This Week in State Tax

A California Court of Appeals ruled against a taxpayer in a dispute over nonrecognition of the gain from an involuntary conversion. The taxpayers were awarded $7.5 million in damages for grapevines that were destroyed by chemicals recommended by a crop advisor. They used the proceeds from the lawsuit to purchase approximately 40 acres of citrus trees. On their California individual returns, the taxpayers claimed protection under IRC 1033, which permits nonrecognition of gain when a taxpayer receives compensation for property that was destroyed, stolen, seized, condemned, or otherwise involuntarily converted so long as the compensation takes the form of, or is used to purchase property that is “similar or related in service or use.” For individual income tax purposes, California adopts this provision by reference (Rev. & Tax Code § 18031). For corporate income tax purposes, California law is substantially similar rules to IRC 1033 (Rev. & Tax Code § 24943-44). The Franchise Tax Board rejected the taxpayers’ nonrecognition claim, and the taxpayers ultimately appealed to Sacramento County Superior Court. The trial court judge dismissed the case, and the taxpayers again appealed.

Before the state Court of Appeals, the only issue was whether citrus orchards were “similar or related in service or use” to the destroyed grapevines. Under federal precedent from the 9th Circuit , the court was required to “look to the taxpayer's relationship to his [or her] old and new investments” and consider all the facts and circumstances. The court determined that the citrus orchards were not similar to the grapevines. In reaching this conclusion, the court identified grapevines as “improvements to land”, while the citrus orchards included both improvements (the citrus trees) and the land itself. The additional purchase of land resulted in a fundamentally different investment. In particular, the court noted that even if the trees were destroyed, the taxpayers retain value from the investment in the form of potentially productive land; this would not be the case for an investment consisting entirely of grapevines.

While this case directly relates to the nonrecognition provision for the individual income tax, this understanding of the “similar or related in service or use” language is likely relevant for interpreting that same language found in the California corporate income tax code. Contact Candace Axline or Geoff Way with questions about Skouti v. Franchise Tax Board.

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The Michigan Tax Tribunal (Tribunal) ruled that an electricity generator making wholesale sales of power was required to source its receipts to Michigan—the state in which it “delivers” electricity to its distributor via a substation—rather than to the locations of the ultimate consumers of the electricity. Michigan law sources the sale of electricity to the state in which the sales contract requires the electricity to be shipped or delivered “based on the ultimate destination at the point that the property comes to rest…” After initially sourcing its wholesale receipts entirely to Michigan, the taxpayer later amended its returns for several tax years to source receipts from electricity that was ultimately delivered to out-of-state consumers to the state in which those consumers used the electricity (reducing its Michigan sales factor from 98 percent to approximately 89 percent).

At the Tribunal, the taxpayer relied on both the U.S. Constitution (arguing that sourcing 100 percent of wholesale receipts to Michigan violated the internal and external consistency tests under the Supreme Court’s due process jurisprudence) and Michigan law (arguing that sourcing receipts to the location of the ultimate customer better complied with the language of Michigan’s sourcing statute). In response, the Michigan Department of Treasury (Department) argued that the total amount of electricity exported from the Michigan zone to which the taxpayer injected its electricity did not support the quantity of out-of-state transmissions claimed by the taxpayer, that Michigan law sources receipts from the sale of electricity to where the “contract requires” the electricity to be delivered, and that the only contract entered into by the taxpayer required delivery to Michigan substations. The Department also sought to distinguish numerous cases cited by the taxpayer and argued as well that the proper remedy for any constitutional issues identified by the taxpayer was a petition for alternative apportionment.

The Tribunal began its decision by analyzing the transaction to determine (1) that the distributor was properly identified as the purchaser because title passed to the distributor; and (2) that the ultimate destination governed under the terms of the contract was the Michigan substation. The Tribunal acknowledged tension between the statute’s references to both the terms of the contract and the ultimate destination of the sale, but it determined that the destination identified in the contract was the sourcing location most in keeping with the statutory language because the contract did not support a determination of the ultimate destination. The Tribunal also rejected the taxpayer’s constitutional arguments, most notably by ruling that it was reasonable to source 100 percent of the taxpayer’s wholesale receipts to Michigan when all the taxpayer’s electricity was generated in Michigan. Contact Dan De Jong with questions about CMS Energy Co. v. Dep’t of Treasury.

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Voters in the City of Seattle recently approved Proposition 1A, a ballot initiative imposing an “excess compensation” payroll tax on taxpayers engaging in business in Seattle. “Excess compensation” is defined as annual compensation paid to an employee of more than $1 million, and the rate of tax is 5 percent of the excess compensation. The tax, payable in quarterly installments, took effect on January 1, 2025, and it is in addition to the existing Payroll Expense Tax applicable to certain taxpayers in the city. The new tax is expected to raise approximately $52 million annually, and revenues are dedicated largely to the Seattle Social Housing Developer, a Public Development Authority, to develop and maintain affordable housing in the City. For questions regarding the tax, please contact Michele Baisler.

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It’s still early in the legislative calendar in most states, but things have begun to come somewhat into shape. Below is a review of a variety of business tax measures under consideration this year.

Digital Services – Rhode Island Governor McKee has proposed a tax on digital advertising services in the state as part of his budget (H.B 5076, Art. 5). The bill would impose a 10 percent tax on the assessed base, defined as gross revenues derived from digital advertising services in Rhode Island. The tax is imposed only on persons with greater than $1 billion in gross annual revenues. Montana is also considering a tax on digital advertising services (SB 192). The tax would be imposed at the rate of 10 percent of the assessable base, defined as annual gross revenue derived from digital advertising services in the state. The tax would apply to all persons with worldwide gross digital advertising revenues exceeding $25 million. In some variations on the theme, Washington State is considering a measure (HB 1887) to require the licensing of certain brokers in the business of collecting and selling certain personal biometric data of Washington residents. The bill would also impose a “severance tax” on such brokers based on the number of residents about which brokered personal data is collected each month. Last, a Maryland bill (HB 414) would impose a tax on certain social media platforms allowing the exchange of images among persons connecting on the platform.

Retail Delivery Fees –The Vermont General Assembly is considering a $.30 retail delivery fee on retail sales of tangible personal property delivered in the state, effective July 1, 2025.  Funding would be dedicated to transportation purposes. See the January 27 TWIST for a discussion of similar measures in Maryland and Mississippi.

Miscellaneous Indirect Tax Bills – If enacted, Texas Senate Bill 265 would exclude services provided by a marketplace provider “in relation to the processing of a sale or payment for a marketplace seller” from the definition of taxable data processing services for sales tax purposes, effective October 1, 2025. The Alaska legislature is deliberating imposition of a two percent sales tax on the “sale of property or services delivered in the state by a marketplace facilitator,” if the facilitator had $250,000 in gross revenue or 200 separate sales in the state in the prior year (HB 97).  The Rhode Island budget (HB 5076, Art. 5) would extend the hotel tax of five percent to “whole home short term rentals” of houses, condominiums and dwellings by any person, including room resellers. Virginia HB 1755, imposing the sales tax on digital goods and streaming services, failed to advance from the House Finance Committee.

Connecticut Budget – Governor Ned Lamont included several important business tax measures in his FY 2026 Budget as presented to the General Assembly. They include (a) eliminate cap providing that the conversion to combined reporting in 2016 cannot cause a taxpayer’s liability to increase by more than $2.5 million over separate filing, effective for tax years beginning after January 1, 2025; (b) repeal provision allowing corporations with greater than $6 billion in cumulative NOLs to deduct 100 percent of the losses exceeding that amount and limit such entities to deducting 50 percent of the loss as with other corporations; (c) accelerate phase-out of the capital tax base to January 1, 2026 – two years earlier than currently scheduled; and (d) extend the 10 percent corporation tax surcharge through tax year 2028. The surcharge, which applies to corporations with total income of $100 million or more and those that file as part of a combined group, is currently scheduled to expire at the close of tax year 2025.

IRC Conformity – Idaho has enacted a measure (HB 3, chapter 1) that updates the state’s date of conformity to the Internal Revenue Code to the Code in effect on January 1, 2025.  Legislation (HB 1028) enacted in South Dakota also updates its IRC conformity to the Code “as amended and in effect on January 1, 2025.”

Combined Reporting – A bill introduced in Oregon (SB 419) would require worldwide combined reporting for corporate tax purposes and eliminate the current water’s edge election. New Hampshire House Bill 502, which would have required worldwide combined filing for the business profits tax, was deemed “Inexpedient to Legislate” by the Committee on Ways and Means.

Miscellaneous Corporate Measures –The Arizona legislature is considering a measure (HB 2850) to eliminate an option for corporate income tax sourcing using only the sales factor and requiring use of a double-weighted sales factor, effective for tax years beginning after December 31, 2025. The measure would also adopt market-based sourcing for sales of other than tangible personal property, effective for tax years beginning after December 31, 2025. Virginia House Bill 1866, which would have adopted market-based sourcing for sales of other than tangible personal property, failed to advance from the House Finance Committee. Please stay tuned to TWIST for updates throughout the legislative sessions.

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