TEXAS: An Introduction to Tax: Litigation
Overview of Tax Litigation – Texas
Tax authorities throughout the United States are ramping up spending on tax enforcement to unprecedented levels. The Inflation Reduction Act alone, which Congress enacted in August of 2022, provided the Internal Revenue Service with an addition USD80 billion to spend over the next decade. The IRS has pledged to focus its deployment of these funds to improve enforcement on taxpayers earning more than USD400,000. State and local governments are implementing their own increases in tax enforcement resources.
As a result, tax enforcement – and the inevitable tax controversies that follow – are on the rise in the United States at both the federal and local levels. Because tax laws and their application often are not black and white, more enforcement generally translate into more disagreements between taxpayers and tax authorities. Let’s briefly look at what lies ahead for tax audits both at the Federal level, on which much has already been written, and at the state and local level in Texas, which has not drawn as much attention.
Federal Tax Enforcement
Shortly after Congress enacted the Inflation Reduction Act, the Department of the Treasury and the IRS initiated an effort to develop a plan to prioritize the initiatives that the new-found USD80 billion would fund. The largest focus identified for deploying the USD80 billion is tax enforcement to increase tax collections and shrink the tax gap (the difference between taxes due and taxes paid). Treasury’s most recent tax gap estimate is USD496 billion annually.
According to the 150-page Strategic Operating Plan, the IRS will deploy the USD80 billion in a manner that increases enforcement of high-dollar compliance issues, such as those related to complex partnership structures, large corporations, and high-income individuals. Aside from the Strategic Operating Plan, taxpayers should expect the IRS to continue the march on well-trotted territories like captive insurance, offshore bank accounts, and transfer pricing. Other issues will also draw increased activity, such as digital asset transactions and greater resource allocation to listed transactions. New issues are also surfacing from 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 new legislative acts implicate, an increase in legitimate disagreements over the law’s application should be anticipated. Taxpayer challenges to audit issues under these new tax laws may also test the resources of IRS Appeals and of the government’s litigation staff.
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, with only a 5% decrease. These tax collections were buoyed by the pandemic’s increase in on-line sales and new laws surrounding the collection of taxes on such sales from remote seller and internet marketplace providers. By first quarter of 2021, sales tax revenues had bounced back to pre-Covid levels. By year-end 2022, sales tax revenue increased 19.3% to USD43 billion. The 2023 fiscal year is projected to be another robust year in sales 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. , However, the Comptroller at times construes the enumerated categories of services more broadly than they appear to be defined by statute. 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. 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 as well as 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.
The Comptroller’s office audits taxpayers and concludes the audit with a Notification of Audit Results. Upon receiving this notification, taxpayer have several procedural options to receive reconsideration of the results. These options have changed in recent years, and require consideration of the pros and cons of each option.
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” (eg, city governments and school districts) within their jurisdictions. Issues involving whether property should be taxed, the determination of taxable values, and the application of exemptions are within the purview of the appraisal districts.
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.
Both the Texas Constitution and Texas Tax Code grant Texas property owners 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. Taxpayers may also qualify for one or more of the over 50 exemptions from property taxation. Most exemptions require that the property owner apply for the exemption, with some requiring annual applications.
Once the appraisal district notices 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 (ie, 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, Texas property tax litigation 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 shifts fees to the appraisal district if they prevail.
Conclusion
Tax enforcement is a necessary governmental function to collect revenue needed to fund the many government programs that exist. But governments don’t always get it right when it comes to deciding which taxpayers to should pursue or on what grounds. Our federal, state, and local governments often seek to impose and collect taxes against taxpayers that do not actually owe the amounts alleged. Taxpayer should work constructively with their governments to prevent such erroneous tax assessments. Taxpayers must remain vigilant to protect and preserve their procedural rights to prevent governmental overreach. Tax procedures, particularly at the state and local levels, are minefields. The above overview provides some broad strokes, but the devil is in the details. 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.