Texas Tax Roundup | April 2023: Pleas to the Jurisdiction, Retail and Wholesale Franchise Tax Rate, and More -

Howdy folks, and welcome back to another edition of the Texas Tax Roundup, where we gab about all things Texas tax and perhaps even some things Texas tax adjacent. As ole T.S. once put it, “April is the cruelest month” [1]—although maybe not for the same reasons he had. Because instead of “breeding lilacs out of the dead land”[2] or some such, which implies at least a glimmer of hope (although that might be why he thought it was so cruel, him being a bit of a downer, you know), April 2023 showered us with a string of taxpayer defeats, the one bright spot being a smackdown on a plea to the jurisdiction by the Texas Comptroller.

Court Opinions

Franchise Tax

Plea to the Jurisdiction/Total Revenue

Hibernia Energy, LLC v. Hegar, No. 03-21-00527-CV (Tex. App.—Austin Apr. 21, 2023, no pet. h.)—The Texas Third Court of Appeals affirmed the trial court’s judgment denying the Comptroller’s plea to the jurisdiction but also denying a taxpayer’s/consultant’s claim for refund for franchise taxes attributable to the inclusion in total revenue of gains from the sale of oil-and-gas leasehold interests.

The taxpayer, a limited liability company, acquired oil-and-gas leasehold interests in 2010, and then sold these interests in 2012 and 2014 at a gain of $95,866,370 and $296,691,853 for each year respectively. The taxpayer included these gains in its total revenue for purposes of determining its franchise tax liability for the respective franchise tax report years and paid the taxes.

In 2015, the taxpayer hired a consultant that filed a refund claim on the taxpayer’s behalf for the franchise taxes paid that were attributable to these gains.[3] The reason given for why the taxpayer was entitled to a refund was that it had overstated total revenue by including gains whose inclusion was not required under applicable law.

A limited liability company by default is treated as a partnership for federal income tax purposes.[4] A partnership is required to file a Form 1065, U.S. Return of Partnership Income to “report the income, gains, losses, deductions, credits, and other information about the operation of the partnership.”[5]

Under the Texas franchise tax, the total revenue of a taxable entity treated as a partnership for federal income tax purposes is calculated by first adding up the amounts reportable as income on various lines on the entity’s Form 1065:

Line 1c (balance of gross receipts or sales over returns and allowances);
Line 4 (ordinary income or loss from other partnerships, estates, and trusts);
Line 6 (net gain or loss from the sale or exchange of business property);
Line 7 (other income or loss);
Form 8825, line 17 (net rental real estate income or loss);
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 is includable in the taxable entity’s total revenue.[6]

Other items not relevant here are then subtracted to determine the taxable entity’s total revenue.[7]

In its refund claim, the taxpayer argued that it did not and was not required to report the gains from the sale of the oil and gas interests on Form 1065, Schedule K, Line 11 (and, apparently, did not and was not required to report the gains on any other line used to calculate total revenue).

The refund claim went through an informal review process with the Comptroller, which resulted in a denial of the refund claim.[8] The taxpayer then requested a formal administrative hearing in 2016, which resulted in the administrative law judge (“ALJ”) denying the refund claim.[9] In 2020, the Comptroller issued a decision adopting the ALJ’s recommendation to deny the refund claim.[10] The taxpayer filed a motion for rehearing, which was in turn denied.[11]

Flashback to 2017. In that year, the consultant purchased the taxpayer’s refund claim and obtained an assignment from the taxpayer of all rights and interest to the refund claim.[12]

After the denial of the motion for rehearing, the taxpayer filed a petition in Travis County district court seeking a refund of the taxes issue.[13] The petition listed the taxpayer as the plaintiff, and the consultant was listed as the party submitting the petition. Later, the taxpayer and consultant amended the petition to list the consultant as a plaintiff, with the consultant again listed as the party submitting the petition.

The Comptroller filed a plea to jurisdiction with the district court. (For those who don’t know, a plea to the jurisdiction in Texas is a way to get a case dismissed on the grounds that the court does not have authority to hear the case. This can because either the Texas Legislature has not granted that specific court the authority to hear that type of case—for instance, Texas state tax cases generally cannot be brought in any other court than Travis County district court—or the plaintiff lacks standing or has not taken certain procedural steps to get the case before the court. For more info, see Jason’s blog post here.)

The Comptroller argued that once the taxpayer had assigned its interest in the refund claim to the consultant, any action it took after that point in connection with the refund claim was invalid. Thus, the taxpayer did not have the authority to file the motion for rehearing, which is a statutory prerequisite for being able to bring a refund suit for Texas state taxes. Along the same lines, the Comptroller contended that after the refund assignment the consultant became the party that was required a motion for rehearing, which it failed to do. As a result, the Comptroller maintained that the trial court lacked the authority to hear the case.

The court of appeals upheld the trial court’s denial of the Comptroller’s plea to the jurisdiction. The court observed that under the Texas common law, an assignee of a cause of action may sue either in its name or in the name of the assignor without the trial court being deprived of jurisdiction to hear the case.[14] The court also looked to the Texas Tax Code, which says that refund claim may be brought either by the person who directly paid the tax or that person’s assignee.[15]The Code further provides that the person claiming the refund can request a formal hearing and, if dissatisfied with the Comptroller’s decision, file a motion for rehearing.[16] Thus, before the assignment the taxpayer was the only party who could file the refund claim. After the assignment, the taxpayer continued to be the party that could file a motion for rehearing and file a tax-refund suit in district court. The court held that while the consultant could have pursued the refund claim in its own name after the assignment, nothing in the common law or statutes required it to do so.

On the other hand, the court of appeals also upheld the trial court’s denial of the taxpayer’s/consultant’s refund claim. The court rejected the taxpayer’s argument that it did not have to report its gain from the sale of its oil and gas interests on line 11 of the Form 1065 despite the Internal Revenue Code and instructions to the form stating that all partnership income must be reported. The court also rejected the taxpayer’s assertion that it couldn’t calculate its gains from the sale of the oil and gas interests (probably because it seems to have done so on its original franchise tax report).

Notable Additions to the State Tax Automated Research (“STAR”) System

Franchise Tax

Primarily Engaged in Retail or Wholesale Trade

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 not entitled to the reduced franchise tax rate applicable to taxpayers “primarily engaged in retail or wholesale trade.” This rate applies to taxpayers whose activities are described in Division F (Wholesale Trade) or G (Retail Trade) of the 1987 Standard Industrial Classification (“SIC”) Manual, if:

(1) the total revenue from these activities is greater than the total revenue from its activities in trades other than the retail and wholesale trades;

(2) less than 50 percent of the total revenue from its activities in retail or wholesale trade comes from the sale of products it produces or products produced by an entity that is part of an affiliated group; and

(3) the taxable entity does not provide retail or wholesale utilities.[17]

The taxpayer primarily installed flooring for others and was involved in flooring materials cleaning and restoration. The taxpayer argued that it was classified under Division F, SIC Classification 5713 (Floor Covering Stores):

Establishments primarily engaged in the retail sale of floor coverings. Establishments included in this industry may incidentally perform installation, but contractors primarily engaged in installing floor coverings for others are classified in Construction, Industry 1752.

The ALJ found that the taxpayer did not provide sufficient evidence that 70% of its revenue came from the sale of flooring as opposed to labor or other services. The taxpayer’s contracts and invoices were lump sum (in other words, they didn’t set out separate line items for labor from materials). The taxpayer also didn’t provide source records supporting a segregation of its revenue streams for sales of flooring as opposed to sales of labor/services.

Additionally, the ALJ believed that the taxpayer’s customers were purchasing both flooring and installation with neither element being more important than the other, thus placing the taxpayer more appropriately under SIC Division C, Classification 1752 (Floor Laying and Other Floor Work, Not Elsewhere Classified):

Special trade contractors primarily engaged in the installation of asphalt tile, carpeting, linoleum, and resilient flooring. This industry 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’t qualify for the reduced rate applicable to taxpayers primarily engaged in retail or wholesale trade.

Nexus

Comptroller’s Decision Nos. 118,220, 118,221 (2023)—The ALJ ruled that a company with one to two employees located in Texas had nexus with the state and was therefore subject to Texas franchise tax and sales and use tax. The company was in the business of “brand strategy, creative and content development, engagement management, public relations, search marketing, social media, paid media, analytics, and the compilation of monthly reports.” The company used its website to solicit sales nationwide. The ALJ determined that the company was selling data processing services and information services, both of which are taxable under the Texas sales and use tax.[18] The Comptroller identified the company’s in-state employees by reviewing business reports issued by the Texas Workforce Commission. The ALJ found that the company solicited business in Texas through its website and had employees operating in Texas, causing the company to have constitutional nexus with the state for purposes of Texas franchise tax and sales and use tax.[19]

Sales Tax

Officer/Director Liability

Comptroller’s Decision No. 118,232 (2023)—The ALJ affirmed an assessment of sales and use tax against the sole owner of a company for a period during which the company continued operating a restaurant in the state after its right to do business had been forfeited due to the company’s failure to file its franchise tax report.[20]

Resale Exemption

Comptroller’s Decision No. 118,151 (2023)—The ALJ ruled that a fitness club didn’t qualify for the resale exemption on its “purchases of fitness equipment, towels, member kits, and consumable items (shampoo, body wash, etc.).” The ALJ found that there was no evidence that these items were transferred to club’s members or, if they were sold, the amount that the club charged for the items.[21] The ALJ rejected the club’s argument that it had detrimentally relied on Comptroller advice by pointing out that the club had failed to establish that any erroneous advice was communicated to the club directly in a private letter ruling.[22]

Health/Medical Products

Comptroller’s Decision No. 118,989 (2023)—The ALJ found that the purchase of menstrual pads and feminine hygiene products did not qualify for exemption from sales and use tax as “wound care dressing.”[23] The term “wound care dressing” is defined as “an item that absorbs wound drainage, protects healing tissue, maintains a moist or dry wound environment (as appropriate), or prevents bacterial contamination.”[24] The ALJ determined that the meaning of “wound” implies some sort of injury to the body, and thus feminine hygiene products cannot be considered “wound care dressings.”

(Attempts have been made in the past few Texas legislative sessions to enact a specific exemption from sales and use tax for feminine hygiene products.[25] The furthest one of these attempts has gotten is in the current legislative session, with the House of Representatives passing H.B. 300 by a wide margin.[26] The bill, which also includes exemptions for various other “family care items”, has been referred to the Senate Finance Committee, where testimony was taken on May 8, 2023. The bill is currently pending before that committee. This legislative 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 tax based on a bank deposit analysis when the taxpayer provided incomplete records to the auditor and failed to provide complete documentation at the hearing. The ALJ also affirmed a finding of tax collected no remitted when the taxpayer collected tax at 8.25% but only remitted 6.75% to the state.

State and Local Tax Services

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At Freeman Law, our experienced attorneys regularly guide our clients through complex state and local tax issues—issues that are frequently changing as states seek to keep pace with technology and the evolution of business. Staying ahead requires sophisticated legal counsel dedicated to understanding the complex state tax issues that confront businesses and individuals. Schedule a consultation or call (214) 984-3000 to discuss your local & state tax concerns and questions.

[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) (Classification of Certain Business Entities).

[5] Instructions to Form 1065 (2022).

[6] Tex. Tax Code § 171.1011(c)(2)(A) (Determination of Total Revenue from Entire Business).

[7] Id. § 171.1011(c)(2)(B).

[8] Id. § 111.1042 (Tax Refund: Informal Review).

[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 and Orders).

[11] See Tex. Tax Code § 111.105(c); 34 Tex. Admin. Code 1.35 (Motion for Rehearing).

[12] See Form 00-985 Assignment of Right to Refund.