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TEXAS: An Introduction to Tax: Litigation

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Overview of Tax Litigation – Texas 

The perfect storm for more aggressive tax enforcement is brewing. Shutdowns from the pandemic – and its toll on the country’s economy – have shrunk government tax collections at the federal, state and local levels. At the same time, governments have expanded spending programs (exceeding $5 trillion at the federal level) to stimulate the economy and throw economic lifelines to many Americans suffering from the consequences of the pandemic. At the end of the day, somebody has to pay for the delta between government revenues and expenditures. Add to this the perception that a substantial chunk of the gap could be closed by collecting taxes that are owed but unpaid.

Let’s briefly look at these dynamics and their impact on tax enforcement both at the federal level, on which much has already been written, and at the state and local level, specifically in Texas, which has not drawn as much attention.

Federal Tax Enforcement 

With trillions of dollars in new spending, the Internal Revenue Service is being tasked with renewed efforts to collect taxes from the wealthiest taxpayers. According to an April 28, 2021 press release from Treasury: “A recent study found that the top 1% failed to report 20% of their income and failed to pay nearly $175 billion in taxes owed annually.” The IRS has been pitching Congress to close the tax gap by funding increased enforcement focused on large corporations, partnerships and global high-wealth individuals.

Much of the IRS’ contemplated investment will be directed into the IRS’ Large Business & International Division (LB&I). The Division will need to overhaul technology, improve enforcement efforts, and hire and train auditors to focus on complex investigations of large corporations, partnerships and global high-wealth individuals. LB&I’s efforts will likely continue the march on well-trodden territories like captive insurance, offshore bank accounts and transfer pricing. But the efforts will expand to new revenue-raising targets. New issues and enforcement initiatives are beginning to surface, with LB&I (and the broader IRS) wrapping up the first wave of corporate and high-wealth individual audits covering tax years impacted by the Tax Cuts & Jobs Act of 2017 (TCJA), and under new audit procedures for partnerships under the Bipartisan Budget Act of 2015 (BBA). Given the sheer volume of novel issues that these recently enacted laws implicate, clients and practitioners can anticipate an increase in legitimate disagreements over the laws’ application. Taxpayer challenges to audit issues under these new tax laws may also test the resources and independence of the recently re-branded IRS Independent Office of Appeals, and the government’s bandwidth to litigate the many burgeoning issues that Appeals is unable to resolve. To the extent taxpayers and the IRS cannot resolve their tax disputes, taxpayers have a deficiency forum available to challenge proposed assessments through the United States Tax Court (where approximately 97% of all federal tax cases are heard), or taxpayers can pay the applicable tax and seek refunds through their local Federal District Court or the Court of Federal Claims.

Texas Tax Enforcement – Statewide Taxes 

In Texas, the primary revenue-generating tax at the statewide level is the sales tax, which accounts for roughly 1/3 of total tax collections in any given year. During the pandemic, Texas’ sales tax collections were remarkably resilient. It experienced about a 5% drop. These tax collections were buoyed by the pandemic’s increase in online sales and new laws surrounding the collection of taxes on such sales from remote sellers and internet marketplace providers; more on that in a moment. By first quarter of 2021, sales tax revenues had bounced back to pre-COVID levels. Texas was not immune to significant drops in revenues during the pandemic however. Hotel occupancy taxes and alcoholic beverage taxes dropped by 52% and 41% respectively. Due to the hard hit onshore oil and gas sectors, oil production and natural gas production taxes collectively dropped about 57%. Texas has no personal income tax, but it does have a business income-based franchise tax based on the margin of taxable entities, which also declined in tax collections.

Given the importance of the sales tax to fund Texas’ economy, taxpayers should anticipate – and are already experiencing – heavy enforcement in this area. In Texas, the Comptroller of Public Accounts (Comptroller) is primarily responsible for tax enforcement. Texas imposes its sales tax on any retail sales of 'taxable items', which are defined as tangible personal property and certain specifically enumerated taxable services. Importantly, in Texas, if a service is not specifically enumerated as taxable, then it is not subject to the Texas sales tax. The Comptroller does at times, however, construe the enumerated categories of services more broadly than they appear at first blush. It is often important to check the Comptroller’s regulations and decisions to appreciate the scope of the categories, at least in the eyes of the Comptroller’s office. If taxable, the state sales tax rate is 6.25%, and in general there is also a local tax that piggybacks and may increase the overall rate by up to 2%. The sales tax laws in Texas also provide many exemptions and exceptions to taxation, and interacts with the use tax.

The increase in tax collections from remote sellers and marketplace providers on the internet was previously mentioned. In any discussion of state sales taxes, it seems obligatory to mention a state’s treatment of e-commerce following the U.S. Supreme Court’s decision in South Dakota v. Wayfair. In general, remote sellers have Texas tax collection and reporting obligations if they have economic nexus in the state. Sellers that have a physical presence in the state are not considered remote sellers and remain subject to Texas’ normal set of rules. Texas has provided two safe harbors for remote sellers. First, remote sellers with total Texas revenue of less than $500,000 in the preceding twelve calendar months are not required to obtain a tax permit or collect, report and remit sales and use tax. Second, to reduce the burden of computing the local tax rates which vary throughout Texas, remote sellers may use a single local use tax rate published in the Texas Register by Jan. 1 of each year (1.75% for 2021). In legislation effective October 1, 2019, marketplace providers engaged in business in Texas must collect, report and remit state and local sales and use tax on all sales made through their marketplace. A marketplace provider is a taxable entity in Texas, and must report and remit Texas franchise tax, if it has physical presence or economic nexus in the state.

From a tax enforcement perspective, the Comptroller also focuses audit resources on the Texas franchise tax. Most entities formed in Texas or doing business in Texas are subject to the franchise tax. However, it does not apply in the case of most sole proprietorships, certain general partnerships and most trusts. If applicable, the taxable 'margin' is computed in one of the following ways: (1) total revenue times 70%; (2) total revenue minus cost of goods sold (COGS); (3) total revenue minus compensation; or (4) total revenue minus $1 million. Audit issues tend to arise with respect to what is included in revenue, and in regard to eligibility for the second method listed above involving COGS and what’s included in COGS. In general, total revenue is determined from revenue amounts reported for federal income tax minus statutory exclusions contained in the Texas Tax Code. Cost of goods sold generally includes costs related to the acquisition and production of tangible personal property and real property. Not surprisingly, in the real business world, it is not always apparent how these principles ought to apply, and taxpayers do not always agree with the Comptroller’s view on these issues.

As mentioned, tax enforcement for statewide taxes in Texas is primarily the responsibility of the Texas Comptroller. The Comptroller’s office audits taxpayers and concludes the audit with a Notification of Audit Results. Upon receiving this notification, taxpayers have several procedural options to receive reconsideration of the results. This includes a second look within the audit division by seeking Independent Audit Review, as well as the opportunity to petition for redetermination, which entitles the taxpayer to an administrative hearing. Once a petition is filed, the Comptroller assigns a hearings attorney, with whom the taxpayer may work to resolve the case or prepare it for hearing before an administrative law judge (ALJ). Taxpayers dissatisfied with the results following the ALJ’s decision may seek judicial review in Texas district court. Texas tends to be pro-business, and the Comptroller tends to be reasonable and resolution-oriented; tax disputes are often resolved during the administrative hearings process. There are nevertheless situations in which the Comptroller and the taxpayer agree to disagree on the administrative level and submit the case for judicial review.

Texas procedures, however, are far more complex than the above simplified summary and are laden with traps for the unwary. Careful review of the procedural rules is advisable at each step in the process.

Texas Tax Enforcement – Local Ad Valorem Taxes

Texas property taxes are not administered by the Texas Comptroller. They are administered by 'appraisal districts' throughout Texas, who in turn administer the appraisal and tax roll processes for 'taxing units' (e.g., city and county governments and school districts) within their jurisdictions. Any issues involving whether property should be taxed and at what value are within the purview of the appraisal districts.

In Texas, property taxes are based on a property’s valuation and are imposed on real property and business tangible personal property, subject to a long list of exemptions. Property tax is not imposed on non-business personal property, nor is it imposed on intangible property.

The processes for appraisal districts to identify and appraise property differ between real property and business tangible personal property. The appraisal districts proactively identify real property in their jurisdictions and issue valuation notices to the property owners of record, typically without input from the property owners. For business tangible personal property, the property owners have a legal obligation to 'render' by April 15 of each year their property by filing a report with the relevant appraisal district that self-identifies the business personal property taxable within the appraisal district and proposes a valuation. This rendition process comes as a surprise to many taxpayers, often years after they have already been in operation; but there are mechanisms to remedy past failures and limitations on the number of years the appraisal districts may go back to add omitted property to the tax rolls. Identifying what property needs to be rendered may be particularly confusing to property owners in connection with fleets of vehicles or heavy equipment that lack a fixed location. Ultimately, regardless of the commencement of the foregoing process, the appraisal district assigns a value to the subject property, which the taxpayer has a right to challenge.

In Texas, property owners have a right to challenge any appraisal that (1) exceeds the property’s fair market value, or (2) is not equal and uniform with valuations of similarly situated properties. These rights are embedded in both the Texas Constitution and Texas Tax Code. Taxpayers may also qualify for one or more of the over 50 exemptions from property taxation. Several of the more commonly invoked exemptions are residential homestead, federally-exempt property, and the in-transit exemption. Eligibility for and the amount of an exemption is generally determined by the claimant's qualifications on January 1. Most exemptions require that the property owner apply for the exemption, with some requiring annual applications. If an appraisal district denies an exemption, the property owner has a right to challenge the denial, similar to their rights to challenge the appraisal district’s appraisal of the property. But challenges to appraisals are far more common.

Once the appraisal district notifies an owner of a property’s value, or denies an exemption, the property owner may challenge the appraisal district’s action by filing a 'protest'. As with many tax issues that turn on valuations – whether estate taxes, transfer pricing or local property taxes – there typically is not a single, clear-cut value that should be assigned to any particular piece of property. Expert appraisers often disagree on the proper valuation. Accordingly, disputes over the correct value of property are common. Each appraisal district establishes an appraisal review board (ARB) to hear these disputes on the administrative level (i.e., before a dispute escalates into and imposes on the resources of a court of law). If a taxpayer does not receive adequate recourse from an ARB, the taxpayer has a right to judicial review. Notably, for property tax litigation, Texas has a specific statute that bucks the general American rule that each litigant pays their own fees; prevailing taxpayers may recover reasonable attorneys’ fees if the court finds either an unequal or excessive appraisal. This rule cuts one way and does not shift fees to the appraisal district if it prevails. As such, seeking attorneys’ fees can be a valuable tool to bring the appraisal district to the negotiating table during the litigation process.

Conclusion 

Tax enforcement is a necessary governmental function to collect revenue needed to fund the many government programs that exist. Coming out of the pandemic, taxpayers should expect increased enforcement activity at the federal, state and local levels. Unfortunately, governments don’t always get it right when it comes to deciding which taxpayers it should pursue and on what grounds. They regularly seek to impose and collect taxes against taxpayers that do not actually owe the amounts alleged. Taxpayers should seek to work constructively with government agencies to nip such situations in the bud if possible. It also critical, however, that taxpayers remain mindful of – and preserve – their important procedural rights to prevent governmental overreach. But tax procedures, particularly at the state and local levels, are minefields. The above overview provides some broad strokes, but the devil is in the detail. Taxpayers should carefully review the applicable rules to ensure they do not commit procedural missteps that divest them of important rights designed to ensure they pay their fair share of taxes but not more.