Real Estate Tax Update
Key Tax Savings Strategies (explained below)
Business Privilege Tax
Contractors, subcontractors and other businesses should apply for refunds of municipal business privilege taxes paid during the last 3 years imposed by municipalities that are not where they are headquartered or have a permanent branch office.
Contractors, subcontractors and other businesses headquartered in a municipality that has no business privilege tax have a slight competitive advantage (averaging 0.3% of their gross receipts) over contractors and subcontractors and other businesses located in municipalities that impose a business privilege tax.
Contractors, subcontractors and other businesses should seek a refund of all business privilege taxes paid during the last 3 years imposed by Pennsylvania municipalities on gross receipts earned outside of Pennsylvania
Sales Tax Owners, contractors, and subcontractors should not pay sales tax on expenditures related to sewer lines being dedicated to a municipal government or its sewer authority.
Contractors and subcontractors should carefully review their bids and executed construction contractors to determine if any items being purchased for projects for charities and governmental organizations qualify as exempt “building machinery and equipment.” They should submit exemption certificates to the vendors for exempt items and seek refunds for exempt items on which tax was already collected.
Businesses making selling to out-of-state purchasers or purchasing themselves from out-of-state vendors should monitor the national Streamlined Sales Tax Project of states seeking to provide more uniform sales tax statutes and administration and how it will affect their businesses. States are moving to uniformity with the expectation Congress will lift the ban on the imposition of sales tax collection responsibilities on Internet and other out-of-state vendors.
Owners, contractors, subcontractors and other businesses should determine whether they have obtained the maximum annual deduction under Section 179 of the Code for purchases of personal property (including off-the-shelf software).
Building owners and commercial tenants should consider the favorable effect on their project budgets of the shorter 15 year depreciation schedule for leasehold improvements and restaurant expenditures that qualify under the 2004 act.
_The new Code Section 199 tax deduction for domestic manufacturing includes construction and software development activities. Taking this deduction will increase after tax profit and cash flow.
Pennsylvania Municipalities Business Privilege Tax Cases Impact Contractors and Other Businesses
In the business privilege (gross receipts) tax area, the Pennsylvania Supreme Court and the Commonwealth Court have each recently handed down a significant decision involving general contractors that have broader implications in applying to other businesses who perform services or conduct sales outside of Pennsylvania or outside of the municipality where their base of operations is located. In Northwood Construction Company v. Township of Upper Moreland, 856 A.2d 789 (Pa. 2004), as amended September 14, 2004 (originally decided September 2, 2004), the Pennsylvania Supreme Court affirmed the portion of the Commonwealth Court’s opinion reported at 802 A.2d 1269 (Pa. Cmwlth. 2002), holding that the township where the contractor had its permanent base of operations could tax the entire gross receipts of the contractor where it had no bona fide offices outside the township. The court rejected the contractor’s characterization of its temporary on-site offices (job trailers) as multiple bases of operations that would require a tax credit under the ordinance. The Pennsylvania Supreme Court, however, reversed the portion of the Commonwealth Court’s opinion that allowed taxation of gross receipts performed outside of Pennsylvania, holding unlike intrastate (Pennsylvania) receipts. The Pennsylvania Supreme Court held that it was unconstitutional to tax interstate receipts (receipts outside of Pennsylvania) even if the jurisdiction where the work was performed did not impose a similar gross receipts tax and even if the contractor did not maintain any permanent offices outside of Pennsylvania. This distinction is based upon the constitutional principle that a state (or its political subdivisions) may not tax more than its fairly apportioned share. Complete Auto Transit, Inc. v. Brady, 430 U.S. 274, 51 L.Ed. 2d 326, 97 S. Ct. 1076 (1977). The Northwood case was appealed by Upper Moreland Township to the United States Supreme Court, docketed to No. 04-1046, but on April 4, 2005, the petition for certiorari was denied.
In a case successfully litigated by Thomas J. Weber of Goldberg Katzman, P.C., V.L Rendina, Inc. v. City of Harrisburg, 859 A.2d 888, 2004 LEXIS Pa. Commw 726 (Pa. Cmwlth. 2004), Petition for Allowance of Allocator filed by the City with the Supreme Court of Pennsylvania on November 5, 2004, docketed to 1010 MAL 2004, the Commonwealth Court held that the city could not tax gross receipts generated from construction in Harrisburg where the only office the contractor maintained in Harrisburg was a job trailer. The court held that this office was not a “base of operations,” so as to authorize the city to impose the business privilege tax. In the Rendina case, the court noted that no meetings were held there, the contractor did not solicit business from there, or control business other than the job itself. Therefore, the court held under Gilberti v. City of Pittsburgh, 511 Pa. 100, 511 A.2d 1321 (1986), that it was not a “base of operations” so as to authorize the imposition of the tax. It is to be noted that in the Northwood case, the contractor did conduct meetings in its job trailers, but the court held they were still not “bases of operations” so as to entitle the contractor to a credit allowed under the township’s ordinance for business privilege taxes paid to jurisdiction where the taxpayer has “bona fide offices.” On November 5, 2004, another panel of the Commonwealth Court, with the President Judge presiding, followed the Rendina case. Sch. Dist. of Scranton v. R.V. Valvano Constr. Co., 863 A.2d 48, 2004 Pa. Commw. LEXIS 808 (Pa. Cmwlth. Nov. 5, 2004).
Because there is a three (3) year statute of limitations under the Local Tax Collection Law, 72 P.S. § 5566b, and the Local Taxpayers Bill of Rights, 53 Pa. C.S.A. § 8431, it is important that contractors file immediately for refunds of business privilege tax imposed by municipalities where their base of operations or a bona branch office (not a field trailer or project specific office) is located. Furthermore, contractors should even file for refunds for business privilege taxes imposed the municipality where their base of operations is located to the extent the taxes are imposed upon gross receipts received from work or sales outside of Pennsylvania. Interest is due on the refunds. Local Taxpayers Bill of Rights, 53 Pa. C.S.A. § 8426. Contact Arnold B. Kogan of Goldberg Katzman, P.C. for advice on seeking refunds.
Pennsylvania Business Tax Reform Commission Report Recommends Tax on Pass-through Entities which are often used to hold real estate
The Commission’s Report, dated June 18, 2004, recommended the continued statutory phase-out of the capital stock tax but also recommended an entity level tax of 2% on all pass-through entities (S corporations, limited liability companies and partnerships) subject to being granted a net operating loss deduction. So long as this is based on net income, leveraged real estate held by a pass-through entity would not be negatively affected. But, once the depreciation deduction is used up, and the entity begins to report taxable income, an entity level tax would reduce the benefits of the pass-through.
Pending Pennsylvania Tax Legislation
Governor Rendell has proposed continuing the phase-out of the capital stock and franchise taxes. The House Republican Majority Leadership introduced House Bill No. 615 (Printer’s No. 1219), referred to the Committee on Finance on February 16, 2005, accelerating the phase-out schedule, including the reduction of 2006 rate for those taxes from its scheduled reduced rate of 4.99 mills to 2.99 mills. See also the more recent leadership House Bill No. 1312 (Printer’s No. 1560), introduced on April 11, 2005, that would also reduce the rate to 2.99 mills. The Senate Republication Majority’s Senate Bill No. 250 (Printer’s No. 308) would reduce the rate only to 4.50 mills. The Governor recommended the current phase-out schedule reducing the 2006 rate to only 4.99 mills from the 5.99 mills 2005 rate.
There is also House Bill No. 802 (Printer’s 964) introduced on March 14, 2005, and referred to the Committee on Finance, that would double the capital stock and franchise tax exemptions from $125,000 to $250,000, effective for 2005 and beyond. While this bill has number of sponsors from the Committee on Finance from both parties, it remains to be seen whether this will receive the Governor’s support and be enacted.
It should be noted that the Tax Reform Commission’s recommendation for the entity level tax on pass-through entities has not yet been introduced in legislative form. It is also not in the Governor’s current budget proposal.
Should the House Bills providing for the substantial capital stock, franchise tax rate reduction and increased exemption be enacted, Pennsylvania will be well on its way to eliminating the capital stock and franchise taxes as an influence on the selection of an entity for holding real estate or operating a business.
Streamlined Sales and Use Tax Project
Nationwide, there is a Streamlined Sales and Use Tax (SST) Project that is in response to the Federal ban on requiring out-of-state vendors to collect tax on Internet Sales. This ban is in the form of a 1992 decision of the United States Supreme Court prohibiting states from requiring out-of-state vendors to collect tax on sales to residents of a state where the vendor does not have a physical presence or nexus in the state seeking to impose the requirement. Quill v. North Dakota, 504 U.S. 298 (1992). The Supreme Court held that it was an unconstitutional imposition upon interstate commerce due to the 7,500 separate sales tax jurisdictions with their myriad of provisions. Congress also enacted a ban under its constitutional powers to regulate interstate commerce. Internet Tax Freedom Act, last extended until November 1, 2003 by the Internet Tax Nondiscrimination Act, Public Law 107-75, 115 Stat. 703, 47 U.S.C. § 609.
To date, this Congressional ban has not been renewed. The Congressional ban on taxation of Internet access was, however, extended until November 1, 2007. Public Law 108-435, 118 Stat. 2615, approved December 3, 2004. And, there is a bill pending in Congress to extend the ban on taxation of Internet access permanently. S. 849, 109th Cong., 1st Sess., introduced by Senator Allen, Senator McCain and others on April 19, 2005. See also H.R. 1684, 109th Cong., 1st Sess. and H.R. 1685, 109th Cong., 1st Sess. Introduced on the same date. In spite of the ban, contractors and other customers purchasing from out-of-state vendors remain liable for the equivalent use tax. Pennsylvania, as with most states, will include a use tax audit whenever it audits for sales tax. This involves the Department of Revenue’s auditor reviewing the business’s purchases during the audit period to make sure either sales tax was collected by the vendor or use tax was remitted directly by audited business. The Streamlined Sales and Use Tax Project, made up of various state governments, seeks to create uniformity in sales tax provisions so that the imposition of sales on out-of-state vendors becomes less onerous, and thus meet the concerns of Congress and the Supreme Court.
Pennsylvania is a participating state in the Streamlined Sales and Use Tax Project, but has not yet joined the Streamlined Sales and Use Tax Agreement and so is it not a member of the SST Implementing States, the project’s governing body. House Bill No. 92 (Printer’s No. 86), Session of 2005, was introduced on January 25, 2005, and last re-referred to the Committee on Appropriations on March 15, 2005, to authorize the Commonwealth to join the SST Agreement. A similar bill was introduced in 2001 (House Bill No. 900 (Printer’s No. 4163), Session of 2001) that passed the House after several revision, but then died in the Senate. However, the Commonwealth would still have to make the changes to its sales tax laws to implement the SST Agreement. Implementing this Agreement would have broader implications than just on Internet and other out-of-state sales tax collections. The Agreement would require changes in various statutory definitions and the administration of exemptions to achieve greater uniformity. Uniform Sales and Use Tax Administration Act, as approved December 22, 2000, and last amended January 24, 2001, Section 6.a. and b., located at the SST Project’s Web site: http://www.streamlinedsalestax.org/library.html. The Agreement’s implementation requires a uniform exemption certificate, but it does not appear to affect the definition of exempt “building machinery and equipment” as discussed below. See the SST Project’s Simplified Exemption Administration Process, 1-12-04v and revised draft of 1-03-05 (see Materials for January 5-7, 2005 Meeting, http://www.streamlinedsalestax.org/library/mtg_0105.htm, available on its Web site. Pennsylvania and other states will be reluctant to enact implementing legislation until Congress indicates a willingness to allow collection of taxes on out-of-state Internet and other vendors if the states achieve a standard of uniformity.
Scope of Pa. Sales Tax Exemption Narrowed for Materials Used in Construction Projects Owned by Exempt Organizations and Governmental Bodies
In Plum Borough School District v. Commonwealth, No. 849 F.R. 2001, 2004 Pa. Commw. LEXIS 773, CCH MULTI-STATE SALES TAX REP. (PA.) ¶ 203-297 (Pa. Cmwlth. Oct. 29, 2004), the court held that the traditional realty-personalty fixture test based on the ease of removal set forth in Beck Electric Construction, Inc., 379 A.2d 626 (Pa. Cmwlth. 1977), affirmed in part, reversed in part, 485 Pa. 604, 403 A.2d 553 (1979), was subsequently legislatively overruled in Section 204 of the Tax Reform Code of 1971, as added by the act of June 29, 2002 (P.L. 559, No. 89), 72 P.S. § 7201(pp). Therefore, under current law, the only exemption exempt organizations are entitled to, for materials used in a real estate project, are those that fall within the statutory definition of the “building machinery and equipment.” The court, in reaching this decision, held that Section 204 was an exemption, not an exclusion, even though that Section was labeled as an “exclusion” in the statute. An exemption is construed strictly against the taxpayer (in this case the contractor who had assigned its refund claim to the School District), while an exclusion is constructed against the taxing body. Therefore, the court construed the provision against the School District which stepped into the shoes of the contractor. This case has not been appealed, because it not only limits the scope of a Pennsylvania Supreme Court decision but it also is based upon an interpretation of what constitutes an exception.
Persons and businesses affected are contractors who now need to include the cost of the sales tax in their bids, and project owners who need to budget those taxes, which are significant, in their construction budgets. Until this case is finalized by no appeal or a disposition by the Pennsylvania Supreme Court, the parties should write a provision in their construction contracts to cover a possible reversal. This should also be addressed in the bid documents. The provision should state, for example, the bid should include sales tax for items not falling within the statutory definition of “building machinery and equipment.” The contract should provide that the governmental entity is assigned the rights of the contractor to obtain the refund (as was done in Plum Borough case) if the case is reversed by a later decision of the Supreme Court of Pennsylvania involving a similar issue or by an act of the General Assembly with an effective date on or before the now taxable items were purchased.
Dedicated Water and Sewer Lines and Other Public Utility Property Exempt from Sales Tax
Contractors and owners turning over water and sewer lines to a municipal authority or other public utility are also entitled to exemption on the cost of such line. Pa. Dept. of Revenue Legal Letter Ruling Nos. SUT-04-024 (Nov. 3, 2004), http://www.revenue.state.pa.us/revenue/cwp/view.asp?A=238&QUESTION_ID=244695; and SUT-04-025 (Nov. 8, 2004), http://www.revenue.state.pa.us/revenue/cwp/view.asp?ASTION_ID=2413=238&QUE77. Also, under City of Philadelphia v. Commonwealth of Pennsylvania, 569 Pa. 381, 803 A.2d 1262 (2002), the Supreme Court of Pennsylvania, in departing from its previous decisions, held that property that is predominantly used by a public utility is exempt from sales tax. No longer do they have to be exclusively used by a public utility.
Federal Taxation – the American Jobs Creation Act of 2004 benefits the Real Estate Industry
The new act contains a number of provisions that benefit real estate activities. The references below are to sections in H.R. 4520, 108th Cong., 2d Sess. (2004), signed into law by the President on October 22, 2004. References are to House Bill, and the Internal Revenue Code (I.R.C.) except where indicated.
_1. Provides domestic (activities in the United States) manufacturing activities (includes construction activities) with a 9 percent (for 2005 and 2006 and only 6 percent in 2007, 2008 and 2009) tax deduction (equivalent to a 3 percent rate reduction) on the lesser of the taxpayer’s Qualified Production Activities Income or taxable income (determined without regarded to section 199. Section 199, I.R.C. § 199. Qualified Production Activities Income is the excess of domestic production (including construction) gross receipts over the sum of the costs of goods sold, other deductions, expenses or losses directly allocable to such receipts; and a ratable portion of deductions, expenses, and losses not directly allocable to such receipts or another class of income. Congress designed this tax benefit to encourage jobs creation and retention; so the Code limits the deduction to no more than 50% of the W-2 wages paid by the taxpayer during the calendar year. I.R.C. § 199(b)(1). The IRS has issued a 37 page notice giving a detailed explanation of the operation of this tax benefit, pending the issuance of regulations for which it is seeking comments. IRS Notice 2005-14 (Feb. 14, 2005), IRS Bulletin 2005-7, http://www.irs.gov/irb/2005-07_IRB/ar08.htm. To some extent this may increase the demand for real estate by providing additional cash flow from reduction in taxes to manufacturers and owners for expansion in the United States._
2. Extends through 2007, the previously enhanced Section 179 expense personal property deduction allowing small businesses to immediate expense up to $100,000 of new investment reduced by the amount of total investment in personal property exceeds $400,000. Both the $100,000 and $400,000 limits are increased for inflation for 2004 and 2005 (in 2004 they were increased to $102,000 and $410,000, respectively. Rev. Proc. 2003-85, I.R.B. 2003-49, 1184). The Act leaves in place the authorizations to use the Section 179 deduction for motels and hotels but does not remove the prohibition against using this deduction for furniture and equipment in apartment buildings or air conditioning and heating units. Section 201, I.R.C.§ 179(b)(5). Off-the-shelf software available for purchase, but not custom software, qualifies for expensing under Section 179(d)(1)(A).
3. Reduces the depreciation period for restaurants (more than 50% of the square footage must devoted to the preparation and seating for on-site consumption) and leasehold improvements from 39 years to 15 years. Sections 211(b) and (c), I.R.C. § 168(e)(3)(E)(v). To date, Pennsylvania has not sought to decouple this faster depreciation (technically still straight line depreciation) from its tax base as it did with the 30% bonus depreciation enacted in the Federal Job Creation and Worker Assistance Act of 2002 (P.L. 107-146). See 72 P.S. § 7401(1). Because this provision is limited to restaurants and leasehold interests that are often involved in community revitalization, the provision stands a better chance of not being decoupled by Pennsylvania and other states. However, older multi-story (3 or more stories) urban buildings where the restaurant only occupies the first floor will fail to meet the 50% of the square footage test. Leasehold improvements do not include any work to the structure such as support beams, floor joists or elevators that are often needed in recycling older buildings. Those items, however, would be included as restaurant property of the project meets the 50% of square footage test.
4. Enhances the use of the passive losses in an S corporation by allowing suspended losses to be transferred incident to a divorce. Section 235, I.R.C. § 1366(d)(2).
5. The beneficiary of a qualified subchapter S trust is now generally allowed to deduct suspended losses under the at-risk rules and the passive loss rules when the trust disposes of the S corporation stock. Previously, the trust was considered the owner, so the suspended losses could have been more easily lost. Section 236, I.R.C. § 1361(d)(1). However, the trust, not the beneficiary, will continue to recognize any gain or loss on the sale, so the actual use of the suspended losses may be limited, since those losses still may not be applied by the beneficiary to the gain on the sale that is passed through to the beneficiary.
(Note, in spite of the new law’s improvements to the S corporation structure, the continuation of the prohibition against a second class of stock which prevents special allocations based on risk or other criteria, and the prevention of shareholder loan guarantees of third-party debt from increasing basis for deducting losses significantly limits the use of this structure in real estate transactions.)
6. Enhances community revitalization by increasing the eligibility for Renewal Communities and the New Market Credit Tax Credit by including a jurisdiction’s 2000 census data in the qualification determination. Section 637 of Senate Amendment, I.R.C. § 1400E(g)(1).
7. Provides that the Alternate Minimum Tax does not impact farmers when they use income averaging to smooth out fluctuations in their annual income. This is done by providing that, in computing AMT, a farmer’s regular tax liability is determined without regard to farmer income averaging. Thus, a farmer receives the full benefit of income averaging because averaging reduces the regular tax while the AMT (if any) remains unchanged. Section 243, I.R.C. § 55(c)(2).
8. Provides several tax relief provisions for timber, including: (a) capital gains treatment for outright sales of timber; (b) safe harbor rules for timber Real Estate Investment Trusts (REITs); (c) expensing of reforestation costs; and (d) an election to treat timber as a sale or exchange. Section 283 of the House Bill and Section 333 of the Senate Amendment, I.R.C. § 631(b).
9. Increases the capital expenditure limit for Industrial Development Bond financing from $10,000,000 to $20,000,000 for manufacturers. Section 301 of Senate Amendment, I.R.C. § 144(a)(4)(G).
10. Increases from 2 to 5 years the minimum holding period for $250,000 exclusion of gain on the sale of a principal residence where that occurs after the owner has received the residence in tax-free exchange under Section 1031 of the Internal Revenue. Section 641 of House Bill and Section 492 of Senate Bill, I.R.C. § 121(d)(10).
11. Institutes a two-year suspension of duties (4.7%) on ceiling fans and other products, since there is no U.S. production. Section 801, amending subchapter II of chapter 99 of the Harmonized Tariff Schedule of the United States, Item No. 9902.84.14, 19 USCS § 1202.
For further information on any of the topics discussed in this article, contact Arnold B. Kogan at Goldberg Katzman, P.C.
*An earlier version of this article appeared in the newsletter of the Section of Real Property Probate and Trust Law of the Pennsylvania Bar Association.