Today the Internal Revenue Service notified taxpayers that it will soon be issuing regulations addressing the deductibility of state and local tax payments for federal income tax purposes. The IRS also reminded taxpayers that federal law controls the characterization of payments for federal income tax purposes regardless of the characterization of the payments under state law. These forthcoming regulations are targeted at efforts by some states, including New York and New Jersey, to pass laws providing for mechanisms to work around the newly-enacted federal cap on state and local deductions. These “workarounds” typically allow taxpayers to make payments to specified entities in exchange for a tax credit against state and local taxes owed.

The federal Tax Cuts and Jobs Act (TCJA) limited the amount of state and local taxes an individual can deduct in a calendar year to $10,000. The IRS said that the regulations, to be issued in the near future, will help taxpayers understand the relationship between federal charitable contribution deductions and the new statutory limitation on the deduction of state and local taxes. The IRS also warned that it is continuing to monitor other legislative proposals being considered to ensure that federal law controls the characterization of deductions for federal income tax filings. The limitation imposed by the TCJA applies to taxable years beginning after December 31, 2017, and before January 1, 2026.

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The State of Minnesota has joined the growing list of states that are criminally prosecuting business owners for using “zapper” programs to commit tax evasion.  Yesterday the Minnesota Department of Revenue and the St. Louis County Attorney’s Office announced the convictions of a Duluth restaurant and its owners for tax crimes based upon their use of sales suppression software.  This represents the first time that Minnesota has criminally prosecuted anyone for using a zapper.

Commonly called “zappers,” sales suppression software programs run on a point-of-sale computer or cash register and are used to secretly delete some or all of a restaurant’s cash transactions and then reconcile the books of the business. The result is that the company’s books appear to be complete and accurate, but are in fact false because they reflect fewer sales than were actually made. Business owners using zapper programs often maintain two sets of books, in order track the business’ real revenue. A recent article published by BNA estimates that tax-zapping software costs states $21 billion in taxes annually and that 30 percent of the electronic cash registers, or point-of-sale systems, in the United States have a zapper installed.

The restaurant in question, Osaka Sushi Hibachi & Steak House, is owned by Dan Xu and Zhong Wei Lin.  Dan Xu pleaded guilty to one felony count of aiding in the filing of false tax returns.  Zhong Wei Lin pleaded guilty to one felony count of failing to pay sales tax.  The court stayed prison sentences for both individuals in lieu of the immediate payment of restitution in full and a year of probation.  The restaurant itself pleaded guilty to two felony counts of aiding in the filing of false tax returns and fifteen felony counts of failing to pay sales tax.  The court ordered the corporation to pay restitution as well.  All three defendants paid restitution in the total amount of $292,760.

During their plea hearing, Xu and Lin admitted to intentionally using “zapper” computer software in the point of sale system at their restaurant.  The software, which was called “Happy World,” was contained on a thumb drive that was discovered by investigators during a search of the restaurant.  The Happy World software automatically created a second set of books that removed line items from cash transactions after the fact, allowing the business to underreport its monthly sales and avoid paying sales tax collected from customers.

“These are first-of-their-kind convictions in Minnesota and highlight our investigators’ efforts to combat the growing use of sales suppression software,” said Revenue Commissioner Cynthia Bauerly.  “These convictions demonstrate our determination to level the playing field so that businesses who report and pay their fair share of tax don’t have to compete with those who break the law.”

“Deliberately failing to turn over sales taxes collected increases the tax burden on all residents.   We hope this case sends a message to others engaging in this kind of behavior that it will not be tolerated, and you will be prosecuted when caught,” said St. Louis County Attorney Mark Rubin.

As we have previously reported, state revenue departments and attorneys general (and not the Internal Revenue Service) are leading the effort to combat the use of zappers.  More than half of the states have now enacted laws criminalizing the use of sales suppression devices, and in the last two years, authorities in Washington, Michigan, Illinois, and Connecticut have successfully prosecuted criminal cases against businesses and their owners – primarily in the restaurant industry.  The Minnesota case is yet another example of aggressive action undertaken recently by state authorities against zappers, and should serve as a stern warning to business owners using (or considering using) such technology.

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A number of parties have filed amicus curiae briefs in South Dakota v. Wayfair, a case that could substantially reshape the state sales tax landscape.  See here.  Perhaps one of the most interesting amicus briefs was filed by a group of U.S. Senators who support South Dakota in its urging the Supreme Court to overturn the Quill Corp. v. North Dakota physical presence standard.  The Senators are Heidi Heitkamp from North Dakota, Lamar Alexander from Tennessee, Richard Durbin from Illinois, and Michael Enzi from Wyoming – two Democrats and two Republicans.

The Senators argued that, as of 2015, there were almost $26 billion in uncollected sales and use taxes because of Quill.  Merchants with physical locations in the Senators’ states are at an economic disadvantage because they must charge higher prices than out-of-state retailers who need not collect tax.  The Senators noted that their states –North Dakota, Tennessee, Illinois, and Wyoming – rely heavily on state sales taxes for revenue.  As a result, when Wayfair makes sales in those states, the Senators argued, Wayfair has a significant price advantage over businesses with physical presences in those states because it is not required to collect those state taxes under Quill.

The Senators emphasized that Justice Kennedy has said that Quill was “questionable even when decided, [and] now harms States to a degree far greater than could have been anticipated earlier.”  Direct Mktg. Ass’n v. Brohl, 135 S.Ct. 1124, 1135 (2015) (Kennedy, J., concurring).

The Senators also tried to persuade the Court that there would be no confusion if the Court overturned the bright-line rule in Quill.  First, they argued that there is little evidence that states would pass burdensome use tax collection laws if Quill were overturned.  According to the Senators, the same internet technologies that make Quill problematic—because they facilitate large scale remote sales that deprive states of sales tax revenue they would collect from brick-and-mortar retailers—have driven down compliance costs, which reduces the likelihood that state laws would impose significant costs on remote sellers.  Second, the Senators argued that the overturn of Quill would not mean the Court could not protect interstate sellers though other doctrines, such as the balancing test in Pike v. Bruce Church, Inc., 397 U.S. 137 (1970).  Third, Congress, the Senators argued, is standing by to act if states overstep by imposing harsh burdens on out-of-state retailers.  This last point is interesting, but it is worth questioning whether it is persuasive, because Congress has yet to legislate Quill away, despite the fact that it has had many years to do so.  As a result, it is worth considering whether Congress would get involved.

The Supreme Court will hear oral arguments April 17, 2018.

As clients reach retirement age, many often consider a change in their domicile as part of their retirement plan. Aside from the warmer winters, Florida is a popular state for change of domicile because it has no income tax and no state inheritance tax. Another important aspect of becoming a Florida resident is the Florida Homestead Exemption provided by the Florida Constitution. In addition to allowing for a reduction in local real estate taxes, the Homestead Exemption also provides that the homestead is exempt from claims of creditors of the Florida resident.

Illustrated "Welcome to Palm Beach, Florida" Retro Poster.Most times, the tax authorities challenging the change in domicile are from the state the taxpayer is leaving, since they are losing a taxpayer, rather than the new state. For example, New York, Pennsylvania and New Jersey have a 183-day rule which provides that if you are present in the state for 183 days you are deemed to be a resident for income tax purposes. This means that you would have to pay income tax as a resident if you are present in that state for 183 days. Florida, on the other hand, does not have a 183-day rule for purposes of determining whether you are a resident. So it is often the exit state that challenges a change in domicile when the taxpayer files a final resident return.

In the recent Florida case of Ramos v. Motamed, decided by the Circuit Court for Palm Beach County, the taxpayer’s change of domicile was challenged in the destination state of Florida rather than the exit state of California. The case was not initiated by Florida. Rather, it was a creditor seeking to enforce a judgment against the debtor. The creditor argued that the Homestead Exemption should not apply to the debtor because he was not really a Florida resident, and therefore should not protect the taxpayer’s luxury condominium from being used to satisfy the creditor’s judgment.

The taxpayer did all of the usual steps to establish a new domicile, such as obtaining a property in the state, changing his voter registration, obtaining a Florida driver’s license and even obtaining a new local library card.

However at trial, the creditor provided other evidence indicating that the debtor did not actually move to Florida. In particular, he presented gym records showing that the debtor attended his gym in California 300 out of 365 days in 2015. The court determined that based on this evidence, the taxpayer did not actually change his domicile to Florida. He was therefore not entitled to Florida’s Homestead Exemption, and his condominium could be used to satisfy the creditor’s judgement. The property was listed for judicial sale and sold shortly thereafter.

If you are considering a change in your state of domicile, this case shows that while changing your driver’s license, voter registration and other administrative details are relevant factors, the most important thing is that you actually move to the new state.

At least for this one taxpayer, who loved to go to the gym, you could say that his attempt to change domicile was an exercise in futility which did not work out.

The New Jersey legislature may enact a law that would create a tax amnesty program for New Jersey taxes.  If enacted, the amnesty program would not exceed 45 days or end later than June 15, 2018.  Under the amnesty program, a taxpayer who previously failed to pay New Jersey tax could pay the deficiency and only half the accrued interest by May 1, 2018.  Eligible taxpayers, however, who choose not to participate in the amnesty program would be subject to an additional 5% penalty.  In addition, participating taxpayers would not be subject to civil or criminal penalties related to the New Jersey taxes.

The amnesty program, however, would only apply to New Jersey tax returns due between February 1, 2009 and January 1, 2018.  Taxpayers under criminal investigation for a New Jersey tax matter would not be eligible for the program.  If New Jersey enacts the amnesty program, it will be a good opportunity for taxpayers to address outstanding New Jersey tax issues.

Calling it the largest sales suppression software case in state history, Washington State Attorney General Bob Ferguson announced the filing of criminal charges last week against the owner of six restaurants for allegedly using illicit point-of-sale software to delete cash transactions and pocket more than $5.6 million in sales tax. The charges include six counts of first-degree theft and three counts of possessing and using sales suppression software, commonly known as a “zapper,” which is illegal in the state of Washington. This case is yet another example of aggressive action undertaken recently by state authorities against zappers, and should serve as a stern warning to business owners making use of such technology.

Sales Suppression Software

Commonly called “zappers,” sales suppression software programs run on a point-of-sale computer or cash register and are used to secretly delete some or all of a restaurant’s cash transactions and then reconcile the books of the business. The result is that the company’s books appear to be complete and accurate, but are in fact false because they reflect fewer sales than were actually made. Business owners using zapper programs often maintain two sets of books, in order track the business’ real revenue. A recent article published by BNA estimates that tax-zapping software costs states $21 billion in taxes annually and that 30 percent of the electronic cash registers, or point-of-sale systems, in the United States have a zapper installed.

State of Washington v. Salvador Sahagun

According to the charging documents (available here, here, here, and here), the defendant, Salvador Sahagun, operated six restaurants in West Seattle, Broadway, Greenlake, Fremont, Lynnwood, and Marysville. During an audit, an auditor with the Washington State Department of Revenue found that point-of-sale records from these restaurants did not match with tax returns submitted by Sahagun. The auditor also found that the majority of sales receipts were missing from Sahagun’s point-of-sale system.

The press release announcing the charges notes that Department of Revenue employees, suspecting that Sahagun was using sales suppression software, visited the seven restaurants on several occasions and paid cash for their meals. The auditor then compared the employees’ receipts with the receipts on the point-of-sale system to determine whether the transactions existed and the amounts matched. The auditor found that three of the restaurants were using sales suppression software to delete or underreport cash transactions. The auditor determined that the other three locations also owed sales tax. The amount of taxes owed from each of the six locations ranged from $43,339 to $2,197,460. In total, the auditor determined that the owner owed $5,615,497 to the state.

State of Washington v. Yu-Ling Wong

While the case filed against Sahagun may be the largest in Washington state history, it is not the first. In February 2016, Washington’s Attorney General filed what he called the “first-of-its-kind” criminal case against a Bellevue restauranteur, Yu-Ling Wong, for using sales suppression software to avoid paying nearly $400,000 in state sales tax. That case began as a routine audit by the Washington State Department of Revenue, which trains its auditors to detect the use of revenue suppression software. Auditors noted an unusual change in cash receipts, as compared to the restaurant’s historical cash receipts, determined that the restaurant’s point-of-sale system could not be trusted, and eventually uncovered the use of Zapper software, which had been provided by a software salesman named John Yin. Yin worked for a Canadian company called Profitek, which sold point-of-sale systems for the hospitality and retail industries. The audit was thereafter referred for criminal prosecution, and the Washington Attorney General executed a search warrant at Yin’s residence. During a law enforcement interview conducted during execution of that search warrant, Yin admitted he sold the Zapper software in approximately 2007 and trained Wong in how to use it.

In August 2016, Wong pleaded guilty to first-degree theft and unlawful use of sales suppression software. The court ordered Wong to pay $300,000 in restitution to the Washington Department of Revenue. In addition, Wong’s business entered a corporate guilty plea to first-degree theft, unlawful use of sales suppression software, and filing a false or fraudulent tax return. In an unusual provision, both Wong and the business are subject to monitoring by the Department of Revenue for a period of five years.

United States v. John Yin

As a result of Washington’s investigation and prosecution of Yu-Ling Wong, the Justice Department announced federal criminal charges against John Yin in December 2016. According to the publicly-filed charging document and guilty plea agreement, Yin worked as a salesman for Profitek from at least 2009 through mid-2015. In addition to its Canadian headquarters, Profitek has offices in China and a growing dealership network across North America. Profitek designed, marketed, sold, and supported revenue suppression software (RSS) – commonly referred to as a “zapper” – as an “add-on” to its Profitek point-of-sale software. The RSS functioned only with the Profitek POS software.

Yin acknowledged in his guilty plea agreement that he successfully sold the POS software, and assisted in the widespread distribution of the Zapper add-on, to dozens of customers in and around Seattle over the course of several years. The Zapper software could only be ordered from a supplier in China, so Yin would put his clients in touch with the Chinese company and facilitate their purchase of the software. Yin also serviced the Zapper software once his clients purchased and installed it.

Yin further admitted that his clients’ use of Zapper software allowed them to consistently and significantly underpay their various federal, state, and local taxes, including business and occupation taxes, Social Security and Medicare taxes, and federal income taxes. The plea agreement stated that eight restaurants in the Seattle area were audited by the Washington State Department of Revenue and found to be using Yin’s Zapper software. The total amount of state sales and federal income taxes avoided by these establishments during the period 2010 through 2013 was $3,445,589.00.

Yin entered a guilty plea on December 2, 2016, to wire fraud and conspiracy to defraud the U.S. government. Yin agreed to make full restitution, in the amount of $3,445,589, to the IRS and Washington state. He was eventually sentenced to 18 months in prison.

Other States’ Efforts to Combat Zappers

Many states in addition to Washington have passed laws outlawing the use of revenue suppression software, including Michigan, Illinois, Connecticut, Florida, Georgia, Utah, and West Virginia, and others — like Mississippi — are considering proposals to enact such laws. The Washington state law, passed in 2013, makes it a class C felony for anyone to “sell, purchase, install, transfer, manufacture, create, design, update, repair, use, possess, or otherwise make available” software or hardware that deletes transactions.

While Washington state appears to be taking the lead in prosecuting business owners who use zappers, it is not alone in that effort. In December, Michigan Attorney General Bill Schuette announced that a sushi restaurant outside Detroit has been ordered to pay nearly $1 million in restitution and to serve a five-year sentence of probation for embezzling sales tax paid by customers and underreporting its income. The restaurant, Sushi Samurai Inc., entered a guilty plea and its owners, Dong and Christina Chang, also pleaded guilty to filing false monthly sales tax returns and filing false joint income tax returns.

In August 2017, the Illinois Attorney General announced that a Chicago restaurant owner was charged with underreporting sales by $1 million. The charges alleged that the defendant used a zapper to falsify electronic sales records in order to avoid paying the full amount of sales and use taxes owed each month. This case was the first zapper prosecution in Illinois, which banned sales suppression software and devices in 2013.

In July 2017, Connecticut’s Department of Revenue Services arrested and charged a New Haven restauranteur with various offenses for using sales tax suppression software. According to a press release announcing the charges, this was the first time the State of Connecticut has charged an individual for using “zapper” software.

Paging the Internal Revenue Service

Conspicuously absent from recent coverage of state efforts to detect, and prosecute, businesses and individuals who employ sales suppression technology is the Internal Revenue Service. Businesses that use zappers to avoid paying sales taxes are presumably underreporting their receipts for federal income tax purposes as well, thereby providing the IRS with an opportunity to at least audit income tax returns if not investigate potential federal tax crimes. Other than the federal prosecution of zapper salesman John Yin, however, the federal government does not appear to be playing a significant role (at least publicly) in the ever-widening crackdown on zappers by state lawmakers and prosecutors. In a few of the state cases, IRS agents appear to be playing no more than a supporting role to state investigators. While we expected a wave of federal prosecutions to follow the Yin case, so far that has not happened. One can only wonder whether the IRS will join the anti-zapper bandwagon or allow the states to continue to lead this fight.

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The U.S. Supreme Court has scheduled oral arguments for April 17 in South Dakota v. Wayfair, a case that could dramatically reshape the sales tax landscape for online retailers.  As previously reported, under current Supreme Court precedent in Quill Corp. v. North Dakota, a state may compel a business to collect its sales taxes only if the business has some physical presence in the states.  South Dakota v. Wayfair directly challenges Quill – which was decided in 1992, before internet sales became what they are today.  States strongly object to the Quill standard because it cuts into their tax revenue, since they cannot impose sales tax collection obligations on out-of-state online retailers who sell to in-state customers.

South Dakota filed its brief on the merits on February 26; Wayfair Inc. must file its brief by March 28.  We continue to monitor developments in South Dakota v. Wayfair and provide further updates.

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The Pennsylvania Department of Revenue this week will start mailing “non-participation penalty assessments” to delinquent taxpayers who failed to participate in the 2017 Tax Amnesty program, Revenue Secretary Dan Hassell announced yesterday. “Individuals and businesses that failed to take advantage of the program will be assessed a 5 percent penalty on their unpaid amnesty eligible delinquencies, as the law requires,” Hassell said. “The department is taking the appropriate steps to ensure that delinquent taxpayers are aware of their outstanding liabilities and the additional penalties they now face.”

Act 84 of 2016 authorized the Tax Amnesty program to net an estimated $100 million for the 2016-17 fiscal year budget. The program exceeded that estimate by providing $130.4 million in net revenue to the Commonwealth of Pennsylvania. The program ran for 60 days, between April 21 and June 19, and allowed eligible individuals and businesses to pay past-due state taxes while having all the penalties and half of the interest waived. Act 84 required the Department of Revenue to notify all known delinquent taxpayers in writing of the existence of the Tax Amnesty program. As a result, the department mailed notification letters to approximately 800,000 known delinquent taxpayers. The statute also called on the department to publicize the program to maximize public awareness and participation.

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