A very difficult problem has surfaced on use tax audits.  It has become popular for taxpayers to purchase property with a credit card.  The problem arises when audited by the Michigan Department of Treasury (Treasury).  Because the credit card statement does not have detail as to if sales tax was paid, the auditors are considering the payment as subject to use tax unless the taxpayer can prove payment of sales tax.

We recommend the taxpayer retain the original invoice and attach it to the credit card statement from which payment is made.  The burden of proof is on the taxpayer to prove the tax was paid.

The Department of Treasury (Treasury) auditors have adopted a policy of going back ten years on a sales tax or use tax audit where the taxpayer is not licensed or registered.  Furthermore, if the audit results in a deficiency, penalty of 25% is applied for failure to file the return.  If records do not exist, Treasury will compute an annual liability from the most current year and project it back ten years.

Treasury is within their statutory right to do the above.  They could go back to the start of business if the taxpayer is not licensed or registered. 

We recommend every taxpayer be licensed for sales tax and registered for use tax.

If the taxpayer fails to file a return or to maintain or preserve proper records, or the Department of Treasury has reason to believe that any records maintained or returns filed are inaccurate or incomplete and that additional taxes are due, the Department of Treasury may assess the amount of the tax due from the taxpayer based on information that is available or that may become available. (MCL 205.68(4))

Failure to produce and keep records for the purpose of examination by the Department of Treasury will be considered willful noncompliance and subject to penalties. In the absence of sufficient records the Department of Treasury may determine the amount of tax due the state by using any information available whether obtained at the taxpayer's place of business or from any other sources, and assess the taxpayer for any deficiencies, plus penalties. Section 17(1) provides: “That assessment is considered prima facie correct for the purpose of this act and the burden of proof of refuting the assessment is upon the taxpayer.” (Rule 205.23)

Licensees are required to keep complete and accurate daily records of all sales, whether for cash or credit, bartered or traded, irrespective of whether the seller regards the receipts from the sales as taxable or exempt. The taxpayer is also required to keep a complete and accurate record of beginning and ending inventories, purchase records, daily sales records, receipts, invoices, bills of lading, and all other pertinent documents pertaining to the business. (Rule 205.23)

If the seller claims sales for exemption on certain sales, it shall be required that he will keep a record of the name and address of the person to whom the sale is made, the date of the sale, the article purchased, the type of exemption claimed, and the amount of the sale. If exemption is claimed by reason of a sale for resale, the taxpayer shall obtain the sales tax license number of the purchaser. (Rule 205.23)

The Michigan Department of Treasury (Treasury) is busy auditing Single Business Tax (SBT) returns and will continue to do so until the four year statutory period for audits has expired.  One of the issues that has continually appeared on SBT audits is the computation of cash basis wages for the compensation addback.  The law specifies that "payments made" to employees, officers and others is added back.  The term "payments made" means on the cash basis; even if the taxpayer reports income on the accrual basis.

In the past, Treasury has allowed the taxpayer to report on either the cash basis or the accrual basis as long as the taxpayer was consistent.  However, in recent audits, the auditors have stuck to the cash basis.  Furthermore, they have computed the addback based on the cash wages paid from the Form 941, Form 940 or from the accrual to cash reconciliation; whichever is higher.

The taxpayer does not have to accept the auditors determination.  The taxpayer should do a reconciliation of cash wages paid as reported on the Form 941, the Form 940 and prove it against the accrual to cash reconciliation.  After identifying the differences, the taxpayer should only agree to the actual cash payment of wages.  This is what the law requires.

The agricultural exemption has been in the Single Business Tax Act (SBTA) since 1978.  However, just recently the Department of Treasury (Treasury) has been disallowing the exemption where the agricultural business is broken-up into several different entities.  They are not allowing separate entities that hold farm real estate or process grain for livestock to benefit from the exemption as they would if included in a single entity.

Does anyone have any experience with this situation? 

How do you argue it with Treasury? 

Please send a comment.

The Michigan Department of Treasury (Treasury) is open to discussion of any Frequently Asked Question (FAQ) which a taxpayer may believe is wrong, misleading or confusing.  An example relates to application of the attribution rules as they pertain to meeting the "control test" for a "unitary business group".  Treasury has verbally agreed to revise FAQ U6 and FAQ U24. 

The EHTC SALT Newsletter for Monday, June 30, 2008 discusses the issues relating to brother-sister types of entities and when they may pass the control test.

At approximately 2:00 A.M. Saturday morning, the House of Representatives passed their version of Senate Bill 1038.  The legislation would provide certain exclusions from the definition of gross receipts under the Michigan Business Tax (MBT).

In the final version, House Democrats stripped out language to exclude gross proceeds from the sale of a business.  The stripped out language was a business interest provision which clarified the exclusion of items that were never intended to be included in gross receipts (e.g., capital contributions) and ensured that only the net gain on a taxable disposition of  a business interest would be included in gross receipts.

In addition, House Democrats "tie-barred" the bill to two un-related issues; "Kreiner" legislation which would lower the bar on what legally qualifies as "serious Impairment of body function" under Michigan's no-fault auto insurance system, and labor legislation that includes campaign check-offs for payroll deductions to go to unions.  Tie-bars mean that all bills must be signed into law in order for any of them to be effective.  Business groups are opposed to both of these "tie-bar" bills. 

As passed by the House, SB 1038 would do the following:

1.Specify that the method of accounting used for federal income tax purposes would be used to determine "gross receipts".

2.Provides that 'gross receipts" does not include bad debt  and previously recognized income relation to proceeds on contingent sales.

3.Provides an exclusion from "gross receipts" for proceeds from hedging transactions, specifying that only the gain from hedging transactions are to be included in "gross receipts'.

4.Provides an exclusion from "gross receipts" for proceeds from treasury functions, specifying that only the gain from hedging transactions are to be included in "gross receipts".

5.Clarify the exclusion for an individual, estate or other person organized for estate and gift purposes when the amount received is not from the active conduct of a trade or business. The term "exclusively" was omitted.

6.Provides an exclusion from "gross receipts" for proceeds from investment activity of an individual and related person.

7.Provides an exclusion from "gross receipts" for interest income and dividends from the US Government, the State of Michigan or other political subdivision.

8.Provides an exclusion from "gross receipts" for foreign dividend and royalty income.

9.Provides an exclusion from "gross receipts" for taxes and other governmental fees collected in an agency capacity and paid to a governmental entity.

10.Provides an exclusion from "gross receipts" for proceeds from a pass-through entity.

The above listing is brief summary of the legislation.  The actual legislation should be read to obtain all the details. 

SB 1038 can be found on the Michigan Legislature's website at:
http://www.legislature.mi.gov/documents/2007-2008/billengrossed/Senate/pdf/2008-SEBH-1038.pdf

Yesterday, I had the privilege and opportunity to moderate a three hour discussion of the Michigan Business Tax at the State Tax Forum sponsored by the Michigan Association of CPAs.  There were over 200 in attendance.

Throughout the morning the various speakers discussed some of the major changes in the MBT as opposed to the SBT.  It seemed after each presentation I added "these provisions are designed to aid or assist a Michigan based business activity".  Then, during the Question and Answer session, someone asked:  How does the MBT provide incentive for service industries to locate in Michigan?

My Answer:  If a service business provides services in Michigan for customers located outside of Michigan, the changes in the nexus standard will make it easier to qualify for apportionment of tax base.  The changes in the apportionment rules for sourcing sales from services will allow the service business to exclude from the numerator of the sales factor those sales where the customer receives the benefit outside of Michigan.  In theory, if all the customers of a service business were located outside of Michigan, they would pay no MBT even if all the service work was performed in Michigan, assuming nexus was established in at least one state other than Michigan.

Also, the Michigan based service business could claim credits for compensation paid in Michigan, investments of tangible property made in Michigan and research and development done in Michigan.  These credits are only available if the business activity was conducted in Michigan.

Having passed and then rescinded an expansion of the unpopular state sales tax on services, the chair of the House Tax Policy committee reveals he is looking at a plan to up the sales tax from 6% to 7% to pay for a cut in the Michigan Business Tax (MBT) surcharge.

Representative Steven Bieda (D-Warren) makes it clear that he is not proposing that, he is merely looking at it. "I am not saying yes to anything and not saying no to anything," according to MIRS.

Representative Bieda and others in Michigan, specifically the Michigan State Chamber of Commerce and the Michigan Manufacturers Association (MMA), want to give businesses some relief from the newly enacted 21.99 percent MBT surcharge.  Representative Bieda said he never supported the surcharge in the first place.  If the governor does not get her plan to use prison reform savings for the tax cut, Bieda wants an alternative.

He is thinking about upping the sales tax rate, which he contends could bring in enough revenue to eliminate the surcharge, perhaps grant some gas tax relief, along with a property tax cut.  In other words, he's looking at what he terms "comprehensive reforms that broaden the base of the sales tax."  "There is some merit to that argument …" he explains.  Having said that, Bieda concedes that all of this would be "relatively difficult" since a two-thirds legislative vote is required to place this before Michigan voters.  But he adds a one-penny increase would not be "out of whack" with neighboring states, which have higher sales tax rates.

Increasing the sales tax rate does not broaden the sales tax base.  The tax base would be the same with a higher tax rate.  The now dead use tax on services would have broadened the tax base by adding services.  The governor's old two penny tax on services would have broadened the tax base.  Both of these proposals died.  Why?  maybe because both former proposals to expand the tax to services was loaded with exemptions and exclusions.  The legislature was picking winners and losers.

If the legislature wants to expand the sales and use tax base, they should read the Michigan Association of Certified Public Accountants (MACPA) whitepaper titled  Technical Observations on the Possible Imposition of a Sales Tax on Services.  The whitepaper is available on the MACPA website or on the EHTC website.  (See below)

Characteristics of an Effective Sales Tax on Services - (From the MACPA Whitepaper Technical Observations on the Possible Imposition of a Sales Tax on Services)

Single Rate – The rate of tax applied to tangible personal property and all services should be the same. A single rate provides for ease in administration, compliance and audit and eliminates any potential conflict with membership in the Streamlines Sales Tax Agreement. The Agreement, of which Michigan is a member, contains a prohibition against the imposition of multiple rates of tax by members seeking to participate in the sales tax registration and collection program. The program is designed to require out of state sellers to collect sales tax on mail order and internet transactions, which is clearly a growing segment of our economy. Being barred from participation in the
program would frustrate efforts to create a level playing field for Michigan based retailers relative to their out of state competitors.

Limited Exemptions – Exemptions for designated services (as opposed to categories of consumers like government, nonprofit) politicize the tax and create significant equity and competitive issues, as well as increase the administrative complexity. Some exempt service providers compete directly with other taxable service providers for the same consumers and these providers would be competitively disadvantaged. The administrative burden created by exemptions is particularly high given the relative lack of precedent for sales taxes on services in other states. The lack of guidance and experience in defining and interpreting exemptions in other states increases the complexity, uncertainty, and controversy around such exemptions.

Input Exemption – Any sales tax on services proposal should provide an input exemption for items of tangible personal property and/or purchased services consumed in rendering a taxable service. The input exemption would be similar to the resale and industrial processing exemptions currently in the Sales and Use Tax Acts In addition, an exemption comparable to the agricultural production exemption should be allowed. The theory of the sales tax is that the tax is imposed on the final buyer, user or consumer. As such, a sales tax on services should provide an exemption not only for services resold such as payments by a general contractor to a subcontractor, but also for items consumed in rendering a taxable service consistent with the current industrial processing exemption applicable to producers of tangible personal property.

A working group has been meeting under the leadership of House Tax Policy Chair Representative Steve Bieda to consider amendments to the MBT as passed the Senate in the form of Senate Bill 1038.  Commentators have given this legislation a very good chance of passage.

Following are the key provisions from the working group:

1.Codify in the statute that the method of accounting to be used for the computation of the modified gross receipts tax base will be the method of accounting used for purposes of the federal income tax.  However, if the accrual method is used, it raises issues with bad debts and similar items for which a deduction or other adjustment is later allowed for federal income tax and which would need to be dealt with for Michigan receipts purposes.

2.Only the net gain from transactions involved with the treasury functions would be included in gross receipts.  This provision may also specifically address hedging transactions and tax-free or other reorganizations.

3.Passive personal investment activity of partnerships and trusts not involved in a trade or business would be excluded from the MBT if for estate or gift purposes.  The proposed law would exclude "exclusively" from the definition.

4.Interest and dividends from federal and Michigan investments would be excluded from gross receipts along with other federal, state or municipal bond income.

5.Foreign royalties and dividends, including deemed foreign dividends, would be excluded from gross receipts.

6.Sales, use, excise, telecommunications, utility, fuel taxes and bottle deposits would be excluded from gross receipts.

7.A flow-through entity receiving income from another flow-through entity subject to the MBT could exclude from gross receipts such income.

8.Exclude gross receipts from property acquired and fully depreciated under IRC section 168 prior to January 1, 2008.

The above list provides a brief sketch of what the working group and the House Tax Policy Committee is working on.

The Department of Treasury in Frequently Asked Question (FAQ) U35 provided some bad news for small businesses.  While a "unitary business group" can eliminate inter-company gross receipts for purposes of the business income tax base, the modified gross receipts tax base and the apportionment sales factor; inter-company gross receipts cannot be eliminated by a small business for purposes of nexus, the filing threshold and the threshold credit.

Elimination of inter-company transactions does not occur when directly determining the level of a unitary business group taxpayer's overall gross receipts; however, inter-company transactions will affect a unitary business group taxpayer's gross receipts threshold amount through application of the apportionment formula.  When determining the gross receipts filing threshold and the eligibility for the Threshold Credit under MCL 208.1411, the taxpayer's overall gross receipts are first apportioned using the sales factor under MCL 208.1303(2).  Because inter-company transactions between unitary business group members are eliminated when determining a unitary business group taxpayer's sales factor, the application of sales factor to a unitary business group taxpayer's overall gross receipts would indirectly eliminate inter-company transactions from the threshold amount.  [Treasury FAQ U35]

The MBTA states that a unitary business group is required to file a combined return that includes each U.S. person included in the unitary business group, and that "all transactions between the persons included in the unitary business group shall be eliminated from the business income tax base, modified gross receipts tax base and the apportionment formula under this act."  [MCL 208.1511]  A "unitary business group" is defined in the MBTA in pertinent part as "a group of United States persons?1 of which owns or controls, directly or indirectly, more than 50% of the ownership interest with voting rights or ownership interests that confer comparable rights to voting rights of the United States persons, and that has business activities or operations which result in a flow of value between or among persons included in the unitary business group or has business activities or operations that are integrated with, are dependent upon, or contribute to each other."  [MCL 208.1117(6)]  [Treasury FAQ U35]

The MBTA expressly provides that the calculation of a unitary business group's business income tax base is determined as "the sum of the business income of each person included in the unitary business group?less items of income and related deductions arising from transactions including dividends between persons included in the unitary business group."  [MCL 208.1201(3)]  Likewise, the MBTA expressly states that for a unitary business group taxpayer, the modified gross receipts tax base (a taxpayer's gross receipts less purchases from other firms) is "the sum modified gross receipts of each person?included in the unitary business group less any modified gross receipts arising from transactions between persons included in the unitary business group."  [MCL 208.1203(3)]  Further, the MBTA clearly states that in calculating the sales factor for apportioning the business income and modified gross receipts tax bases for a unitary business group, sales between the unitary business group members are eliminated.  [MCL 208.1303(2)]  [Treasury FAQ U35]

In contradistinction, the MBTA's provisions governing taxpayer nexus [MCL 208.1200], the filing threshold [MCL 208.1505] and the gross receipts filing threshold credit [MCL 208.1411] do not contain any language providing that for a unitary business group taxpayer the respective gross receipt threshold amounts are determined after eliminating inter-company transactions.  The provision regarding taxpayer nexus [MCL 208.1200] states merely that the $350,000 gross receipts amount is that sourced to Michigan, with no prescribed adjustment for inter-company transactions.  Similarly, the provisions regarding the threshold amount of gross receipts for filing an MBT return [MCL 208.1505] and the range of gross receipts to qualify for the Gross Receipts Filing Threshold Credit [MCL 208.1411] provide only that the gross receipt amounts are those after allocation and apportionment, with no prescribed adjustment for inter-company transactions.  [Treasury FAQ U35]

Treasury FAQ U35 points out the MBTA doesn't specifically provide for the exclusion of inter-company gross receipts for the nexus requirement, filing threshold and the filing threshold credit.  Therefore no inter-company elimination.  However, they conveniently forget to consider in Section 113(3) [MCL 208.1113(2)] definition of person includes "any other group or combination of groups acting as a unit" and the Section 117(5) [MCL 208.117(5)] definition of taxpayer "means a person or a unitary business group".

If the inter-company gross receipts are not eliminated, then the taxpayer would be required to determine nexus, the filing threshold and the threshold credit based on sales to themselves.  I do not believe this is what the legislature intended.  Further, it does not make sense from a logical accounting point of view.