fromsales and use tax as "wound care dressing."23The term "wound care dressing" is defined as "anitem that absorbs wound drainage, protects healing tissue,maintains a moist or dry wound environment (as appropriate), orprevents bacterial contamination."24 The ALJdetermined that the meaning of "wound" implies some sortof injury to the body, and thus feminine hygiene products cannot beconsidered "wound care dressings."
(Attempts have been made in the past few Texas legislativesessions to enact a specific exemption from sales and use tax forfeminine hygiene products.25 The furthest one of theseattempts has gotten is in the current legislative session, with theHouse of Representatives passing H.B. 300 by a widemargin.26 The bill, which also includes exemptions forvarious other "family care items", has been referred tothe Senate Finance Committee, where testimony was taken on May 8,2023. The bill is currently pending before that committee. Thislegislative session ends May 29th. We'll see what happens.)
Estimated Audit/Tax Collected Not Remitted
Comptroller's Decision No. 117,644(2023)—The ALJ upheld an assessment of sales and use taxbased on a bank deposit analysis when the taxpayer providedincomplete records to the auditor and failed to provide completedocumentation at the hearing. The ALJ also affirmed a finding oftax collected no remitted when the taxpayer collected tax at 8.25%but only remitted 6.75% to the state.
1. T.S. Eliot, The Waste Land, line 1.
2. Id., lines 1-2.
3. See Tex. Tax Code § 111.104(Refunds).
4. See 26 C.F.R. § 301.7701-3(b)(1) (Classificationof Certain Business Entities).
5. Instructions to Form 1065 (2022).
6. Tex. Tax Code § 171.1011(c)(2)(A)(Determination of Total Revenue from EntireBusiness).
7. Id. § 171.1011(c)(2)(B).
8. Id. § 111.1042 (Tax Refund: InformalReview).
9. Id. § 111.105 (Tax Refund:Hearing).
10. See 34 Tex. Admin. Code §§ 1.10(b), (c)(Requesting a Hearing), 1.33 (Proposal for Decision and Exceptions),1.34 (Comptroller's Decisions andOrders).
11. See Tex. Tax Code § 111.105(c); 34 Tex. Admin. Code 1.35 (Motion forRehearing).
12. See Form 00-985 Assignment of Right toRefund.
13. See Tex. Tax Code §§ 112.001("Taxpayers' Suits: Jurisdiction), 112.151 (Suit for Refund).
14. Citing Eagle Supply & Mfg. L.P. v. Landmark Am.Ins., 630 S.W.3d 342, 351–52 (Tex. App.—Eastland2021, pet. denied) (citing Texas Mach. & Equip. Co. v.Gordon Knox Oil & Expl. Co., 442 S.W.2d 315, 317 (Tex.1969)); Insurance Network of Tex. v. Kloesel, 266S.W.3d 456, 465 (Tex. App.—Corpus Christi–Edinburg2008, pet. denied).
15. Tex. Tax Code § 111.104(b).
16. Tex. Tax Code § 111.105(a), (c).
17. See Tex. Tax Code §§ 171.0001(12), (18)(General Definitions), 171.002(c) (Rates; Computation ofTax).
18. See Tex. Tax Code § 151.0101(a) ("TaxableServices").
19. See 34 Tex. Admin. Code §§ 3.286(a)(4)(Seller's and Purchaser's Responsibilities), 3.586 (Margin: Nexus).
20. See Tex. Tax Code §§ 171.2515 (Forfeiture ofRight of Taxable Entity to Transact Business in this State), 171.252(2) (Effects of Forfeiture), 171.255 (Liability of Director andOfficers).
21. See generally Tex. Tax Code §§ 151.006 ("Sale forResale"), 151.302 (Sales for Resale); 34 Tex. Admin. Code § 3.285 (ResaleCertificate; Sales for Resale).
22. See 34 Tex. Admin. Code 3.10(c) (Taxpayer Bill ofRights).
23. See 34 Tex. Admin. Code § 3.284(b)(4) (Drugs,Medicines, Medical Equipment, and Devices (Tax Code§151.313)).
24. Id. § 3.284(a)(15).
25. See, e.g., H.B. 321, 87th Leg., R.S. (2021); H.B. 311, 86th Leg., R.S. (2019); H.B. 716, 85th Leg., R.S. (2017).
26. H.B. 300, 88th Leg., R.S. (2023).
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