IRS Ruling that Cables Are Real Estate Could Raise Telecom’s NH Tax Bill

While news that a low-profile telecom provider based in Arkansas plans to spin off its communication lines into a real estate investment trust drove share prices in the sector higher on Tuesday on expectations of significant future tax savings, companies contemplating the maneuver could be in for an unpleasant surprise to the extent that any of the assets to be transferred are located in New Hampshire.

On Tuesday, Windstream Holdings, Inc. issued a press release saying that it had received a private letter ruling from the Internal Revenue Service that the spinoff of its existing fiber and copper network, along with other real estate assets, into a newly created entity qualifying as a REIT will not be subject to federal income tax. Windstream stockholders will retain their shares in the existing company and receive interests in the REIT proportionate to their holdings in Windstream at the date of the spinoff.

While there’s nothing new about a tax-free spinoff, the fact that the IRS had given its blessing to the bundling of wires and cable into a REIT set off a serious buzz throughout the telecom sector and among tax professionals, who had heretofore thought that such assets might not qualify as real estate. The tax savings to Windstream–and to the entire industry–could be huge. Since a REIT is not subject to federal income tax as long as its pays out at least 90% of taxable income to shareholders, the move is projected to result in $100 million of annual tax savings for Windstream, according to a report in the Wall Street Journal. (Stockholders must still report the dividends as income on their individual tax returns.)

Business Profits and Real Estate Transfer Tax Considerations
It’s unlikely that much of the expected tax savings will filter down to either company’s NH Business Profits Tax return since BPT law doesn’t allow the federal income tax deduction for dividends made by a REIT to its shareholders (Rev. 302.05(d)). The BPT tax rate of 8.5% is imposed on the apportioned profits of each business organization operating in the State. Windstream’s website indicates that the company has a sales office in Manchester and provides local business broadband Internet, Internet phone services and network and data services.

Another potential trap could await a telecom contemplating a similar move in the form of NH’s Real Estate Transfer Tax. RETT is a 1.5% levy on the fair market value of real estate transfers, including those carried out between related parties. While there’s no definition of the term ‘real estate’ in the RETT statutes, a determination that the wiring and fiber optic networks of a telecom qualify as real property for federal tax purposes could lend support to an interpretation that they are subject to RETT as well.

A counter to that argument can be found in the State’s property tax law, which holds that “wires, fiber optics, and switching equipment employed in the transmission of telecommunication, cable, or commercial mobile radio services shall not be taxable as real estate” (RSA 72:8-a). But since the RETT statutes don’t tie in to either the Internal Revenue Code or NH property tax law, it’s not clear how much influence either might have in a determination of the issue.

Uncertainty Over Taxability of Leases
In its press release, Winstream said that it will continue to use the transferred assets as part of a long-term, triple-net, exclusive lease from the REIT, with an estimated initial rental payment of $650M a year.

The taxability of leased real estate in NH has been an issue in the last month due to a proposed rewrite of the RETT regulations. An existing rule, which has been left intact, provides that leases of real property are only taxable if they are for 99 years or more. The controversy arose when the Department of Revenue Administration proposed a new rule providing that ground leases become taxable if they have a minimum term of 30 years.

Faced with criticism over the apparent conflict between the 99-year and 30-year rules, the DRA withdrew the proposed rule on ground leases, but still maintained that they are subject to tax since they represent an “interest in real estate”, the transfer of which is specifically taxable under RSA 78-B:1, I(a). Since ground leases are nothing more than a subset of real estate leases, the question then becomes at what point any lease turns taxable since all transfers of an interest in real estate are subject to RETT, unless specifically exempted.

A legislative committee will continue its review of the proposed rules at a hearing scheduled for Aug. 21. See DRA Commissioner Responds to Controversy on Taxability of Ground Leases

Proposed Treasury Department Regulations Created Safe Harbor
Windstream’s decision to seek the private letter ruling from the IRS was possibly related to the Treasury Department’s release in May of proposed regulations clarifying the definition of the term “real property” for purposes of qualifying as a REIT. While existing federal law already includes “inherently permanent structures” within the definition of real estate, the proposed regulations create a “safe harbor” listing for such structures, to include transmission lines and cell towers.1

A Windstream media representative said Wednesday that the company would not be releasing a copy of the private letter ruling, which is not yet available on the IRS’s website

Footnotes

  1. Prop. Treas. Reg. § 1.856-10(d)(2)(iii)(B)

DRA Commissioner Responds to Controversy on Taxability of Ground Leases

Despite the withdrawal of a proposed rule on the taxability of ground leases, a series of recent press interviews with the Department of Revenue Administration’s commissioner might have added to the controversy as to when such leases are subject to New Hampshire’s Real Estate Transfer Tax.

While maintaining a long-standing rule that a lease has to have a term of at least 99 years to be subject to RETT,1 the DRA proposed a new regulation in January stating that assignments of ground leases were taxable if they had a duration of 30 years or more.2 Some real estate professionals and politicians quickly seized on what they saw as a major change in the Department’s interpretation of the law.

Once the controversy became public, the DRA promptly withdrew the proposed rule. In recent days, DRA Commissioner John Beardmore has been quoted in the press as saying that the rule had been “poorly constructed.”

An article in Sunday’s Nashua Telegraph said that, “Beardmore had the rule change withdrawn, reportedly because it actually didn’t go far enough to enforce the taxation of ground leases that already were being taxed.”3 The article also stated that the DRA had determined ground leases were taxable under the current definition of the tax “some time ago” and that the proposed rule “was merely meant to clarify and update the language the agency was already enforcing.”

And the Concord Monitor reported yesterday that, “Beardmore said he didn’t have numbers on how much is actually collected from the tax, but he did say no one has ever challenged it.”4

An article in today’s Union Leader said that Beardmore “believed the rule could be interpreted to apply only to transfers of ground leases and not original leases.”5 The article went on to quote Beardmore directly as saying, “[t]hat’s exactly what we meant by ‘poorly constructed’. And it’s why we withdrew those specific provisions of the rule.”

Still Not Clear When a Ground Lease Becomes Taxable
From some of the comments attributed to Beardmore, it’s not clear whether the Department considers that ground leases are taxable only if they are for a minimum of 99 years or that all leases of real estate are taxable, regardless of how long they run. The latter interpretation, however, seems unlikely because the DRA did not drop the existing regulation stating that a real estate lease is subject to tax only if it has a minimum term of at least 99 years.6 In light of the report that Beardmore withdrew the 30-year rule “because it actually didn’t go far enough to enforce the taxation of ground leases that were already being taxed”, clarification will almost certainly be needed before the controversy can be put to rest.

Today’s Union Leader article reported that the DRA plans to meet with “real estate professionals to come up with a clearer definition of ground leases.” Beardmore also reportedly said that his department “has no timeline to bring a proposal on taxes on ground lease transfers to the Legislature.”

As to the Commissioner’s statement that “no one has ever challenged” the Department’s enforcement of the 30-year minimum for ground leases, an Internet search and a review of court filings turned up nothing indicating that the DRA has ever advanced that interpretation publicly. While it’s possible that the Department has advised some taxpayers of such a position, it would seem surprising if a taxpayer who was audited over the issue would have not pursued it in court, especially considering the apparent conflict with the existing 99-year rule.

Ground Leases a Subset of Real Estate Leases
The DRA has apparently not explained the reasons behind its initial decision to carve out a special rule for ground leases, especially in light of the fact that they are nothing more than a subset of real estate leases in general (which are already covered by the 99-year rule). There is no provision in either the NH statutes covering the conveyance of real estate or the common law stating that a lease of 99 years should be treated any differently from a lease of shorter duration.

Transfers of NH real estate are subject to tax. RSA 78-B:1, I(a) states that RETT “…is imposed upon the sale, granting and transfer of real estate and any interest therein including transfers by operation of law. Each sale, grant and transfer of real estate, and each sale, grant and transfer of an interest in real estate shall be presumed taxable unless it is specifically exempt from taxation under RSA 78-B:2.” (Emphasis added)

Under NH law, a building on leased property is considered real estate. RSA 477:44 states that, “[b]uildings situated on land not belonging to the owners of the building shall be deemed real estate for purposes of transfer, whether voluntary or involuntary, and shall be conveyed, mortgaged or leased, and shall be subjected to attachment, other liens, foreclosure and execution, in the same manner and with the same formality as real estate.”

When a building is erected on “on land not belong to the owners of the building” it is almost always done on property covered by a ground lease. A ground lease has been defined as:

A long-term (usu. 99-year) lease of land only. Such a lease typically involves commercial property and any improvements built by the lessee usu. revert to the lessor.7

A ground lease, just like any other lease of real estate, confers an interest in real estate. The term ‘interest in real estate’ has been defined (in relevant part) as:

Collectively, the word includes any aggregation of rights, privileges, powers and immunities; distributively, it refers to any one right, privilege, power, or immunity.

Interest in the use and enjoyment of land. The pleasure, comfort, and advantage that a person may derive from the occupany of land. The term includes not only the interests that a person may have for residential, agricultural, commercial, industrial, and other purposes, but also interests in having the present-use value of the land unimpaired by changes in its physical condition.8

Legislative Review of Proposed Rules
Even though the DRA has withdrawn the rule on 30-year ground leases, it’s very possible the legislative committee responsible for reviewing agency regulations will press the Department to provide more guidance on the issue at its meeting scheduled for Aug. 21st. 9

There are at least three other rules that could also prove controversial which the Department has not yet had a chance to discuss with the committee. See Proposed Rewrite of RETT Rules Not Always Consistent with Statutes and Proposed Rule Lowers RETT on Entity Conversions to Statutory Minimum.

Footnotes

  1. Rev. 802.01(f) The lease of real estate based on the fair market value of the leased property when the term of the lease is: (1) For a period of 99 years or more; or (2) For a period of less than 99 years and renewal rights could extend the total period of time to 99 years or more
  2. Proposed Rev. 802.01(j) The transfer of a lessee interest in a ground lease including any interest of the lessee in the related improvements that provides for a term of 30 or more years when all options to renew or extend are included, whether or not any portion of the term has expired.
  3. ‘Hidden’ Real Estate Tax; Fodder for Frontal Election-Year Assault, 7/27/14
  4. Republicans, Democrats Mark Battleground in Race to Control State Senate, 7/27/14
  5. Real Estate Transfer Tax Proposal Pulled Off Table, 7/28/14
  6. And the political fallout from an interpretation that the lease of an apartment for a year or two would be significant, to say the least.
  7. Black’s Law (8th Edition)
  8. Black’s Law (8th Edition)
  9. When the DRA appeared before the committee earlier this month to present its final version of the proposed rewrite of all RETT regulations, it ran into problems with another rule and was told to return once it had more complete information on the issue. That rule dealt dealt with the definition of a term that had undergone a statutory change five years earlier. Even though the DRA never modified its existing regulation defining the term, when it finally did, the proposed rule was unchanged from the previous definition. (See Legislature Tells DRA to Provide Background on Controversial RETT Rule) Considering how long the DRA went before working on that rule, the Committee might request quicker action on an interpretation of the more controversial issue of the taxability of real estate leases.

Court Grants Online Travel Companies Some Relief but Allows M&R Tax Case to Proceed

Despite dismissing a number of counts in a civil case brought by the State of New Hampshire against four online travel companies, a Superior Court judge has ruled that the Attorney General’s office had the right to file suit against the OTCs for non-payment of Meals and Rentals Tax without the matter first having gone through the normal audit and assessment procedures of the Department of Revenue Administration.

In a little-noticed ruling issued late last month, the Merrimack County Superior Court also refused to dismiss the State’s claim that the OTCs, which include Priceline, Orbitz, Expedia and Travelocity, had violated the NH Consumer Protection Act. The Court did, however, toss out the AG’s claims of unjust enrichment and conversion. It also rejected the State’s charges of civil conspiracy and breach of fiduciary duty and turned down a request that the OTCs be forced to provide an accounting of all their billings for rentals in NH since the inception of the M&R Tax.

OTCs contract with hotels to purchase rooms at reduced rates. The travel companies, in turn, will rent the rooms over the Internet to end users at a mark-up to the reduced rate, but for less than the going rate charged by the hotel. NH hotels, which frequently do not know the amounts actually charged by the OTCs to the end user, will normally only remit M&R Tax on what they are paid by the travel companies. The State is claiming that tax is due on the difference between the two amounts. The OTCs counter that they have no legal obligation to collect or remit the tax since they do not meet the statutory definition of an “operator”, a claim that they have made with a good deal of success in other states.

Attorney General Can Sue Even If DRA Doesn’t Assess Tax
In an unusual move, the AG’s office bypassed the DRA when it filed a lawsuit against the OTCs last October alleging that they didn’t pay M&R Tax as required by law.1 The AG also claimed that the OTCs had engaged in “deceptive business practices” related to their sales of hotel rooms and rental cars in the State.

In its lawsuit, the AG’s office justified its approach by stating that “[t]his is not a matter that should be dealt with at the administrative level” because, in other states, the defendants “have always denied legal liability and asserted constitutional defenses, and often try to tie up matters in the administrative process for years.”

In siding with the State, Judge Richard McNamara ignored the defendants’ alleged behavior with respect to legal proceedings in other states and instead relied on RSA 78-A:20, II, which states that the AG’s office “may” bring legal action to collect unpaid M&R Tax. In his order, McNamara ruled that:

“Considering the fact that RSA 78-A:20, I does not appear to mandate that proceedings to collect taxes must first proceed at the DRA, the fact that the OTCs have made a conscious decision by not filing tax returns to bypass the DRA’s procedures and have, thus, tacitly waived the procedural protections they would be entitled to in a tax assessment procedure,…the Court declines to dismiss the complaint on the ground that the proceeding to collect taxes must begin at the DRA.”

It is interesting that the Court focused on RSA 78-A:20, which is titled “Taxes as Personal Debt to State”, and not on RSA 78-A:11, “Assessment of Additional Tax”, which lays out the statutory authority under which the DRA “may” assess M&R Tax. The fact that the Legislature saw fit to enact RSA 78-A:20 suggests that it serves a different purpose from that of RSA 78-A:11. The distinction between the two might be found in RSA 78-A:7, I(b), which states that “[t]he occupant, purchaser, or renter shall pay the tax to the operator.” Since M&R Tax is ultimately owed by the party who receives the benefit of the meals or rentals, an argument can be made that all RSA 78-A:20 is meant to accomplish, as it title appears to suggest,2 is to make it clear that any taxes collected by an operator from a consumer are the personal debt of the operator until they are paid over to the State.3 If they are not remitted to the State, the statute also provides authority for the AG’s office to file suit against the operator to force collection of that personal debt.

In fact, there is also statutory authority under RSA 78-A:11 for the AG’s office to act “[i]f the department finds that an operator liable for a tax designs to leave the state, or to remove his property from the state, or to conceal himself or his property, or to discontinue business, or to do any other act tending to prejudice or to render wholly or partially ineffective proceedings to collect the tax…” (RSA 78-A:11, III). The law goes on to state that the AG’s office may bring suit for the collection of tax, but only “at the same time” that the DRA makes its demand for payment from the operator.

If the Court’s interpretation that the AG can file suit for collection of tax at any time under RSA 78-A:20 is correct , it’s not clear why it was necessary for the Legislature to enact RSA 78-A:11, III, which obviously deals only with situations where time is of the essence, but still requires that the DRA issue a tax notice before the AG can become involved. Perhaps the explanation is that RSA 78-A:20 is meant to make clear the fact that the unremitted tax, while originally payable by the consumer, also becomes the personal debt of the operator and can only be pursued by the AG’s office after the DRA has conducted an audit, issued a tax notice and the taxpayer has exhausted its rights of administrative appeal. 4

No Requirement for DRA’s Expertise
In its original complaint, the AG’s office also justified its action by claiming that “the threshold question, whether or not the online travel companies are subject to (M&R Tax) is one of law and does not require the Department of Revenue’s expertise” and that “judicial economy would be served where the legal issues involved would be resolved with less expense and more efficiently and expeditiously within the judicial system.”

The Court accepted that argument, ruling that “…the fact that the ultimate legal issue which (sic) upon which all of the (M&R Tax) claims pled turns is one which the DRA has no particular expertise to decide, the Court declines to dismiss the complaint on the ground that the proceeding to collect taxes must begin at the DRA.”

Not a Trustee Tax
Any interpretation that RSA 78-A:20 is solely intended to establish the operator’s liability for paying the tax as a fiduciary or a trustee of the State might have been undercut by the Court’s rejection of the AG’s companion charge that the OTCs had breached a fiduciary duty, either directly or under a constructive trust, to collect tax and remit it to the DRA.

“The State cites no authority, and the Court believes none exists, for the proposition that a person who collects taxes pursuant to a statutory scheme which requires the person to remit the taxes to the State thereby owes a fiduciary duty to the State,” Judge McNamara ruled.

The Court also rejected the AG’s claim that the OTCs held money owed the State under constructive trust. “Such an equitable remedy is only available where the defendant has no adequate remedy at law,” Judge McNamara ruled. “If the plaintiff is able to succeed, it may recover money damages.”5

Conspiracy and Consumer Protection Act
McNamara also dismissed the State’s allegation that the OTCs had conspired in not paying M&R Tax.

“The State has alleged only that the Defendants engaged in similar business practices; there is no allegation that they are acting in concert or in combination. Conclusory recitations of law, even under New Hampshire’s liberal pleading standards, are insufficient to survive a motion to dismiss.”

The Court did, however, allow the State’s claim that the OTCs had violated NH’s Consumer Protection Act (“CPA”) to go forward, ruling that the issue needed to be fully explored.

“Whether or not a fraudulent representation was made is a quintessential example of a fact intensive determination. As the Defendants argue, it is no doubt true that there is nothing deceptive about a business practice that is disclosed to the consumer. Cecere v. Loon Mountain Recreation Com., 155 N.H. 289, 297-98 (2007). But it is also true that such a determination cannot be made on a motion to dismiss and, therefore, the CPA claim cannot be dismissed.”

Footnotes

  1. There has apparently been only one other instance in which legal action for the failure to pay a tax administered by the DRA was initiated by a party other than the Department itself. In 2007, the Rockingham County Attorney’s office filed criminal charges against the owner of a crematorium for the failure to file business tax returns. The DRA had not issued a tax notice prior to the indictment. There is no specific provision in either the business tax statutes or the statutes governing the administration of the DRA (RSA 21-J) allowing a county attorney (or the attorney general for that matter) to initiate legal action based on alleged violations of tax law. The crematorium owner, who had been under indictment for non-tax-related charges that were subsequently dropped, entered a guilty plea to the tax offenses without ever having challenged the County’s authority to pursue a tax case prior to either the DRA’s issuing of a notice of assessment or having had the opportunity to exhaust his administrative appeal rights. (It appears, however, that the DRA did assist the county attorney in the case.) See Crematorium founder sentenced to up to to 3 years for tax evasion; Gloucester Times, 2/29/08
  2. Whether the title or heading of a revenue rule should be used in interpreting the rule has been a recurring issue over the years. In United States v. Fisher, 6 US 358, 386 (1805), the US Supreme Court stated that, “(n)either party contends that the title of an act can controul plain words in the body of the statute; and neither denies that, taken with other parts, it may assist in removing ambiguities. Where the intent is plain, nothing is left to construction. Where the mind labours to discover the design of the legislature, it seizes every thing from which aid can be derived; and in such case the title claims a degree of notice, and will have its due share of consideration.”
  3. The Electricity Consumption Tax, which was enacted in 1997, states that any amounts collected by a provider become the personal debt of the provider until paid to the State (RSA 83-E:4, II). And when a serious (but ultimately unsuccessful) attempt was made to pass a statewide sales tax in 2001, the proposed legislation stated that any tax collected by a vendor would remain a personal debt until remitted to the State (HB 562). RSA 78-A:20, II, which was enacted in 1967, does not, however, specifically state the obvious that taxes collected are no longer a personal debt after they have been remitted to the State.
  4. Putting the legal arguments aside, it’s not clear why the DRA didn’t just issue a “blue sky assessment” for a very large amount of tax, say a billion dollars, justifying the billing on the fact that the OTCs refused to provide an accounting of their NH revenues. That would have avoided all the wrangling over whether the AG’s office could act independently of the DRA. And, if the courts later agreed that the OTCs were actually operators under M&R Tax law, they would have been forced to provide details on their taxable billings at that time. Some might argue that it ultimately doesn’t matter whether it’s the AG or the DRA that initiates the legal action because, one way or another, it should end up with the same result. But making an end run around the administrative process deprives the taxpayer of important procedural rights. By being taken directly to court, OTCs were denied the opportunity to contest the assessment through the DRA’s confidential administrative process, during which they would have become better informed about the strength of the State’s positions and might have decided to enter into a settlement without being exposed to the opprobrium that often accompanies a public accusation of tax violations.
  5. The AG did not, however, refer to RSA 78-A:20 in making its claims that the OTCs owed the State a fiduciary duty to collect and remit the tax or that they held funds due the State under a constructive trust.

Legislature Tells DRA to Provide Background on Controversial RETT Rule

Not long after beginning its review Thursday of the Department of Revenue Administration’s rewrite of the Real Estate Transfer Tax rules, a legislative committee told the DRA to return at a later date to clarify whether transfers of interests in not-for-profit organizations are subject to the tax.

The first item on the agenda of the Joint Legislative Committee on Administrative Rules (JLCAR) was a proposed rule saying that only entities meeting the definition of a “business organization” under Business Profits Tax law can qualify as real estate holding companies, transfers of ownership interests in which are subject to RETT. Since BPT law states that a not-for-profit organization satisfying the criteria set out in IRC § 501(c) is not a business organization, under the proposed regulation it wouldn’t be considered a real estate holding company for RETT purposes either.

As previously reported in New Hampshire Tax Advantage, that rule is incompatible with the statutory definition of the term “real estate holding company” at RSA 78-B:1-a, VI, which had been amended in 2009 to drop a previous link to the term “business organization”. While the proposed regulation is consistent with the existing rule, Rev. 801.07, for some reason that rule had never been revised to reflect the 2009 amendment.

Citing a NHTA article published on June 8th, a legislator asked why the DRA was leaving unchanged a rule that had been superseded by a statutory amendment five years earlier. Director of Audit Kathy Sher responded that the agency was unaware that the previous reference to business organizations under BPT law had been removed from the RETT statutes.

Due to concern about whether transfers of interests in not-for-profit entities could be subject to RETT, a motion was then approved to delay further consideration of the RETT rules until the DRA could determine the reason why the Legislature had dropped the business organization requirement from the statute in 2009.

Possible Constitutional Problem
As explained in the June 8th NHTA article, that statutory change was presumably made because an exemption for a transfer of an interest in an entity that wasn’t subject to BPT would probably represent an unconstitutional classification of taxpayers since RETT would be owed on a transfer of interests in a similarly situated business that is subject to BPT. An example would be a transfer of an interest in a Sec. 501(c)(2) entity,1 which is a common vehicle for the ownership of real estate by non-profits and is not considered a business organization under BPT law. If the taxability of a direct transfer of real estate made by any entity does not depend on whether it qualifies as a business organization under BPT law, then it would almost certainly be unconstitutional to only subject transfers of interests in the same entity to RETT if it is considered a business organization while exempting similar transfers if it is a non-profit.

It is not clear when the proposed rule on real estate holding companies and the rest of the proposed rewrite of the RETT regulations will be taken up again by the legislative committee.

See also Proposed Rule Lowers RETT on Entity Conversions to Statutory Minimum and DRA Withdraws Proposed Rule Taxing Transfers of Ground Leases Over 30 Years

Footnotes

  1. Correction: When originally published, the article incorrectly referred to a Sec. 501(c)(25) organization.

DRA Withdraws Proposed Rule Taxing Transfers of Ground Leases Over 30 Years

The Department of Revenue Administration announced Monday that it has withdrawn from its proposed rewrite of the Real Estate Transfer Tax regulations a controversial rule stating that transfers of ground leases of 30 or more years are subject to RETT.

In a letter that appeared today on the DRA’s website addressed to the Joint Legislative Committee on Administrative Rules (JLCAR), the Department said that it had received comments about the taxability of ground lease transfers which, “in some instances…confused the new rules regarding leases with Rev 802(f), which addresses the taxability of real estate for a period of 99 years or more.”

If anything, the DRA’s letter appears to add more confusion to the issue, not least because there is no Rev. 802(f) in either the existing or the proposed rules. Apparently, the Department was referring to existing rule Rev. 802.01(f), which states that a lease of real estate is a taxable transfer if it is for a period of 99 years or more, including any renewal rights. Per RSA 78-B:1, I(a), every “sale, granting and transfer of real estate and any interest therein” is subject to RETT unless specifically exempted by statute. A lease of real property is considered to be an interest in real estate.

There had been public criticism of the proposed rule because it states that the transfer of an existing ground lease of at least 30 years is taxable, while the existing rule on the taxability of any new lease of real estate is applicable only if it has a term of 99 years or more. The DRA didn’t explain why it thought that comments it received about the taxability of new leases and assignments of ground leases were “confused”. (In fact, it didn’t even mention that the withdrawn rule had set the minimum term for taxing the assignment of a ground lease at 30 years.) The Department said that it was withdrawing the proposed rule because it “did not accomplish the clarification DRA intended.”

Not Clear if Ground Lease Assignment Must Exceed 99 Years to be Taxable
While the letter went on to state that it is the DRA’s position that “the taxability of ground leases exists currently under New Hampshire law”, it didn’t say whether the Department would consider the transfer of a ground lease of less than 99 years to be subject to tax.

In its letter to JLCAR, the DRA also said that it had received comments that the proposed rule on ground lease transfers constituted a “new tax”. The Department stated that it has “historically asserted the taxability of the transfer of ground leases.”

Since a lease of real estate represents an interest in real estate, the signing of an original lease or the assignment of an existing one would both appear to have always been subject to RETT, with the only question being the minimum length of the lease term that would trigger taxability.

Other rule revisions included in the DRA’s final proposal might not always be consistent with the statutes they are intended to interpret and/or implement. (See Proposed Rewrite of RETT Rules Not Always Consistent with Statutes and Proposed Rule Lowers RETT on Entity Conversions to Statutory Minimum.)

JLCAR has scheduled a meeting for Thursday to review the proposed rewrite of the RETT rules.

Wide-Ranging Revision to Medicaid Enhancement Tax Becomes Law

On Monday, New Hampshire Governor Maggie Hassan signed legislation that is intended to eliminate most doubts about the constitutionality of the Medicaid Enhancement Tax (“MET”) and its near-term impact on the State’s budget.

After lower courts sided with a number of hospitals that had filed suit challenging the law, concerns about a possible budget hit of between $55M and $100M in future years prompted the government to enter into negotiations that resulted in 25 of the 26 hospitals subject to the tax reaching an agreement last month laying out the principles that formed the foundation of the bill signed into law yesterday.

While the MET has generated significant amounts of revenue since its initial implementation, in 1991, hospitals had largely ignored its impact because the State immediately reimbursed any taxes paid with funds received from the federal government under a matching program for state aid provided to offset the cost of uncompensated care. In a circular (but legal) arrangement, the “state aid” in this case consisted entirely of the reimbursement of the MET payments that had just been received from the hospitals. Not long after Washington cracked down on these so-called “Mediscam” arrangements (which were common in other states as well), the NH Legislature in 2011 slashed the State’s payments to hospitals for uncompensated care while maintaining the tax rate of the MET at 5.5%.

Some hospitals laid off staff as a result and initiated legal action challenging the reductions in state aid payments as well as the constitutionality of the tax itself. Several hospitals also started questioning the State on whether revenues that had previously been considered to be part of the taxable base were actually subject to MET.

In the agreement, the participating hospitals promised to drop lawsuits challenging the constitutionality of the MET. In turn, the state guaranteed that small rural hospitals will receive at least 75% of their uncompensated care costs while larger hospitals will be compensated to the tune of between 50% and 55%. The law also provides for a reduction in the tax rate to 5.45% in 2016 and 5.4% a year later, with the possibility of a drop to 5.25% in later periods if total uncompensated care costs drop below $375M. The hospitals also agreed to abide by the guidelines set out by the Department of Revenue Administration in Technical Information Release 2013-007 for determining which outpatient hospital services were subject to tax.1

Revenues for Hospital Years Ending in 2013 Escape Tax Entirely
There have been reports that hospitals also agreed to accept an acceleration of their MET payments as well. While the agreement does provide that hospitals will effectively pay their MET liabilities six months earlier, starting in 2015, it also results in an entire year’s worth of revenues never being subject to tax.

Regardless of the year used by a hospital for financial or income tax purposes, its “taxable period” under MET law always ends on June 30th. And due to the contorted language of the statutes prior to the revision that was signed into law yesterday, the revenues on which MET was calculated for a given taxable period were actually billed by hospitals in a fiscal year that ended as many as 15.5 months before the tax on those billings ever became payable. While the new legislation aligns the end of the hospital fiscal year during which revenues are earned with the taxable period in which the payment of tax must be made, it also results in any revenues billed in a hospital fiscal year ending in 2013 never being subject to tax (see attached spreadsheet).2

Refund Claims
In a statement released yesterday, Gov. Hassan said that the agreement with the 25 hospitals settled “claims that the hospitals had filed for refunds on their 2014 tax payments”. The settlement itself states that the signatory hospitals will waive “Fiscal Years 14 and 15 Refund Requests…and DRA will not audit Fiscal Year 14 returns and payments.” The term “Fiscal Year”, as used in Paragraph I, B. of the settlement, appears to refer to the State’s fiscal year, which ends on June 30th. The returns due in State fiscal year 2014 are for hospital fiscal years ending in 2011 while the payments due in fiscal year 2014 are for hospital fiscal years ending in 2012.

The settlement also provides that hospital refund claims “pending at DRA related to tax payments for years prior to Fiscal Year 14 are not subject to this Term Sheet.” It’s not clear if that means that the State is still contesting any possible claims for refunds made on revenues billed during hospital fiscal years ending prior to 2011.3

St. Joseph’s Hospital in Nashua was the sole holdout, with press reports attributing the hospital’s decision to carry on with its legal challenge to the fact that it doesn’t provide anywhere near as much uncompensated care as the other litigants and therefore didn’t have as much to gain from the agreement. It appears that even if St. Joseph’s prevails in its lawsuit as to the MET’s constitutionality, the other 25 hospitals would still be bound under the terms of the agreement to pay the tax. In crafting the bill that became law yesterday, the Legislature was careful to rephrase its purpose so as to minimize the likelihood of future constitutional challenges.

See also Medicaid Enhancement Tax

Footnotes

  1. The agreement also provided that rehabilitation hospitals would no longer be subject to MET.
  2. However, since the new legislation moved the tax payment date from Oct. 15th to Apr. 15th of each taxable period, both dates fall within the same fiscal year used by the State (July 1 through June 30) for its own budget so there will be no State fiscal year in which the NH budget will be without MET revenues.
    Taxes due on revenues billed by hospitals in their fiscal years ending in 2012 were payable on 10/15/13, which falls in the State’s fiscal year ending 6/30/14, while revenues billed in hospital fiscal years ending in 2014 will be payable on 4/15/15, which is in NH’s fiscal year ending 6/30/15. That means, however, that there will be an 18-month period during which the State receives no MET payments.
  3. The lawsuit successfully pursued in Superior Court by Northeast Rehabilitation Hospital, Exeter Hospital and Catholic Medical Center was for revenues billed in their 2009 fiscal years.

Audit Determines Deficiencies in Awards of NH Tax Credits

In a highly critical report issued Monday, the audit arm of the New Hampshire Legislature said that the agency responsible for promoting economic development in the State had granted tax credits that might not have been authorized by law.

The office of the Legislative Budget Assistant (LBA) found weaknesses in internal controls at the Department of Resources and Economic Development (DRED), which is in charge of overseeing the application and award of tax credits under the Economic Revitalization Zone and Coos County Job Credit programs.

Economic Revitalization Zone Credits
The most significant problems involved the ERZ program, under which taxpayers are awarded credits that they can use as offsets against their business tax liabilities. The credit is primarily based on the creation of jobs in areas identified by DRED as economic revitalization zones. DRED can approve no more than $825K of combined ERZ credits for all taxpayers in a given fiscal year, with no single taxpayer being allowed to take a credit in excess of $40K in a tax period. Credits in excess of that amount can be carried forward for five years.

Of the 29 ERZ credit applications made for tax years 2011 and 2012, the LBA found 19 awards totaling $856K (prior to proration down to the $825K maximum) for which the taxpayer was not eligible. Another four taxpayers who were eligible for a total of $121K in credits had their applications rejected. The following were among the specific issues highlighted by the LBA:

  • Four applications resulted in $237,400 in credits being awarded even though the businesses were not located in approved ERZs.
  • Another four applications, totaling $81K in credits, that were approved were based on employee hires that didn’t occur during the applicable tax year.
  • Approximately $305K of credits were granted even though there was inadequate wage and/or expenditure documentation available.
  • One business that submitted its application after the deadline was still awarded $188K in credits for the subsequent year. The LBA said it could find no documentation indicating that DRED upper management had approved the decision.
  • Tax credit award letters were issued stating that the amounts were “estimated” and that “the calculation of the actual tax credit is the responsibility of the (taxpayer’s) accounting staff.” The LBA concluded that, “[w]ithout a definitive award amount, the Division risked recipients claiming more on their tax returns than estimated.”

“By awarding a business more than it qualified for, the Division effectively prevented another business from receiving the proper amount of tax credits,” the LBA said in its report.

The auditors also found that DRED did not fulfill its statutory responsibility for entering into written agreements with businesses receiving ERZ credits, especially with respect to the duration of the taxpayer’s commitment. “Consequently, the State appeared to have no contractual authority to recover tax credits if a business eliminated jobs or moved immediately after receiving the ERZ tax credit,” the LBA said in its report.

Coos County Job Creation Credit
Under the Coos County Job Creation (CCJC) credit program, a business enterprise that hires a full-time, year-round employee for work in Coos County is allowed to take a $750 credit against its Business Enterprise Tax liability for each of five consecutive tax periods.

The LBA determined that one CCJC credit worth $11,800 was awarded for employees who were retained due to an acquisition, even though the law only allows credits for new hires. Another six applications resulted in $6,500 in tax credits being granted for the hire of part-time employees, despite the fact that the statute only authorizes credits for taking on full-time staff.

Monitoring Program Effectiveness
The LBA also criticized DRED for not analyzing the benefits of the tax credit programs, as it is required to do by law. The auditors said their surveys found evidence that the amount of credits available to a business were “minimal compared to the costs associated with a new employee.”

“[T]he Department should determine whether the approximately $3 million the State allocates to the tax credit programs are affecting job creation or simply defraying the normal cost of doing business. If business behavior is not changed as a result of a tax credit program, a tax credit may not be achieving its intended purpose.”

The LBA noted that NH’s tax credit programs pale in comparison with those of its neighbors. It said that Massachusetts and Maine awarded credits totaling $770M and $54M, respectively, “in recent years”. It also said that Rhode Island, Connecticut and New York offer multi-million-dollar programs for businesses that either remain, expand or set up shop within their borders.

DRED’s Response
While DRED largely concurred with the findings in the audit report, it cited budgetary cutbacks and staff vacancies as contributing to the problems uncovered. The agency said that changes are being made to address the deficiencies and requested that the Legislature provide more statutory guidance for the credit programs.

DRED did object, however, to the surveys published by the LBA, calling them “unreliable” and “incautiously worded”. The auditors countered, saying that they followed generally accepted practices for ensuring the validity and reasonableness of the surveys.

Proposed Rewrite of RETT Rules Not Always Consistent with Statutes

The final proposed rewrite of NH’s Real Estate Transfer Tax rules released last week includes at least one and possibly more regulations that appear at odds with the statutes that they are meant to interpret. Among them is a rule stating that only an entity meeting the definition of a business organization under Business Profits Tax law can qualify as a real estate holding company, which means that a transfer of interest in a non-profit organization cannot be subject to RETT while a direct transfer involving the same entity would be.

Another regulation proposed by the Department of Revenue Administration provides that an assignment of a real estate ground lease with a term of at least 30 years is taxable even though a related rule provides that a new lease of real estate is only taxable if it runs for 99 years or longer. A third regulation exempts changes in certain “carried interests” in a real estate holding company from tax while an acquisition of a stake in the same entity by more conventional means would be taxable.

A final proposal would make transfers pursuant to the statutory conversion of a corporation into an LLC subject to only the $40 minimum amount of tax, despite the fact that the legislative history of the underlying statute appears to require that tax be paid on the fair market value of the entity’s real estate. For a detailed analysis of that rule, see Proposed Rule Lowers RETT on Entity Conversions to Statutory Minimum.

Rev. 801.09 – Only Business Organizations can be Real Estate Holding Companies
Unless specifically exempted, RETT is payable on each direct transfer of real estate (RSA 78-B:1, I(a)). There is no blanket exemption for transfers involving non-profit entities. Transfers of an interest in a real estate holding company are also subject to RETT to the extent of the entity’s NH real estate (RSA 78-B:1-a, V).

Proposed Rev. 801.09 is intended to provide guidance on the statutory definition of the term ‘real estate holding company’. The proposed rule states, among other things, that only an entity that qualifies as a business organization under Business Profits Tax law can be considered a real estate holding company for RETT purposes. Not-for-profit entities falling under the criteria set out in IRC § 501(c) are excluded from the BPT definition of a business organization. While the proposed regulation is consistent with the existing rule, Rev. 801.07, for some reason that rule had never been revised to reflect a 2009 amendment to RSA 78-B:1-a, VI dropping the business organization requirement from the statutory definition of a real estate holding company.

That statutory change was presumably made because an exemption for a transfer of an interest in an entity that wasn’t subject to BPT would probably represent an unconstitutional classification of taxpayers since RETT would be owed on a transfer of interests in a similarly situated business that is subject to BPT. An example would be a transfer of an interest in a Sec. 501(c)(2) entity,1 which is a common vehicle for the ownership of real estate by non-profits and is not considered a business organization under BPT law. If the taxability of a direct transfer of real estate made by any entity does not depend on whether it qualifies as a business organization under BPT law, then it would almost certainly be unconstitutional to only subject transfers of interests in the same entity to RETT if it is considered a business organization while exempting similar transfers if it is a non-profit.

Rev. 802.01(j) – Transfer of Leases with 30- and 99-Year Terms
Proposed Rev. 802.01(j) states that the transfer of a lessee interest in a ground lease (including related improvements) with a term of at least 30 years (including renewal options) is subject to RETT. There is no similar provision under the current rules. However, existing rule Rev. 802.01(f), which remains unchanged under the proposed rewrite, states that leases of 99 years or more (including renewal rights) are subject to tax.

RSA 78-B:4 provides that transfers of real estate “or any interest in real estate” are subject to tax. A lease is an interest in real estate. The fact that a newly signed lease is only subject to RETT if it is for 99 years or more while the assignment of a lease is taxable if it has a term of only 30 years appears inconsistent and illogical. In addition, the new rule subjecting transfers of leases with terms of 30 or more years to RETT represents a benefit to the State and a cost to taxpayers. The fiscal impact statement for the revenue rule, however, claims that there would be none.

Rev. 803.06 – Taxability of Carried Interests
Proposed Rev. 803.06 would, if adopted, exempt from tax any changes in the profit-sharing percentages of a partnership or LLC owning NH real estate. There is currently nothing in the RETT statutes or rules stating specifically that such changes in carried interests are, or are not, subject to tax.2 Even if adopted, however, it’s not clear that the rule would settle the issue for good, especially with respect to changes in the ownership of capital percentages that frequently occur concurrently, but not necessarily in lockstep, with those of the profit-sharing interests in the entity.

Ownership of an interest in a partnership or an LLC involves a bundle of rights. While one of those rights entitles the owner to share in the allocation of the entity’s profits (and losses), another establishes the share of any distributions of capital the owner will receive upon dissolution. They are two different rights, and are not necessarily represented by the same percentage interests. Those percentages are established under the terms of the entity’s operating agreement and sometimes vary from one another to a considerable extent. Even if they happen to be the same, they are still independent of one another.

The operating agreement of an entity taxed federally as a partnership (which includes most LLCs) might provide that one or more parties contribute the capital to fund the enterprise while another party (or parties) provides most of the services deemed necessary for its operation. Such agreements sometimes state that the “services partner(s)” will be allocated a given percentage of the entity’s profits and losses, with an incentive increase in the profit sharing percentage after certain conditions in the operating agreement are met (such as the repayment of the original capital contributions.)

The possible RETT ramifications of such an arrangement become more apparent when the entity – for purposes of this analysis, a partnership – is required to make distributions returning the capital “contributed” by its partners. The operating agreement might provide that the “services” (or “sweat equity”) partner also be granted a right to share in the distribution of the assets of the partnership in proportion to his or her capital account in the entity (which will have increased due to the services performed) upon dissolution of the entity. If the partnership is a real estate holding company, the question becomes whether such “transfers” of ownership interest are subject to RETT.

Carried Interests – Does a Sweat Equity Partner “Buy” an Interest in the Entity?
Per RSA 78-B:1, I(a), each transfer or real estate or “interest in real estate” is presumed taxable unless specifically exempted by law. The right to receive a distribution of the real property of a real estate holding company is an interest in real estate. Transfers of interests in real estate holding companies are taxable to the extent of the fair market value of the entity’s underlying real estate (RSA 78-B:1-a, V). The definition of the term “price or consideration” at RSA 78-B:1-a, IV states that consideration is “…the amount of money, or other property and services, or property or services valued in money which is given in exchange for real estate, and measured at a time immediately after the transfer of the real estate”. Taken together, the above could support the position that the transfer of a carried interest in a partnership (that qualifies as a real estate holding company) in exchange for services provided by a sweat equity partner is subject to RETT, with the taxable consideration equal to the fair market value of the entity’s assets at the time the transfer takes place. The following example is intended to illustrate why such transfers might be considered taxable.

One individual contributes a building worth $1M to the partnership while another contributes nothing, but agrees to do all the partnership’s work. Each partner gets a one-half interest in the entity. The partnership agreement states that the partner contributing the real estate will receive guaranteed payments for the total value of the building contributed whenever funds become available, plus 10% annual interest on that value before distribution of any partnership profits or assets. But on the day following the formation of the partnership, the partners decide that they don’t want to go through with the endeavor. The partnership immediately disposes of its property for the same $1M it had been valued at the day before. The partner who contributed the building gets paid $1M. The other partner gets nothing.

But if the partnership instead continues in existence, the “sweat equity” partner is effectively buying additional interests in the partnership as he or she contributes services. And since the principal asset of the partnership is real estate, the sweat equity partner effectively purchases a 50% interest in that asset once the investing partner has been paid the $1M that the interest was worth on the date of contribution. That would appear to make the “purchase” a transfer of a 50% interest in a real estate holding company.

Another way to look at it is to assume a situation where the entity is a newly created partnership, the only asset of which only asset is a $1M building. But instead of taking on a “sweat equity” partner, the entity hires an individual as its manager to do all of its work in return for a total salary of $500K over, say four years. Assume that after four years, during which time the value of the building remained unchanged, the manager takes the $500K of salary he or she had earned and buys a half interest in the partnership. In those circumstances, the manager would clearly have purchased a taxable interest in a real estate holding company.

In either scenario above, the individual performing all the services ends up with a 50% interest in the real estate holding company. In one situation, tax is obviously owed. In the other, the answer is not so evident. The issue, therefore, is not merely a question of whether the proposed rule should also specifically exempt changes in ownership interest in addition to the profit sharing percentages it currently focuses on. A more detailed review of whether the acquisition of ownership interests in a real estate holding company by a sweat equity partner is subject to RETT is probably needed. Whether such a determination should be made by rule, or be left up to the Legislature, is also an open issue.

Carried Interests – Ongoing Variations in Capital Accounts
One practical problem with implementing any rule stating that carried interests are taxable arises if the ownership of capital percentages on a partnership’s Schedule K-1 vary, as they sometimes do, because of relatively minor changes due to small withdrawals and/or contributions (perhaps because of payments made by a partner on behalf of the entity). It would appear burdensome, if not impractical, to treat each one of those percentage variations as a taxable transfer in a real estate holding company. (In fact, many of them might be so small that, if they were considered taxable, they would require payment of the $40 minimum transfer tax.) Proposed Rev. 802.05(d), however, would appear to exempt such de minimis transfers from tax.

Carried Interests – Rule Doesn’t Apply to Corporations
The fact that the proposed rule on carried interests applies only to partnerships and LLCs brings up the question of whether it violates the NH Constitution’s prohibition of taxpayer classification, which effectively states that similarly situated parties must be treated equally unless there is a compelling public interest for distinguishing between them.

Corporations sometimes issue shares to employees as compensation for services provided. Ownership of those shares includes the right to share in any distributions of the entity’s profits (through dividends) as well as to any distributions of its capital upon dissolution. Since the issuance of those shares serves to dilute the percentage ownership interests of existing shareholders, an argument could be made that it is subject to RETT (assuming that the corporation is a real estate holding company) because the employee effectively “purchased” the stock by way of providing his or her services to the entity. The proposed RETT rule, which only exempts partnerships and LLCs from tax, would effectively discriminate against similar transfers of interests involving a corporation.

Rev. 805.02 – Percentage Requirements for Real Estate Holding Companies
The title to proposed Rev. 805.02 describes the rule as “Determination of Fair Market Value for Purposes of Real Estate Holding Company Status.” Except for minor changes in references to a related rule, Rev. 805.02 is the same as the existing rule. Both the current and the proposed rule require the use of specific formulas and/or appraisals for determining the fair market value of a real estate holding company’s assets.

The current rule was put into place to provide guidance on a previous statutory definition, which stated (among other things) that an organization would meet the definition of a real estate holding company if more than 50% of its gross receipts were derived from the ownership or disposition of real estate or if the fair market value of its real estate made up more than 50% of its total assets. The Legislature presumably dropped those specific percentage requirements from the statute in 2006 because such bright-line percentage thresholds are frequently ruled to be per se violations of NH’s constitutional ban on the classification of taxpayers. Even though existing Rev. 805.02 was never revised to reflect that amendment, there appears to be no reason to retain guidelines for a standard that has been stricken from the statute.

Legislative Hearing on June 20th
The DRA submitted its final proposal for the rewrite of the RETT rules to the Joint Legislative Committee on Administrative Rules, which will review them at its session scheduled for June 20th.

By law, NH Rules have to be readopted no less frequently than every ten years (RSA 541-A:17, I).

Footnotes

  1. Correction: When originally published, the article incorrectly referred to a Sec. 501(c)(25) organization.
  2. So-called “carried interests”, as they are referred to in the proposed RETT rule, are much more controversial in the income tax arena. As commonly understood, the term is used when referring to the federal tax treatment for income earned by the managers of hedge, private equity and venture capital funds. The income earned from those carried interests is subject to federal tax at the much lower rates for long-term capital gains than they would be if required to be reported as ordinary income. There has been considerable criticism of the tax treatment for carried interests because the income is earned from managing someone else’s money and not from the actual contribution by the managers of capital, which is what is required for any other investment to qualify for the lower long-term capital gain rates.

Proposed Rule Lowers RETT on Entity Conversions to Statutory Minimum

The Department of Revenue Administration’s initial proposal for a general rewrite of the Real Estate Transfer Tax administrative rules would, if accepted, subject the statutory conversion of a corporation owning NH real estate into a limited liability company to the minimum $40 of tax required under the law.

The taxability of such conversions at the full fair market value of the entity’s underlying real estate has been the subject of a significant amount of controversy in recent years, with some tax professionals claiming that no transfer of real estate occurs when an entity undergoes a mere change in its form of entity.

Last year, the DRA issued Declaratory Ruling 10391 stating that there would be no RETT payable on a proposed conversion from a corporation to an LLC because there would be no consideration given for the exchange of ownership interests involved in the conversion.1 The Department also based its determination on the fact that RSA 304-C:147 (which was enacted in 2012) states that an entity remains the “same business entity” after the conversion as it was before.2

While the proposed rule3 states that a statutory conversion is considered to be a contractual transfer, it goes on to say that it is done “without consideration” and is therefore subject to only the minimum amount of tax. The logic behind that determination is unclear since consideration is normally regarded as a necessary element of a valid contractual agreement. Black’s Law defines consideration, in relevant part (and with emphasis added), to be:

Something (such as an act, a forbearance, or a return promise) bargained for and received by a promisor from a promisee; that which motivates a person to do something, esp. to engage in a legal act. • Consideration, or a substitute such as promissory estoppel, is necessary for an agreement to be enforceable.4

RETT is due on the “sale, granting and transfer” of real estate (RSA 78-B:1, I(a)). To satisfy the statutory definition of the term “sale, granting and transfer”, a transfer has to be contractual (RSA 78-B:1-a, V), If there is no consideration given as part of a statutory conversion, it would appear that any transfer of the converting entity’s underlying real estate cannot be considered to be contractual. And if a transfer isn’t contractual, then it presumably wouldn’t be subject to RETT either.

The proposed rule might be on firmer grounds if it said that the DRA can’t challenge the amount of consideration declared for the transfer.5 Since deeds for transfers of real estate between related parties often specify only a nominal dollar amount of consideration “and other good and valuable consideration”, minimum tax treatment might appear to be more supportable in such situations. That approach, however, is susceptible to challenge since the DRA has statutory authority to determine the actual price or consideration for the transfer by looking to the fair market value of the real estate (RSA 78-B:9, III).

Rule at Odds with Previous Interpretation
The DRA’s position in both the proposed revenue rule and Declaratory Ruling 10391 appears at odds with Declaratory Ruling 8724, in which the Department determined that RETT would be due on the conversion of a trust with NH real estate to an LLC, with the taxable consideration presumed to be the fair market value of the underlying real estate. In that 2006 declaratory ruling, the Department focused almost entirely on the repeal of a previous exemption for statutory conversions when it stated that, “… the subsequent repeal of that exemption in 2001, would have been nonsensical and unnecessary if the legislature had never intended the real estate transfer tax to apply to statutory conversions.”

In the more recent declaratory ruling, the DRA made no mention of either its earlier finding or the relevance of the repeal of the previous exemption for statutory conversions.

Legislative Intent
One relevant change since the 2006 ruling in support of the proposed rule is the Legislature’s 2012 rewrite of LLC law, specifically the language in RSA 304-C:147 that an entity undergoing a conversion remains the “same business entity” after the conversion as it was before. While that would seem to offer strong support for a finding that no RETT is due pursuant to a statutory conversion, that position doesn’t appear to take into consideration what led up to the bill’s passage. The legislation, as originally approved by the NH Senate, included language stating that any real estate owned by the converting entity would “not be transferred or deemed to be transferred by reason of the conversion.”

That clause was subsequently taken out of the bill, with the House Journal entry for Senate Bill 203-FN-A noting that “sections of the bill that eliminated the collection of the real estate transfer tax during statutory conversions” had been removed and that the legislation “has no impacts on state revenues.” Since the underlying justification in Declaratory Ruling 10391 would probably apply to most statutory conversions, it would appear that the ruling could have a significant impact on state revenues, as would the proposed revenue rule.

While the argument that an entity can’t transfer real estate to itself – which would therefore mean there was no transfer upon which to impose a tax – is appealing on economic substance grounds, if the issue of the taxability of statutory conversions comes down to an interpretation of legislative intent, the explanation in the House Journal would appear to be a difficult obstacle to overcome because the Ways and Means Committee had told the full House that there would be no RETT impact from the revisions.6 That said, it’s always possible that a court might someday rule that there is no “transfer” of real estate pursuant to a statutory conversion so there could have never been anything to tax in the first place.7

The proposed rule addresses only the conversion of a corporation to an LLC made pursuant to RSA 304-C:149. It’s not clear why the rule is limited to conversions of a corporation to an LLC. The statute also refers to conversions of “any other business entity”, which would include partnerships and other entity types as well.

Corporate Reorganizations
Rev. 803.04 of the proposed rewrite of the RETT regulations also includes a provision that RETT would not be due on “single-entity reorganizations” under IRC § 368(a)(1)(F), which governs “mere changes in identity, form, or place of organization of one corporation.” Such events, which are commonly referred to as “Type F” (or simply “F”) reorganizations, generally apply to a corporation that reincorporates in the same state under a new corporate charter or registers as a corporation in another state.8 (Apparently, even a change in organization from a corporation to an LLC or a partnership would still qualify for “Type F” treatment as long as the LLC or partnership elects to be treated as a corporation for federal tax purposes.) Done correctly, a Type F reorganization will not result in taxable income for federal purposes.

Unlike most other reorganizations under the Internal Revenue Code, Type F reorganizations do not require that the “continuity of interest” provisions of the Treasury regulations be complied with. Since IRC § 368(a)(1)(F) states that it applies to “mere changes in identity, form, or place of organization of one corporation”, it would seem that there should be no change of ownership interests accompanying the reorganization. But if a reorganization of a corporation with NH real estate can still qualify for Type F treatment even though it involves some change in ownership, then it would appear that it should not be considered exempt from RETT.

Recapitalizations
Also exempted by proposed Rev. 803.04 are recapitalizations qualifying for tax-free reorganization treatment under IRC Sec 368(a)(1)(E). All of the examples of qualifying recapitalizations described in Treas. Reg. § 1.368-2(e) involve either swaps of corporate bonds for preferred shares or of preferred shares for common stock. Although not defined in either the Internal Revenue Code or the Treasury regulations, the word ‘recapitalization’ has been defined elsewhere, in part, as an “[a]lteration of a corporation’s capital structure, such as an exchange of bonds for stock.”9

None of the examples in the Treasury regulation refer to the possibility of exchanging debt for common shares. While that doesn’t necessarily mean that such an exchange would not qualify as a tax-free recapitalization for purposes of the Internal Revenue Code, if it were possible, it’s not clear that the blanket exemption from RETT granted under the proposed revenue rule would be appropriate in such circumstances.

Although preferred shares have some of the characteristics of debt and are not normally allowed to be voted, they do represent corporate ownership interests and therefore resemble common shares far more closely than do the bonds issued by a corporation. If the holders of the converted debt did not own comparable percentage interests in the corporation’s stock, it would appear that there had been a substantive transfer of equity interests between parties. Existing shareholders would see their relative stakes in the corporation’s equity decline in proportion to the shareholding percentages acquired by the entity’s former debt holders. That would be equivalent to the sale of equity interests in the entity.

See also Transfer of Interests in Real Estate Holding Companies

Footnotes

  1. A number of tax professionals have claimed in recent years that there is often no consideration given either in transfers involving an entity and its owners or between related entities. RSA 78-B:1-a, II states that the term “contractual transfer” means a bargained-for exchange of all transfers of real estate or interests therein between an entity and its owners. While the law (unfortunately) doesn’t define the term “bargained-for exchange,” it wouldn’t appear to have made much sense for the Legislature to include a provision in the law referring specifically to transfers between an entity and its owner as contractual if related parties could simply avoid paying tax by claiming that no consideration was given. Further support for the taxability of related party transfers can be found in Rev. 802.06, which states that the taxable consideration for a transfer of real estate between an entity and its owner or between two entities with a common owner is, “absent proof to the contrary”, equal to the property’s fair market value. To simply accept the taxpayer’s claim in the declaratory ruling that there would be no consideration given would appear to gut the intent of RSA 78-B:1-a, II and Rev. 802.06.
  2. In April, 2014, the DRA came to same conclusion for a conversion of a business trust to an LLC in Declaratory Ruling 10566.
  3. Rev 804.02 “LLC Conversions. The conversion of a corporation to an LLC pursuant to RSA 304-C:149 shall be considered a contractual transfer without consideration and therefore subject to the minimum transfer tax as set forth in RSA 78-B:1, I(b).”
  4. Black’s Law, 8th Edition
  5. By rule, the DRA is currently not allowed to challenge the consideration claimed for certain transfers of real estate involving a testamentary substitute trust.
  6. After passage by the House, the bill was returned to the Senate, which approved the language as adopted by the lower chamber.
  7. See also Statutory Conversions
  8. Type F reorganizations also occur when the shareholders of an existing Subchapter S corporation contribute their holdings in the entity to a newly formed S Corp in exchange for shares in the new company. An election is immediately made for the old S Corp to be treated as a Qualified Subchapter S Subsidiary, which is subsequently converted to an LLC (but is still treated as a QSub.)
  9. Dictionary of Finance and Investment Terms, Third Edition (Barrons)

Court Challenge to Education Tax Credits Could Imperil Property Tax Exemptions as Well

A pending decision in a court case over a mere $128K in business tax credits awarded in 2012 for primary and high school scholarship contributions could have profound implications for the many millions of dollars of New Hampshire real estate qualifying for property tax exemptions currently enjoyed by church affiliated schools.

While much of the attention paid to the case has been focused on the credits themselves, which opponents claim are a backdoor approach to vouchers designed to undermine the public school system, a decision that they violate the NH Constitution could conceivably call into question property tax exemptions that have been available for church supported schools from the early days of the State’s existence. Also potentially at risk are Business Profits Tax deductions for any charitable contributions made to schools sponsored by religious institutions.

A business making a qualifying contribution under NH’s Education Tax Credit (“ETC”) program can reduce its BPT liability by 85% of the amount paid. And after adding in the federal income tax deduction for charitable contributions – which are clearly permissible under the US Constitution, even when made to a religious organization – a profitable business could realize total tax benefits equal to 96% of the amount contributed. While the total amount of contributions made during the program’s first year was small – no doubt due to concerns about the law’s constitutionality – the potential credits awarded in a year could go as high as $5.1M.

Are Scholarships “Money Raised by Taxation”?
The controversy currently before the NH Supreme Court is limited to the constitutionality of credits that businesses can take against their BPT liabilities for contributions to so-called “scholarship organizations” that channel the funds to families for use at schools other than the public schools to which their children would ordinarily be assigned. Opponents of the ETC program claim that it violates a provision in the NH Constitution that prohibits the granting of “money raised by taxation” for the use of church sponsored schools and another that forbids any law compelling taxpayers to contribute towards their support.

Backers of the ETC program argue in response that the program doesn’t depend on money “raised by taxation” because the contributions never actually make their way into the State’s coffers in the first place. Their opponents dismiss that logic as a distinction without a difference, citing a 1981 Supreme Court decision that “the government cannot circumvent prohibitions in the State Constitution by ‘do[ing] indirectly that which it cannot do directly.’”1

A representative of the NH Attorney General’s office, which is defending the law, told the Supreme Court that the credit program is constitutional because the decision as to where to spend the scholarship funds is left up to the family of the student – and not to the government. And, in a legal brief, a group arguing in favor of the credits cited previous Supreme Court advisory opinions that “indirect and incidental” aid to religious organizations is allowed under the NH Constitution, which it said was never “intended (to mean) that members of a denomination should be deprived of public benefits because of their beliefs.”2

Superior Court Strikes Down Credits for Religious Schools
A superior court ruled last year that the ETC violates the NH Constitution to the extent that it funds scholarships to religious schools.3 The trial judge rejected arguments that because the contributions pass directly from businesses to scholarship organizations, no public funds were used to finance the scholarships. He ruled instead that the program simply diverts money that would have otherwise been paid to the government in the form of taxes. “The program has been shown to have money raised by taxation inevitably go toward educational expenses at nonpublic religious schools without restriction regarding how the money may be used,” the court said.4

In their appeal to the Supreme Court, backers of the ETC program counter that the credits are little different from the property tax exemptions for religious organizations that have been determined to be constitutional because they benefit a wide range of institutions – both religious and secular – and therefore do not establish or advance religion.5 While opponents of the ETC acknowledged the constitutionality of property tax exemptions for religious organizations because they are available to both religious and non-religious entities, they claim that the program doesn’t meet that same standard since the credits would primarily benefit church schools which “predominate among the nonpublic schools.”

Standing to Challenge ETC Less Problematic under NH Law
The current court proceedings do not include a challenge to the ETC program on “establishment of religion” grounds brought under the First Amendment of the federal Constitution. In 2011, the US Supreme Court rejected a request to strike down a similar program allowed under Arizona tax law, finding that the plaintiffs lacked legal standing to contest the issue.

“Respondents’ contrary position – that Arizonans benefiting from the tax credit in effect are paying their state income tax to (school tuition organizations) – assumes that all income is government property, even if it has not come into the tax collector’s hands. That premise finds no basis in standing jurisprudence.”6

The issue of standing appears less problematic in NH because of a recent change in State law providing that a taxpayer is not required “to demonstrate that his or her personal rights were impaired or prejudiced” to enter an appeal on constitutional grounds (RSA 491:22). One of the parties challenging the ETC program is a business organization.7

Charitable Deductions and Property Tax Exemptions Vulnerable
The issue of Education Tax Credits has possible ramifications for BPT deductions and property tax exemptions as well. Contributions to religious schools and foundations organized to support church sponsored schools are deductible for federal income tax purposes if the recipient meets the requirements of IRC § 501(c)(3). To qualify under that section of the Internal Revenue Code, the entity must be “organized and operated exclusively for religious, charitable, scientific, educational, or literary purposes…”.

The starting point for determining a business organization’s taxable base for BPT purposes is its gross business profits, which effectively ties into the amounts reported on its federal income tax return. Any deductions for direct or indirect contributions to religious schools taken on the federal return of a business organization are therefore effectively carried forward to its BPT return. As such, if the ETC program is determined to be in violation of the NH Constitution’s provision prohibiting the use of “money raised by taxation…for the use of the schools of institutions of any religious sect or denomination”, then an argument could be made that deductions taken on a BPT return for contributions to religious schools would be similarly unconstitutional.

The same interpretation would also appear to apply to property tax exemptions that benefit church sponsored schools with NH real estate. “Charitable organizations and societies” are exempt from real estate property tax under RSA 72:23. Religious schools would normally qualify under the statutory definition of the word “charitable” which is described at RSA 72:23-l as:

“a corporation, society or organization established and administered for the purpose of performing, and obligated, by its charter or otherwise, to perform some service of public good or welfare advancing the spiritual, physical, intellectual, social or economic well-being of the general public or a substantial and indefinite segment of the general public that includes residents of the state of New Hampshire, with no pecuniary profit or benefit to its officers or members, or any restrictions which confine its benefits or services to such officers or members, or those of any related organization.”

Given the scope of property tax exemptions enjoyed by church sponsored schools in NH, the question of whether a tax credit is effectively synonymous with a tax exemption is obviously an important collateral issue to any determination as to the constitutionality of the ETC.8 Superficially, at least, the difference between the two is obvious: an exemption reduces or eliminates the taxable base on which a tax liability is calculated while a credit is considered to be an actual payment of the tax liability itself. If it turns out, however, that there is no substantive difference between the two, and the high court ultimately determines that the credit at issue here constitutes state support for church supported schools, it could prove problematic for supporters of the ETC and, ultimately, for all religious institutions with school property in NH.

Entanglement of Church and State
The plaintiffs looking to shoot down the ETC program downplay claims by its supporters that property tax exemptions for religious schools would be in jeopardy if the credits are found to be unconstitutional. The opponents of the program say that since property tax exemptions are granted to a wide variety of secular entities as well, they don’t “advance religion” in the same way the credits would, which would primarily be used for scholarships to church sponsored schools.

They also argue that tax exemptions are far less likely to lead to the “entanglement” of church and state that might run afoul of the First Amendment’s prohibition against laws hindering the “free exercise” of religion than would a program like the ETC, which involves a significant degree of government involvement in its regulation.

The NH Supreme Court heard oral arguments in the case in mid-April. It’s not clear when a decision will be handed down.

Footnotes

  1. Plaintiffs’ brief, citing Burrows v. City of Keene, 121 N.H. 590, 597 (1981)
  2. Intervenors’ brief, citing Opinion of the Justices, 109 NH 578 (1969)
  3. Duncan v. State of New Hampshire, 219-2012-CV-00121 (2013)
  4. The decision was not, however, a total defeat for proponents of the program since the court also held that the credits pass constitutional muster when they are used to fund scholarships to non-religious schools.
  5. Appeal of Emissaries of Divine Light, 140 NH 552 (1995)
  6. Arizona Christian School Tuition Organization v. Winn, 09-987 (2011)
  7. During arguments before the high court, an out-of-state attorney arguing in favor of the ETC stated that the interpretation that anyone who paid any NH tax has standing to sue the State over another tax that he or she had never been liable for would mean that he could challenge the constitutionality of a NH statute merely because he had paid the State’s Meals and Rentals Tax for his stay in Concord the night before.
  8. “It is undoubtedly true that all exemptions from taxation are practically equivalent to a direct appropriation. Such is the effect of the exemption of houses of public worship, parsonages in part, and seminaries of learning.” Canaan v. Enfield Village Fire District, 74 NH 517 (1908) citing State v. Express Co., 60 NH 219 (1880), 60 N.H. 219, 260.

NH Sues Online Travel Companies for Meals and Rentals Tax

Earlier this month, the New Hampshire Attorney General filed a lawsuit against four online travel companies alleging that they didn’t pay Meals and Rentals Tax and had engaged in “deceptive business practices” related to their sales of hotel rooms and rental cars in the State.

Online travel companies contract with hotels to purchase rooms at reduced rates. The travel companies, in turn, will rent the rooms over the Internet to end users at a mark-up to the reduced rate, but for less than the going rate at the hotel. The hotels will frequently not know the amount actually charged by the on-line travel company to the end user. Accordingly, the Department of Revenue Administration had previously announced (in Technical Information Release 2008-002) that the hotel operator is only responsible for remitting Meals and Rentals Tax equal to the amount it receives from the on-line travel company, provided that the State receives at least the appropriate amount of tax based on the wholesale rental rate.

But in the TIR, the DRA also said that the law requires M&R Tax to be calculated “on the room rate paid for the occupancy by the end user, regardless of the hotel’s going rate for the room and regardless of the contract amount between the operator and the on-line booking company”. The TIR didn’t state, however, that any difference between the amount of tax remitted by the operator to the DRA and the total paid for the occupancy by the end user was owed by the online travel company.

Tax Calculated on Retail Price but Remitted on Lower Wholesale Price
The matter didn’t surface again, at least publicly, until April, 2013, when the NH Attorney General’s office said that it was looking to hire outside legal counsel to pursue the online travel companies.1 Two weeks ago, the AG’s office filed suit against Priceline, Orbitz, Expedia and Hotels.com claiming, among other things, that the defendants had never filed M&R Tax returns and had engaged in tax evasion.2

The suit claims that, “in most cases”, the only tax paid on hotel rooms booked by the defendants was determined on the “net rate” price that they had paid to the NH hotels, and not on the amounts actually charged to the traveler (Paragraph 37).3 M&R Tax is due on the gross consideration for a rental, with no deductions allowed against that amount (RSA 78-A:3, VIII(a), Rev 701.18).

The controversy apparently turns on whether an online travel company can be considered an “operator”, which is the party responsible for collecting and remitting M&R Tax to the State. Rev. 701.13(d) includes in the definition of “operator” anyone “who acts in the capacity of an agent for an owner in renting sleeping accommodations, a motor vehicle or providing taxable meals” (emphasis added).

In supporting its position that the online travel companies are required to collect and remit M&R Tax, the AG’s office made the following claims:

  • “Because Defendants act as retailers and/or agents, and/or combinations of individuals,” the tax due is” on the full amount paid by the end user. (Paragraph 37)
  • “Due to the contractual or factual relationship between the Defendants and the hotels, the Defendants and the hotels act on behalf of each other to provide/sell customers Lodging, and are thus, agents of one other and combinations of individuals under the law. The Defendants and the hotels join in a common undertaking to sell hotel rooms for their mutual benefit with the understanding that they are to share, to some degree, in the profits or losses generated. As such, they operate as joint enterprise members and, thus, the Defendants have joint enterprise membership liability.” (Paragraph 73)

While the State claims the online travel companies are agents of the hotels, it included a statement from Travelocity’s 2002 10-K filing (Paragraph 68) that the company says it follows the “merchant model”, which the company claims makes it the merchant of record in the transaction rather than a sales agent.

And Steve Shur, president of the Travel Technology Association, a trade group representing the defendants, was quoted as saying in response to the NH lawsuit that, “[w]e don’t acquire hotel rooms. We don’t rent hotel rooms. We don’t operate hotels. We facilitate the reservation and in some instances collect the payment from the consumer which is then remitted directly to the hotel operator which are (sic) responsible for then submitting the tax payment.”4

Non-Tax Charges Include Civil Conspiracy, Consumer Protection Act Violations
The AG’s suit went far beyond the alleged violations of M&R Tax law, and included claims that the defendants were also guilty of conversion, unjust enrichment and violations of the Consumer Protection Act and had engaged in civil conspiracy.

It’s interesting that the AG’s office filed suit in Superior Court for the allegedly underpaid tax without (apparently) having first gone through the formal DRA audit, assessment and internal appeal process. If the DRA had instead assessed the tax, the taxpayer would have been able to appeal to the Department’s hearing officer. Only if the taxpayer lost at that level would it then be able to enter an appeal to the courts.

It’s not clear that M&R Tax law allows the AG’s office to enter a legal action for unpaid taxes before the DRA issues a notice of assessment. RSA 78-A:11, I, which appears to be the sole provision in the M&R Tax statutes allowing the assessment of tax, states that the DRA can prepare an estimate of tax liability if an operator fails to submit a return and to make a demand for payment of the tax determined.5 If the taxpayer chooses to ignore such a “jeopardy” notice of assessment – with all the interest and penalties attached – that would be its right. The State would then have a clear path to pursue collection in the courts.

In Paragraph 89 of the suit, the AG’s office says that “[t]his is not a matter that should be dealt with at the administrative level” because, in other states, the defendants “have always denied legal liability and asserted constitutional defenses, and often try to tie up matters in the administrative process for years.” The AG also justified its action (in Paragraph 97) by stating that “the threshold question, whether or not the online travel companies are subject to (M&R Tax) is one of law and does not require the Department of Revenue’s expertise” and that “judicial economy would be served where the legal issues involved would be resolved with less expense and more efficiently and expeditiously within the judicial system.”

The AG’s office found statutory support for filing its lawsuit in RSA 78-A:20, II, which states that, “[a]n action may be brought by the attorney general at the instance of the commissioner of revenue administration in the name of the state to recover the amount of taxes, penalties, and interest due from the operator…” Since the title of that section is “Taxes as Personal Debt to State”, it’s possible that the provision only applies once the DRA has issued a notice of assessment (even if based on an estimate using the best information available) legally establishing the amount of the taxpayer’s liability.

In fact, many of the other counts in the AG’s suit, including conversion, unjust enrichment, assumpsit and civil conspiracy, appear ultimately based on the allegation that the defendants did not pay M&R Tax.6 If the only way to legally establish that tax due was not paid is by first issuing a notice of assessment indicating the amount of the underpayment, then those counts could possibly be unsustainable.

Instead of having the DRA issue jeopardy tax assessments, the AG’s office requested the court order the online travel companies to provide an accounting to the State for all information necessary to compute the correct amount of their respective tax liabilities “since the beginning of the M&R Tax” (Paragraph 143).7 Given the number of years that online travel companies have been offering rooms and vehicles in NH and the M&R Tax rate, which was 8% from 1991 through mid-2009, (when it was raised to the current level of 9%), the unpaid tax liability would be very significant. The AG also requested a civil penalty of up to $10K for each violation of the Consumer Protection Act.

Business Profits Tax
The only tax covered by the State’s lawsuit was Meals and Rentals Tax. It is not clear whether the online travel companies are also subject to NH Business Profits Tax. If an online travel company receives income from the rental of hotel rooms or vehicles in NH, it is possible that it is subject to BPT as well because it has physical nexus in the State since it rents rooms to third parties. The DRA might also claim that the company has “economic nexus” in the state.

In its filing, the AG’s office cited public filings by the defendants that could be interpreted to mean that they have physical nexus in NH:

  • “Under the merchant model, we receive inventory (hotel rooms, airline seats, car rentals, destination services) from suppliers at negotiated rates.” Expedia Form 10-K, Mar. 31, 2003, at F-3.
  • “For most of these transactions, we establish the price we will accept, have total discretion in supplier selection, purchase and take title to the particular product and are the merchant of record.” Priceline.com Form 10-K, Mar. 15, 2003, at 29.
  • “We contract with hotels and other lodging properties in advance for volume purchases and guaranteed availability of rooms at wholesale prices and resell these room to consumers through our websites…” Hotels.com Form 10-K (Apr. 2, 2001) at 3, 18.
  • “[W]e receive inventory directly from a hotel at a negotiated rate, and we determine the retail price at which we choose to offer it to the consumer.” Obritz, Inc. Form 10-K (Mar. 18, 2004) at 28

Footnotes

  1. See NH Looks For Outside Legal Help to Collect M&R Tax from Online Travel Companies.
  2. Paragraph 3, State of New Hampshire v. Priceline.com, Incorporated, et al., Merrimack County Superior Court. It’s important to note that no actual hotels were charged, presumably because they had paid the correct amount of tax required, as per TIR 2008-002.
  3. Among the “deceptive business practices” alleged to have been entered into by the defendants, the State claims that the online travel companies bill their customers “tax recovery charges” which are designed to approximately equal or exceed taxes on the retail rate paid for the hotel room (Paragraph 35). The lawsuit states that the travel companies then bundle those tax charges in with unspecified “fees” in order to disguise from the end user how much less tax is actually remitted to NH. The AG’s office claims that the defendants “unlawfully pocket the difference” between the two (Paragraph 47).
  4. Travel websites push back against N.H. lawsuit over taxes, Concord Monitor 10/28/13
  5. Of course, if a taxpayer is providing no information upon which the DRA can make an informed estimate, the Department can turn to other sources. If, for example, a public company provides sales for the United States in its annual report, the DRA would presumably be justified in determining tax by multiplying those sales by NH’s percentage of the country’s overall population. The DRA would probably even be allowed to increase that amount by some factor just in case NH sales were disproportionately high. If the estimate is overly high, the taxpayer would be able to demonstrate that fact to the court.
  6. “General assumpsit. An action based on the defendant’s breach of an implied promise to pay a debt to the plaintiff.” Black’s Law (8th edition)
  7. The M&R Tax first went into effect in 1967.

Hospitals Challenge DRA’s Interpretation of Taxable Revenues under MET

A document released by the Department of Revenue Administration to provide guidance on the State’s Medicaid Enhancement Tax (MET) has come under criticism from some hospital officials. On Tuesday, the DRA issued a technical information release in which it said that outpatient hospital services that are reimbursable by Medicaid are subject to MET, regardless of whether the patient was actually covered by Medicaid or not.

According to press reports, hospital officials quickly protested the DRA’s position. The Concord Monitor reported Thursday (Special Commission Considers Changes to Hospital Tax) that the chief financial officer of Dartmouth-Hitchcock Medical Center, Robin Kilfeather-Mackey, said that some of the definitions of what is taxable under the MET statutes are inconsistent with negotiations held between hospitals and the state last year over taxable revenues. The Union Leader also reported today that the hospitals contend that laboratory fees, X-rays, physical therapy and professional services are similarly exempt from MET (State, Hospitals Still at Odds over Medicaid Taxes Owed).

The Monitor article reported that DRA Commissioner John Beardmore disagreed, telling the Medicaid Enhancement Tax Study Commission that hospitals are wrong in their claim that only revenue from services reimbursable by Medicaid is subject to the tax. The Commission was set up by the Legislature to determine whether changes to the statute were necessary.

From its inception, in 1991, MET operated below the radar screen because hospitals were immediately reimbursed for 100% of the tax they paid to the State through Medicaid’s Disproportionate Share Hospital (DSH) program. Under a loophole that has since been closed, the federal and state governments would each issue payments to the hospitals equal to 50% of any tax paid, which was considered to be a reimbursable Medicaid cost. The State effectively pocketed the other half of the MET payments. In 2011, the federal government ruled that provider-based taxes such as MET could no longer be reimbursed dollar-for-dollar, and that they must instead be distributed according to each provider’s Medicaid costs.

That same year, the NH Legislature decided to plug a major hole in the State’s budget by slashing Medicaid funding to general hospitals. Large hospitals saw their Medicaid funding cut far more sharply than smaller providers, a move which led to staff cutbacks by some of the bigger facilities. And now that the MET was actually eating into their bottom lines, the hospitals started to take a closer look at what revenues were actually subject to the tax.

Possible Constitutional Issue
In 2011, a number of the larger hospitals filed suit against the State in federal court alleging that the Legislature had effectively eliminated their DSH funding in contravention of Medicaid law. In a footnote to the lawsuit, the plaintiffs said that they had also filed a challenge with the DRA as to the constitutionality of some unspecified aspect of MET law and were pursuing their remedies through the state administrative and judicial appeal process.

Under the MET statutes, only “general hospitals” are subject to the tax, which is payable at 5.5% of net patient services revenue, a term that includes both inpatient and outpatient services. NH also imposes a Nursing Facility Quality Assessment Tax and an ICF (Intermediate Care Facility) Quality Assessment Tax, each of which requires institutions meeting their respective statutory definitions to pay the State 5.5% of their net patient services revenues.1

The MET, Nursing Facility and ICF taxes on a combined basis cover only four of the 19 separate Medicaid categories. (Inpatient and outpatient hospital services subject to MET are each considered a separate category.) The fact that only “general hospitals” are required to pay MET while other health care professionals and entities providing services similar to those available at a general hospital do not could expose the law to a claim that it violates the NH Constitution’s prohibition against taxpayer classification. An example would be a physician-owned practice that resets a broken bone or a stand-alone clinic that does blood work for a patient. If a general hospital has to pay MET on either charge but a clinic does not, an argument could be made that the law treats taxpayers differently.

TIR 2013-007
The DRA issued Technical Information Release 2013-007 to provide guidance on the taxability of certain outpatient hospital services.2 The TIR only deals with outpatient hospital services that would be reimbursable by Medicaid, regardless of whether the patient was actually covered by Medicaid or not. The relatively small number of outpatient patient services that are not reimbursable by Medicaid are not covered by the TIR. The DRA said, however, that they are still subject to MET.

The DRA made a distinction between services that are eligible for cost-based reimbursement from Medicaid and the “professional service component” of outpatient hospital service that is subject to fee-based reimbursement from the federal program. Per the DRA, the former is always subject to MET (for all patients, including non-Medicaid patients) while the latter is not. The one exception to the fee-based rule covers laboratory services, which the TIR says are subject to MET, even though reimbursable according to a fee schedule.3

The TIR addresses the taxability of a number of specific outpatient services, with the Department’s guidelines based on the general principles explained above:

Services Taxable Explanation
Adult Day Care No Provided under a separate license from that of hospital.
Ambulance Service No Assuming that they are provided under a separate license and billed under a separate provider number from that of hospital.
Ambulatory Surgical Center Depends Taxable if the center is a licensed outpatient hospital department and billed under the hospital’s provider number.* Otherwise, not taxable.
Dental Service Revenue – Professional Fee Depends Taxable if provided under the hospital license and billed under the hospital’s provider number.* Otherwise, not taxable.
Dental Service Revenue – Facility Fee Depends (AKA the “technical component”) Taxable if billed under the hospital’s provider number.* Otherwise, not taxable.
Diabetes Education Depends Taxable if billed under the hospital’s provider number.* Otherwise, not taxable.
Durable Medical Equipment Depends Taxable if billed under the hospital’s provider number.* Otherwise, not taxable.
Emergency ALS Training Program Depends Taxable if billed under the hospital’s provider number*. Otherwise, not taxable.
Laboratory Services Yes
Nutritional Consultation Depends Taxable if billed under the hospital’s provider number.* Otherwise, not taxable.
Physician Services (but see below) Depends Taxable if billed under the hospital’s provider number.* Otherwise, not taxable.
Physician Services – Facility Fee Depends (AKA the “technical component”) Taxable if billed under the hospital’s provider number.* Otherwise, not taxable.
Physician Services – Emergency Room Yes
Podiatry Services – Professional Fee Depends Taxable if provided under the hospital license and billed under the hospital’s provider number.* Otherwise, not taxable.
Podiatry Services – Facility Fee Depends (AKA the “technical component”) Taxable if billed under the hospital’s provider number.* Otherwise, not taxable.
Psych DPU (Distinct Part Unit) Yes It is an inpatient hospital service.
Retail Pharmacy No Retail pharmacies are separately licensed from the hospital and have separate provider numbers
Rural Health Clinic Depends Taxable if clinic operates as a department of the hospital and bills under the hospital’s provider number.* Otherwise, not taxable.
Swing Bed Depends Although an inpatient service, which is always subject to MET, it could be instead subject to NFQA Tax, if provided as a nursing facility service.
Senior Center Clinic Depends Taxable if clinic operates as a department of the hospital and bills under the hospital’s provider number.* Otherwise, not taxable.
Wound Care Clinic Depends Taxable if clinic operates as a department of the hospital and bills under the hospital’s provider number.* Otherwise, not taxable.
* The billing must also be as outpatient hospital services for which cost-based reimbursement would be available under Medicaid, regardless of who actually pays.

 

Footnotes

  1. While the nursing and intermediate care facility statutes both describe the payments required as a “fee”, they appear in the statute books under the section on “Taxation”. Interestingly enough, neither appears to be broken out in the State’s monthly or annual revenue reports.
  2. Inpatient hospital services are not covered by the TIR.
  3. The TIR says that some hospitals claimed that only the revenue from laboratory services provided with an additional outpatient hospital service is taxable under the MET and that revenue from a laboratory service in and of itself is not taxable under the MET. The DRA said that all revenue from lab services provided as an outpatient hospital service, billed to Medicaid as an outpatient hospital service and reimbursed as an outpatient hospital service is subject to MET, regardless of whether Medicaid paid for the services.

Significant Impact on I&D Tax and RETT from DRA Ruling on Statutory Conversion

The New Hampshire Department of Revenue Administration has issued a declaratory ruling on a statutory conversion from a Subchapter S corporation to a limited liability company that will result in the entity not owing Real Estate Transfer Tax (RETT) due to the conversion and its owners not being liable for future Interest and Dividends Taxes (I&D Tax).

Interest and Dividends Tax
The I&D Tax aspects of the ruling could prove to be the most significant. Generally speaking, an entity is subject to the tax if it has non-transferable shares. If it doesn’t, its NH-resident owners are instead liable on any distributions made out of the current-year or accumulated profits of the entity (RSA 77:3, I(b)). Per the DRA’s rules, all corporations are considered to have transferable shares (Rev. 901.02(b)).1

In its request for a declaratory ruling, the taxpayer stated that the LLC would not have transferable interests and requested a determination that distributions from the LLC to its NH resident members would not be considered dividends for I&D Tax purposes. While the taxpayer did not say whether the LLC would continue as an S Corp after the conversion, it did state that the entity would elect to be treated as an association taxable as a corporation and that the LLC’s members “will all be persons eligible to be shareholders of a small business corporation pursuant to the requirements of IRC §1361(b).” (Per IRC § 1361(a), only “small business corporations” can elect Subchapter S status.)

In Declaratory Ruling 10391, the DRA agreed that because the taxpayer will have non-transferable shares after conversion to an LLC, none of its distributions would be taxable to its owners. By converting to an LLC with an operating agreement that restricts transferability of its ownership interests, taxability switched from the entity’s owners to the LLC itself. Of course, if the LLC has little or nothing in the way of taxable interest and dividend income, there will presumably be a significant reduction in the amount of tax due from previously when the shareholders had to pay I&D on all dividends received.

The upshot of the conversion appears to be that the LLC and its owners will no longer be subject to double taxation in NH (even though the LLC is still treated as an S corporation for federal tax purposes.) While the entity will continue to be subject to Business Profits Tax (BPT), its owners will no longer have to pay the I&D Tax for which they were previously liable.2

At least one uncertainty remains. Rev. 903.07(c) requires that, on termination of S Corp status, distributions evidenced by a reduction in the entity’s accumulated adjustments account become taxable to its shareholders, either directly or indirectly.3 From the DRA’s ruling, it’s not completely clear that any distributions by the LLC, if and when it eventually terminates S Corp status, would be subject to I&D Tax. A good argument could be made that it wouldn’t because the entity would presumably still have non-transferable shares at that time.

Although the owners of an LLC with non-transferable shares that has a valid Subchapter S election will not be subject to I&D Tax on distributions received from the entity, the entity will apparently still have to file Form DP-9, Small Business Corporations Information Report, to the DRA (RSA 77:17-a, Rev. 2905.01).

Real Estate Transfer Tax
The corporation is in the business of leasing real estate, which will be continued by the successor LLC. In the declaratory ruling, the DRA determined that RETT would not be due pursuant to the conversion because there would be no consideration given for the exchange of ownership interests and because, under RSA 304-C:147, the entity remains the “same business entity” after the conversion as it was before.

There was a previous exemption for entities undergoing a statutory conversion. That exemption (as well as another for mergers) was dropped in 2001 in conjunction with the repeal of the State’s Legacy and Succession Tax. In Declaratory Ruling 8724, which was issued in 2006, the DRA had said that tax would be due on the conversion of a trust with NH real estate to an LLC. In that earlier declaratory ruling, the Department focused almost exclusively on the repeal of the previous exemption for statutory conversions when it stated that, “… the subsequent repeal of that exemption in 2001 would have been nonsensical and unnecessary if the legislature had never intended the real estate transfer tax to apply to statutory conversions.” In its ruling last month, the DRA made no mention of either its earlier finding or the relevance of the repeal of the previous exemption for statutory conversions.

The one specific change since the 2006 ruling that apparently swayed the DRA was the Legislature’s 2012 rewrite of LLC law – specifically the language in RSA 304-C:147 that an entity undergoing a conversion remains the same business entity after the conversion as it was before.

While that would seem to offer strong support for a finding that no RETT is due pursuant to a statutory conversion, that position doesn’t appear to take into consideration what led up to the bill’s passage. The legislation, as originally drafted to amend RSA 304-C:149, VIII(c), included language stating that any real estate owned by the converting entity would “not be transferred or deemed to be transferred by reason of the conversion.” That clause was subsequently taken out of the bill, with the House Journal noting that “sections of the bill that eliminated the collection of the real estate transfer tax during statutory conversions” had been removed and that the legislation “has no impacts on state revenues.”

Other language in the revised LLC act, especially RSA 304-C:149, VIII(b), which says that all property “shall be vested” in the successor LLC , might help support a conclusion that RETT is not due on a conversion, but that provision is largely unchanged from its predecessor at RSA 304-C:17-a, VIII(b) and had been in place when the Legislature dropped the earlier exemption, in 2001.
(See also Statutory Conversions Involve the “Same Business Entity“)

Business Taxes
The taxpayer also requested a determination from the DRA as to whether there would be any business tax implications pursuant to the statutory conversion. The taxpayer stated that its conversion would be tax free federally to both the entity and its owners under IRC § 368(a)(1)(F). Given the tight link between taxable income for federal purposes and the rules for reporting taxable income for BPT purposes, the DRA agreed.

The Department also ruled that there would be no additional Business Enterprise Tax owed because of the conversion.

Only RETT Impacted by Rewrite of LLC Act
While the RETT consequences of the declaratory ruling appear to stem largely from the “same business entity” amendment made to LLC law last year, the impacts on I&D Tax and business taxes have no connection to that statutory change.4

As with any declaratory ruling, the DRA said that it applied only to the particular circumstances and facts presented by the petitioner (Rev. 209.02).

Footnotes

  1. But see Constitutionality of Premise that all Corporations have Transferable Shares
  2. In fact, if the LLC has income subject to the 5% I&D Tax, its BPT liability would be lowered by more than the I&D Tax it would have to pay because it would be able to deduct the interest and dividend income from its business profits, which are subject to the 8.5% BPT tax rate. Plus, the LLC would still be able to take the federal deduction for I&D Tax paid, which flows through to its NH BPT return. See I&D Tax not Subject to Add Back Requirement
  3. But if distributions aren’t made until the LLC is being dissolved, they wouldn’t be taxable anyway because liquidating distributions are exempt from tax.
  4. Another recent statutory change involving Subchapter S corporations could also have a significant impact on I&D Tax owed. See Taxability of I&D Distributions from a Trust.

Report: Second Leg of Reverse Like-Kind Exchange No Longer Taxable

A company that facilitates like-kind exchanges claimed recently that the New Hampshire Department of Revenue Administration has changed its position on the taxability of the second round of exchanges involving exchange accommodation titleholders, and no longer considers such transfers to be subject to Real Estate Transfer Tax.

Under federal income and NH Business Profit Tax law, a taxpayer is able to defer recognition of gain on the sale of certain qualifying property if it is replaced by “like kind” property within a specified period of time. The deferred gain is only recognized when the replacement property is disposed of in a subsequent taxable transaction. While like-kind exchanges normally involve the sale of the relinquished property before the replacement property is acquired, the process is occasionally reversed. In such situations, the taxpayer must contract with an “exchange accommodation titleholder” (“EAT”), which will take title to the replacement property in order to achieve the desired tax deferral.*

Such agreements require that the EAT acquire legal title to the property from a third party, which means that if the property is NH real estate, RETT will be due on the acquisition. Because the EAT actually takes title to the property, a direct deeding of the real estate is not possible when it subsequently transfers the property to the taxpayer doing the exchange. Per RSA 78-B:1, I(a) and Rev. 802.01(a), all transfers are presumed taxable unless specifically exempted. Since there is no statutory exemption for reverse exchanges, that would appear to mean that a second round of RETT would also be due when the EAT ultimately transfers the property to the taxpayer who had hired it to facilitate the exchange.

However, in the July 30, 2013 issue of the New York Real Estate Journal, an official of a firm that facilitates like kind exchanges authored an article saying that it had sought guidance from the NH DRA that a second round of RETT was not due when an EAT transferred real estate to the taxpayer . The article said that the DRA, despite having previously charged a duplicate transfer tax “in all reverse exchanges”, ultimately concurred with the firm’s position that a second round of RETT was not due.

The DRA has not put out any declaratory rulings on the issue.

 

* Reverse exchanges normally take place when a taxpayer sees an opportunity to acquire property but fears that it will no longer be available when the taxpayer is finally ready to dispose of the property to be relinquished. An EAT is also required to take title to property when a taxpayer is trying to achieve tax deferral in a “build-to-suit” exchange, which involves major improvements being done to the replacement property prior to the taxpayer’s acquisition of legal ownership.

 

Court Rules Education Tax Credits Can’t Fund Scholarships to Religious Schools

A New Hampshire judge ruled Monday that a law allowing credits against business taxes for contributions to fund elementary and high school scholarships is unconstitutional to the extent that the funding would benefit religious schools.

The education tax credit, which was passed last year by a Republican-dominated legislature, has been under attack as a thinly disguised voucher program. The decision1 was not, however, a total defeat for proponents of the program. While Strafford County Superior Court judge John Lewis struck down credits for scholarships that would be used at faith-based schools, he also ruled that the credits pass constitutional muster if they are used to fund scholarships to non-religious schools.

Public Funds Can’t Be Used to Fund Religious Schools
Article 83 of the New Hampshire Constitution states that, “… no money raised by taxation shall ever be granted or applied for the use of the schools of institutions of any religious sect or denomination.”  Judge Lewis rejected arguments that because the contributions pass directly from businesses to special purpose “scholarship organizations”, no public funds were used to finance the scholarships. He ruled instead
that the program simply diverts money that would have otherwise been paid to the government in the form of taxes.

The suit challenging the credits was brought by the American Civil Liberties Union and Americans United for Separation of Church and State.

Governor Maggie Hassan, a Democrat, issued a statement Monday calling the court decision “a victory for New Hampshire public education.”

The court battle, which will likely now be appealed to the New Hampshire Supreme Court, was not the only effort to abolish the education tax credit program. After Democrats took control of the House of Representatives in the November elections, the House passed legislation repealing the entire program. The repeal effort was tabled, however, by the Senate, which retains a slight Republican majority.

The education tax credit program allows taxpayers to reduce their business taxes by an amount equal to 85% of contributions made for scholarships intended to help students attend the elementary and secondary school of their choice, including faith-based educational institutions. Combined with the federal deduction for charitable contributions, a profitable business would recoup 96% of each scholarship donation.

Scholarships can only be awarded to students who come from a family or household that has a total annual income that does not exceed three times federal poverty guidelines. In 2012, the poverty guideline for a family of four was $19,090.  Based on that amount, a family with household income of up to $57,270 would qualify for the credit.

 

Footnotes

Hassan to Nominate John Beardmore as Commissioner of Dept. of Revenue Administration

Governor Maggie Hassan announced Tuesday that she will nominate John Beardmore to be commissioner of the New Hampshire Department of Revenue Administration.

In a press release, the Governor’s office said that Beardmore currently serves as Director of Administration at the Department of Safety. He previously held a variety of budget-related positions in state government, including Budget Director under former Governor John Lynch as well as a number of positions at the Office of Legislative Budget Assistant.

The DRA commissioner’s position has been vacant since the end of February, when Kevin Clougherty’s four-year term as head of the tax agency expired.

In the press release, Hassan said, “cuts to DRA positions in recent years have put a significant strain on the department that they have for the most part handled admirably, but it is clear that the agency needs revitalized leadership to improve their effectiveness and communication with taxpayers and with the legislature.

Beardmore, who also serves as trustee for the New Hampshire Retirement System, received his Master of Public Administration degree from the University of Massachusetts, Amherst, after receiving his B.A. from the University of New Hampshire.

The Executive Council, which is made up of the Governor and five councilors, has to approve the nomination. Hassan will formally make the nomination at the Council’s bi-weekly meeting tomorrow.

Senate Committee Considers Amendment to Exclude Tips from BET

The Senate Ways and Means committee will hold a hearing on Tuesday on an amendment that would makes most, if not all, tips paid to employees of New Hampshire businesses exempt from the state’s business enterprise tax (BET).

The Department of Revenue Administration (DRA) has recently been conducting audits of NH restaurants, informing them that they must pay BET on all tips received by their wait staffs instead of just on the minimum wage amounts they are required to pay tipped employees.

Under a DRA regulation in effect during the first 14 years of the BET tax, tips were exempt as long as they were not deductible expenses for the employer. (Tips are normally neither taxable income nor deductible expenses on the employer’s federal income tax return.) When the DRA made general revisions to the BET rules in late 2007, that regulation was not readopted.

For federal payroll tax purposes, the employer of tipped employees is generally considered to have paid the tips as compensation to its employees. One possible explanation for the DRA’s decision to drop the rule exempting tips, and to start auditing taxpayers over the issue, could lie in the fact that the BET definition of taxable compensation at RSA 77-E:1, V is directly tied into the federal treatment of wages for payroll tax purposes under IRC § 3401. That link to the federal statute could support the DRA’s position that all tips are includible in the employer’s taxable base for determining BET liability.

Under NH legal precedent however, the DRA could be on shaky ground if it is trying to change an interpretation of an ambiguous law that it had consistently interpreted in another way over a period of years.

The New Hampshire Business Review (NHRB) reported on May 3rd (Did DRA tip the balance on BET calculation?) that the New Hampshire Lodging and Restaurant Association had hired an attorney, who advised it that employers should not be subject to BET on “gratuitous” tips because they were paid by customers, and not by the business owner.

Under the BET statutes, tax is owed on the “enterprise value tax base”, which is defined to consist of all compensation, interest and dividends paid “by the business enterprise”. Complicating the issue is the fact that the word “compensation” is defined under the BET statute to include all wages, salaries, fees, bonuses, commissions or other payments “paid or accrued…on behalf of or for the benefit of employees…”.

Senators Robert Odell and Jeb Bradley, both Republicans, attached the amendment exempting tips to a bill, which had already passed the House of Representatives, establishing a commission to study the implementation of keno gambling in the State. The amendment specifically changes the definition of taxable compensation to include only those payments that were paid or accrued “by the business enterprise”. It is not clear if mandatory gratuities, which are often charged by restaurants for parties of six or more, would also be exempt from BET.

While the DRA frequently provides the Legislature with a report on the impact on tax collections of a pending amendment, none was included with the bill that was published on the Legislature’s website.

In an article published last week (NHLRA turns to Senate to block BET tips policy), NHBR reported that a DRA official said the agency would only apply its current interpretation of the law on a going forward basis because of the “confusing and conflicting information” it had issued in the past.

NH Budget: Tax Increases or Delays of Pending Tax Cuts?

As a divided New Hampshire Legislature moves fitfully toward a showdown over the state’s next two-year budget, semantical skirmishes are breaking out as to whether delays in the implementation proposed by Governor Maggie Hassan for business-friendly tax legislation are actually tax increases in disguise, the Concord Monitor reported today in its Capital Beat column.

When Republicans enjoyed lopsided majorities in both houses during 2011 and 2012, they passed a number of measures that were intended to reduce business tax burdens, but which would only kick in after the end of the two-year legislative session. In February, Gov. Hassan, a Democrat, proposed a budget that would delay implementation of those tax measures even further. Hassan told lawmakers at the time that the previous Legislature had made a number of promises for tax law changes, “but pushed off to the next legislature the job of paying for them.”

While Democrats have recovered control of the House, they are two seats shy of a majority in the Senate. That slight shortfall could frustrate the governor’s plans.

The Monitor reported that Greg Moore, state director for Americans for Prosperity, said several state senators told him that they were opposed to any delay in implementation of the tax law changes made by the prior Legislature. (AFP is an influential political advocacy group which, among other things, supports cutting taxes and government spending.) Moore said that the delays in the proposed budget were the same as a tax increase. He was especially critical of the impact that the measures would have on business planning.

“Even though you might not technically pay your taxes until later, the reality is, from a planning perspective, you’re suddenly having the rug pulled out from under you,” Moore said.

The Monitor quoted Susan Almy, a Democrat and chair of the House Ways and Means Committee, as saying that the Governor’s proposals were “a delay of a tax cut” instead of a tax hike.

The House has already approved a budget package, which includes the suspensions of tax measures requested by the Governor. Currently before the Senate are amendments that would:

  • Delay by one year an increase in the threshold for filing a business enterprise tax (BET) return. Businesses currently must file a BET return if they have at least $150,000 of gross business receipts or $75,000 of enterprise value tax base. The previous Legislature increased those minimums to $200,000 and $100,000, respectively, for tax years ending on or after 12/31/13.
  • Put off by one year a doubling of the five-year period for carrying forward and applying BET credits against business profits tax (BPT) liabilities. Under the Governor’s budget, the longer carryforward period would begin for tax years ending on or after 7/1/15.
  • Suspend by one year an increase in the amount of net operating loss that can be generated in any given tax year, from $1 million to $10 million, and carried forward to offset a subsequent year’s BPT liability. The higher carryforward amount approved by the previous Legislature kicked in for losses incurred in tax years beginning on or after 1/1/13.
NHTA's Press and Blog Review features summaries of selected information 
from articles and web postings that might be relevant to NH taxpayers. 
While NHTA specializes in taxes administered by the Department of Revenue 
Administration, the Review could also include articles about other tax 
matters of possible interest to NH taxpayers. Often times, NHTA will 
supplement material included in the original article or web posting to 
provide context and additional information.

 

Bill Increasing Personal Compensation Deduction Safe Harbor Sent to Governor

The New Hampshire Senate on Thursday passed a bill increasing by 50% the “safe harbor” that relieves partnerships and proprietorships from having to provide support for personal compensation deductions taken against the Business Profits Tax.

The safe harbor will increase to $75,000 if Governor Hassan signs off on HB 598, which has already cleared the House of Representatives. While the safe harbor shelters businesses from having to support deductions for the value of services provided by their owners up to the current limit of $50,000, they must still demonstrate that at least one owner provided some services if asked to do so by the Department of Revenue Administration.

The safe harbor first became law in 2011 after complaints that the DRA was auditing a large number of taxpayers over the amount of personal compensation deductions taken on their BPT returns. Although the safe harbor shields taxpayers from having to support deductions up to the statutory limit, any deductions taken must still meet the requirements of IRC § 162(a)(1), which sets the federal standard for determining the propriety of employee compensation deductions .

Burden on DRA to Prove Deduction is Clearly Unreasonable
The BPT statutes allow a business to take a personal compensation deduction in excess of the statutory maximum if it maintains records for the deduction and provides support for the services, if requested to do so by the DRA. As long as the business is able to demonstrate that each individual for whom a deduction is claimed performed some personal services during the taxable period, the deduction is presumed reasonable unless the DRA can prove, by a preponderance of the evidence, that it is “clearly unreasonable”.

While the safe harbor is available to business organizations filing proprietorship and partnership returns, corporations do not have a similar shelter for the services provided by employees who are also shareholders.

Restaurants Protest DRA’s Move to Charge BET on Tips

The Department of Revenue Administration has recently started informing NH restaurants that they must pay Business Enterprise Tax on all tips received by their wait staffs instead of just on the minimum wage amounts they pay to tipped employees, according to an article in the current issue of New Hampshire Business Review.

In the article (Did DRA tip the balance on BET calculation?), NHBR reports that state tax auditors have sent determination letters to a number of restaurants advising them that BET is owed on all tips received, and not just on the minimum wage that they are required by law to pay tipped employees. While the standard minimum wage is $7.25 an hour, tipped employees must be paid at least $3.27 an hour under the assumption that their tips will more than make up the difference. Restaurants are still required to include tips received by employees on the W-2 forms issued after the end of the year.

Businesses in NH are required to calculate their BET liabilities on all compensation that they pay their employees. (Any interest or dividends payments made by a business also go into the calculation of the 0.75% tax.)

NHBR reports that the New Hampshire Lodging and Restaurant Association hired an attorney, who advised it that employers should not be subject to BET on “gratuitous” tips because they were paid by customers, and not by the business owner. Under the BET statutes, tax is owed on compensation paid “by the business enterprise”.

The association met with DRA officials, who agreed to suspend the issuance of tax notices “as it revisits the issue”. The article also says that the DRA advised the trade group that it will only apply its interpretation of the law on a going forward basis.

Regulation Removal Puts Tips Back on the Table
The article said that the DRA administrative rules were clear from 1993, when the BET first became law, until late 2007, when a change in the regulations was adopted. Under the rules in effect until 2008, Rev. 2402.01(d)(8) excluded from taxable compensation any “…tips to an employee in the course of employment by an employer provided that such amounts are not deductible expenses for the employer.” (Tips are neither taxable income nor deductible expenses on the employer’s income tax return.) When the DRA made general revisions to the BET rules, that regulation was not readopted.

For federal payroll tax purposes, the employer of tipped employees is generally considered to have paid the tips as compensation to the employees. One possible explanation for the DRA’s change of heart could lie in the fact that the BET definition of taxable compensation at RSA 77-E:1, V is directly tied into the federal treatment of wages for payroll tax purposes under IRC § 3401, which could mean that all tips are includible in the employer’s taxable base for determining BET liability.

Under NH legal precedent however, the DRA could be on shaky ground if it is trying to change an interpretation of an ambiguous law that it had consistently interpreted in another way over a period of years.

Possible Legislative Action
NHBR reported that the hospitality trade association’s attorney, Peter Beach of Sheehan Phinney Bass + Green, also recommended that it consider proposing legislation to formally change the law to make it clear that tips are not subject to BET.

It is not clear whether any businesses are currently paying BET on their employees’ tip income or how much BET would be due the state if tips were subject to tax.

 

 

NHTA's Press and Blog Review features summaries of selected information 
from articles and web postings that might be relevant to NH taxpayers. 
While NHTA specializes in taxes administered by the Department of Revenue 
Administration, the Review could also include articles about other tax 
matters of possible interest to NH taxpayers. Often times, NHTA will 
supplement material included in the original article or web posting to 
provide context and additional information.