On April 23, 2010, Governor Christine Gregoire signed into law a $794 million tax-increase bill. The new law, known as Second Engrossed Substitute Senate Bill 6143-S.PL(2ESSB 6143), is 113 pages long and covers numerous issues, but four issues struck me as being particularly relevant to our law firm’s clients.
Out-of-State Companies Face Liability for Washington State B&O Taxes
Many clients of our law firm are based outside of Washington and do business in this state. The new tax bill seeks to impose B&O tax liability on out-of-state businesses that provide services in Washington or collect royalties on the use of intangible property in Washington, if they have a “substantial nexus” with Washington. Until now, B&O tax liability applied only if out-of-state businesses had a physical presence in Washington. Effective June 1, 2010, out-of-state businesses with no physical presence in Washington will be subject to Washington’s B&O tax if they have:
-More than $50,000 of property located in Washington; or
-More than $50,000 of payroll located in Washington; or
-More than $250,000 of receipts from Washington; or
-At least 25% of the taxpayer’s total property, total payroll or total receipts located in Washington.
The tax bill also extends the new “substantial nexus” test to businesses that have a physical presence in Washington, “which need only be demonstrably more than a slightest presence.” A business is deemed physically present if it, “either directly or through an agent or other representative, engages in activities in [Washington] that are significantly associated with the [businesses’] ability to establish or maintain a market for its products in this state.”
Many out-of-state businesses will be impacted by this new tax liability. Thinking about many of our firm’s clients, it strikes me that this new tax liability seems to directly apply to custom software developers and application service providers who do business with customers in Washington state.
There remains an open Constitutional question about whether a state can impose taxes on a taxpayer with no physical presence in the state. In the 1992 case of Quill v. North Dakota, the U.S. Supreme Court ruled that the Commerce Clause requires a physical presence in a state before that state can require an out-of-state seller to collect sales and use taxes. However, the Court’s decision in Quill did not specifically state that the physical-presence nexus requirement also applied to other types of taxes, such as income, franchise and B&O taxes. In June 2009, the U.S. Supreme Court declined to hear two appeals in two cases, Capital One Bank v. Commissioner of Revenue and Geoffrey, Inc. v. Commissioner of Revenue, which could have led to a definitive answer. It is possible that Washington’s adoption of the substantial nexus test could be the subject of a Constitutional challenge. In fact, the language of the new law expressly anticipates a challenge:
“If a court of competent jurisdiction, in a final judgment not subject to appeal, adjudges any provision of section 104(1)(c) of this act unconstitutional or otherwise invalid, Part I of this act is null and void in its entirety.”
Corporate Directors Must Pay B&O Tax on Board Compensation
With the new tax law, directors of Washington corporations must now pay B&O tax on amounts received as compensation for serving as a director. Historically, the Department of Revenue treated directors’ compensation as exempt from B&O taxes because in providing such services they were not engaging in business. The text of the actual bill expresses a legislative finding that “corporate directors are not employees or servants of the corporation whose board they serve on and therefore are not entitled to a business and occupation tax exemption under RCW 82.04.360.” The B&O tax rate for directors will be 1.8%. Corporate directors would be wise to consult with their tax professionals regarding this new tax liability, in part because they may qualify for relief under the expanded small business credit.
Liability for B&O tax will begin on July 1, 2010 and will not be retroactively applied to amounts received. Since the new law speaks expressly to directors of corporations, it should not apply to individuals serving on board structures or oversight committees created in other entities such as limited liability companies and limited partnerships.
New Law Targets Real Estate Development Projects Structured To Avoid Washington State Excise Tax
The new tax law states a clear intention to “stop transactions that are designed to unfairly avoid taxes,” and then proceeds to take aim, quite transparently, at a creative transaction used by real estate developers over the past several years precisely to avoid excise and other state taxes on development projects.
These joint ventures between developers and with their general contractors are most commonly limited liability companies. The developer typically owns 99% of the joint venture LLC and the general contractor owns 1%. To capitalize the business, the developer contributes to the LLC the underlying project real estate and the general contractor contributes 1% of that amount. Through the governing documents, the parties establish a structure whereby any member of the LLC contributing more than their initial required capital is entitled to a return of excess capital. The same agreement calls for the general contractor to provide construction services to the LLC and the value of the construction services is then returned to the general contractor in cash as excess capital contributions. The idea is that since the general contractor is providing construction services to a company it partially owns, such services should be exempt from excise tax liability. The governing documents also contain provisions drastically limiting the ability of the general contractor to share in the upside profits of the development project, but also indemnifying the general contractor from the downside investment risk of the project failing. Essentially, the general contractor enjoys a guarantee that will be paid, regardless of how the project performs.
Clearly, the new tax law specifically targets these joint ventures. The new law creates a new section to RCW 82.32 reading, in part:
“The department [of Revenue] must disregard, for tax purposes, …[a]rrangements that are, in form, a joint venture or similar arrangement between a construction contractor and the owner or developer of a construction project but that are, in substance, substantially guaranteed payments for the purchase of construction services characterized by a failure of the parties’ arrangement to provide for the contractor to share substantial profits and bear significant risk of loss in the venture.”
It appears the new tax law is intended to have retroactive effect with respect to such joint venture arrangements, with some limited exceptions. For example, exempted are joint ventures that, based on the new law, would be found to have under-reported its tax obligations and did so based on “specific written instructions provided by the department to the taxpayer, a determination published under the authority of RCW 82.32.410, or other documents made available to the department to the general public.” The new tax law defines “specific written instructions as “tax reporting instructions provided to a taxpayer and which specifically identify the taxpayer to whom the instructions apply.” It is believed that many developers sought advance determinations from the Department of Revenue about their joint venture structures, and so may be able to avoid the impact of the new law. Similarly, the provisions of the new law would expressly “not apply to tax periods ending before May 1, 2010 that were included in a completed field audit conducted by the department.”
Here’s why all of this should matter to developers and general contractors who formed these joint ventures. If the Department of Revenue finds that a tax deficiency resulted from such a joint venture, “the department must assess a penalty of thirty-five percent of the additional tax found to be due as a result of result of engaging [in such a transaction].” Significantly, the department is not permitted to assess the 35% penalty if, before the department discovers the tax deficiency, “the taxpayer discloses its participation in the transaction to the department.” Quite obviously, the legislature is encouraging these joint ventures to self-report and pay tax deficiencies in order to avoid the 35% penalty. However, if the department finds that all or any part of the deficiency resulted from an intentional effort to evade tax payments, a penalty of 50% must also be charged. I expect the 50% penalty to be a big stick wielded by the department, since these joint ventures were quite obviously formed to avoid Washington state excise taxes. For participants in these joint ventures, the only good news in all this is that the department is expressly forbidden from imposing the 35% penalty in combination with the 50% penalty.
More Individuals Face Personal Liability for Unpaid Sales Taxes
Under prior law, certain individuals faced personal liability for any sales tax collected but not paid to the Department of Revenue in connection with the termination, dissolution or abandonment of a corporation or LLC. Individuals facing liability included officers, members, managers, or other persons having control or supervision of collected sales taxes or whose job it is to file returns or remit collected sales taxes to the Department. The new law expands the definition of potentially liable persons (referred to as “responsible individuals”) to include “…any current or former officer, manager, member, partner, or trustee of a limited liability business entity with an unpaid tax warrant issued by the department,” as well as “any current or former employee or other individual with the responsibility or duty to remit payment of the limited liability business entity’s unpaid sales tax liability reflected in a tax warrant issued by the department.”
Responsible individuals are liable for unpaid sales taxes if they willfully fail to remit them to the Department of Revenue. Significantly, former and current Chief Financial Officers and Chief Executive Officers are personally liable for unpaid sales taxes, regardless of whether they were aware of the unpaid sales tax liability. Essentially, the new law creates strict liability for CFOs and CEOs.
If a responsible individual in a company is itself an entity, the new law creates a statutory veil-piercing mechanism for sales tax liability. Now, “responsible individual” includes any current and former officers, members or managers of the limited liability business entity or entities or of any other limited liability business entity involved directly in the management of the taxpayer.”
In addition, the new law refers to “limited liability business entities,” as opposed to the references under prior law to corporations and LLCs. The new language is presumably intended to sweep in limited partnerships and any other form of limited liability entity that may exist in the future.
The prior law predicated liability on the “termination, dissolution, or abandonment “of a corporation or LLC. The new law adds insolvency to the list, thereby giving the department greater flexibility to pursue responsible individuals earlier. Insolvency exists when a company’s debts exceed the fair market value of its assets, and the department may presume a company is insolvent if it refuses to disclose to the Department the extent and state of its assets and liabilities.
The new law creates many new tax liabilities, but here I’ve only discussed four that I think are particularly relevant to our business clients. Now is a good time for companies to check in with their accountants and lawyers and make sure they understand how the new tax laws will impact their businesses.