I've been in Minnesota the past week or so, going down memory lane with my family. We lived in Minnesota for 7 years but haven't been back for 12 years. Lots of things have changed AND stayed the same.
I was going to write this edition about how you can't keep looking back (in the rear-view mirror) AND move forward in life at the same time. I was also going to mention that sometimes looking back can be a good thing - reminding you of good memories while also reminding you of why you left (i.e., cold, snow, cold - did I say cold?) - allowing you to move forward with clarity and focus.
The same can be said for state taxes. Albeit, with state taxes, companies are often living in the past, the present and the future AT THE SAME TIME. The past is made up of audits, notices, amended returns, refund claims, etc. The present is made up of compliance, current transactions, returns, etc. The future is made up of planning, restructuring, estimated payments, etc. It is difficult to simply focus on the present in the state tax world. The past can come back to bite you when you least expect it and the future can come too quickly (i.e., year-end planning or 12/31).
WHEN STATE TAX COURT DECISIONS DON'T MATTER
In the vein of the 'past coming back to bite you,' since I'm in Minnesota this week, it's only fitting that I mention this case, Cities Management, Inc. v. Commissioner, Minn., A23-0222, opinion 11/22/23.
In this case, the Minnesota Supreme Court held that a nonresident must treat their gain on the sale of their interest in a Minnesota company (S corporation) as business income and apportion the gain to Minnesota on its 2015 tax return. The nonresident shareholder couldn't treat the gain as nonbusiness income and allocate the gain to their home state.
It is important to note that the nonresident and the buyer agreed to making a 338(h)(10) election. Consequently, the sale of S corporation stock would be treated as a sale of the S corporation's underlying assets for federal income tax purposes and the purchaser would obtain a stepped-up basis in the S corporation's assets.
The issue isn't so much as to the court's conclusion, but rather, more so to HOW the state and court arrived at their conclusion.
The nonresident had treated the gain on the sale of goodwill as nonbusiness allocable income on its Minnesota return pursuant to advise from their CPA who relied on the tax court’s interpretation of MN section 290.17 in Nadler v. Commissioner of Revenue, No. 7736 R, 2006 WL 1084260 (Minn. T.C. Apr. 21, 2006).
In Nadler, the tax court determined that income generated by the sale of goodwill constituted “nonbusiness income” that was subject to allocation under subdivision 2(c) of section 290.17. Nadler, 2006 WL 1084260, at *7–8. Nadler was not appealed.
Following the tax court’s decision. Based on Nadler, the public accounting firm advised the nonresident shareholder and the S corporation (CMI) that gain on the portion of sale proceeds considered goodwill would be taxed under Minn. Stat. § 290.17, subd. 2(c). This provision directs that gain on the sale of goodwill “that is connected with a business operating all or partially in Minnesota is allocated to this state to the extent that the income from the business in the year preceding the year of sale was assignable to Minnesota under subdivision 3.”
Unbeknownst to the nonresident shareholder, CMI, or their accountants, the Department of Revenue had internally taken the position that it “d[id] not acquiesce” to the tax court’s decision in Nadler. Minn. Dep’t of Revenue, Technical Advice Memorandum (May 4, 2007). As early as 2007, the Department was circulating non-public internal technical advice memoranda and other documents in which it informed auditors that the Department would not follow the tax court’s reasoning in Nadler. The Commissioner did not make the Department’s disagreement with the tax court’s decision public until July 2017, when Revenue Notice 17-02 was issued. This notice “advise[d] non-resident individuals that the department does not administer the income allocation provisions in [section 290.17] using the Minnesota Tax Court’s reasoning in Nadler v. Commissioner, No. 7736 R, 2006 WL 1084260 (Minn. Tax Ct.).” Minn. Dep’t of Revenue Notice No. 17-02 (July 3, 2017).
In September 2018, following an audit of the CMI's income tax return, the Commissioner determined that CMI had applied the incorrect allocation rule in section 290.17 to income from the sale. Under the Commissioner’s view of the statute, that income was business income subject to apportionment and thus should not have been assigned under subdivision 2(c).
DO YOU SEE ANYTHING WRONG WITH THIS?
The taxpayer relied on a 2007 MN tax court ruling for a transaction it incurred in 2015. The state did not follow the 2007 ruling but didn’t tell the public until 2017. Then the state audited the taxpayer and made the assessment of additional tax based on its own internal interpretation in 2018.
Effectively, this case tells taxpayers that you can't rely on tax court decisions if the state disagrees even if the state never publicly tells you that it isn't going to follow the ruling. If the state tells you they disagree with the ruling after your file your return, then they can audit your return and issue additional tax even though you had no idea and were attempting to follow legal authority and got advice from your CPA.
What is your CPA supposed to do when they conduct research?
Are CPAs supposed to advise clients to take positions that are in the state's best interest despite having court decisions to the contrary?
Are taxpayers and CPAs supposed to assume that states disagree with tax court decisions and will not follow them?
What are taxpayers and CPAs supposed to do?
ATLEAST THERE IS DISSENT
Justice Anderson and Chief Justice Hudson of the MN Supreme Court dissented in the opinion.
Excerpts from their dissent are as follows:
But the actions of the Commissioner of Revenue here—namely, the decision to disregard the tax court’s interpretation of a statute and adopt the Commissioner’s own interpretation without notice to the public—raise serious concerns about the fundamental fairness of the underlying audit that led to this appeal. The court recognizes the problematic conduct of the Commissioner, but because the court elects not to provide a remedy, I respectfully dissent.
The court accurately sets out the undisputed facts here. Based on the tax court’s holding in Nadler v. Commissioner of Revenue, No. 7736 R, 2006 WL 1084260 (Minn. T.C. Apr. 21, 2006), the majority shareholder, Kim Carlson, along with the co-owner of Cities Management, Inc. (CMI) agreed to sell the business on certain terms and also relied on Nadler in characterizing income from the sale of the business in preparing and filing the 2015 tax return.
At no point during any of these events were Carlson and her tax advisors aware that the Commissioner had rejected the tax court’s interpretation of section 290.17 in the Nadler opinion. As the record produced during discovery demonstrates, the Commissioner decided within a year of the tax court’s issuance of Nadler that the Department of Revenue would not accept the tax court’s interpretation of section 290.17. For instance, a technical advice memorandum dated May 4, 2007, noted that “the Department of Revenue decided not to appeal the Tax Court decision in Nadler v. Comm’r of Revenue . . . but does not acquiesce to that decision regarding the treatment of goodwill under Minn. Stat. § 290.17 in that case.” Other documents lay out the Department’s instructions to its employees to apply the Commissioner’s own interpretation of section 290.17 rather than the Nadler interpretation of the statute.
But what is perhaps most troubling about this conduct is the Commissioner’s lack of transparency. For more than 10 years after the Nadler opinion was issued, the Commissioner did not make public the Department of Revenue’s position on the interpretation of section 290.17. Public notice of the Commissioner’s disagreement was not provided until July 2017 when the Department issued Revenue Notice 17-02. In this revenue notice, the Commissioner publicly advised taxpayers for the first time that “the department does not administer the income allocation provisions in [section 290.17] using the Minnesota Tax Court’s reasoning in Nadler v. Commissioner.” Minn. Dep’t of Revenue Notice No. 17-02 (July 3, 2017).
This revenue notice was, of course, no use to CMI; the business was sold and the 2015 tax return was filed relying on Nadler before the Commissioner issued the revenue notice. The Department itself acknowledged the basic unfairness of this situation when CMI administratively appealed the audit. In removing the substantial understatement penalty initially assessed against CMI, the Department noted that CMI “reasonably relied on Nadler and the Department had issued no written guidance until 2017 (Revenue Notice 17-02) disputing the Nadler decision.”
Given the outrageous conduct of the Commissioner, I would instead announce an equitable rule that the Commissioner is bound by tax court decisions that are not appealed unless the Department of Revenue provides public notice of its disagreement with the tax court opinion.
It is vital that taxpayers “have trust and confidence that Minnesota’s tax system is fairly and equitably applied to all.” Mauer v. Comm’r of Revenue, 829 N.W.2d 59, 76 n.2 (Minn. 2013); see also State v. Melde, 725 N.W.2d 99, 102 (Minn. 2006) (“Essential to the guarantee of due process is fundamental fairness.”).
But how are we to expect taxpayers to have confidence in a system in which the Commissioner ignores the tax court’s interpretation of tax statutes and unilaterally adopts the Commissioner’s preferred interpretation of the law—all without notice to the public?
Simply put, taxpayers deserve some assurance that if they prepare their tax returns in reliance on the tax court’s interpretation of the law, the Commissioner cannot subsequently change the rules, or at least not without notice to the public. Applying this equitable rule to the circumstances before us, it is clear that the Commissioner is bound by the tax court’s interpretation of section 290.17 in Nadler.
The tax court issued its opinion for Nadler in 2006, and although the Commissioner disagreed with the tax court’s interpretation of section 290.17, no appeal was taken. The Commissioner did not give public notice of disagreement with Nadler until 2017, when Revenue Notice 17-02 was issued. CMI filed the tax return underlying this appeal in 2016—before the Commissioner gave public notice.
I conclude that the Commissioner is bound by the Nadler interpretation of section 290.17 for the purposes of this appeal. There is no dispute that CMI accurately applied the Nadler interpretation when it concluded that gain on the sale of goodwill was subject to taxation under Minn. Stat. § 290.17, subd. 2(c). Accordingly, I would reverse the decision of the tax court and remand for the tax court to vacate the Commissioner’s assessment.
THOUGHTS?
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