Understanding the burden of proof can make or break a state tax case. “The taxpayer failed to meet its burden of proof” is perhaps the most frequently written phrase in state tax opinions, particularly at the administrative level. Many lawyers, accountants, and even tax practitioners may not have a full understanding of exactly what that means. It is particularly exasperating for taxpayers to hear or read that phrase following long hours of audit review, document production, evidence presentation, and oral hearing testimony. Particularly in state tax cases, it is important to focus on who has the burden of proof, what is the burden of proof, and how can that burden be satisfied?
Which Party Bears the Burden of Proof?
While the burden of proof generally lies with the taxpayer for nontaxable or exempt sales or purchases, the state taxing authority often has the burden of proof on penalties, including fraud penalties and assessments of state tax liabilities against individuals, transferees, successors, and nominees. The state taxing authority also generally bears the burden of proving proper notice; however, proper notice is often satisfied by mailing a notice to the taxpayer’s last known address of record.
What Standard Applies?
Once it is determined which party bears the burden of proof it’s important to ascertain the standard that applies. Knowing whether an item is excluded or exempted from tax goes hand-in-hand with identifying the applicable standard. While many taxpayers and auditors throw around the terms “exempt” and “nontaxable” as if they were synonymous, there is a very important distinction and that distinction has a direct impact on the standard for the burden of proof.
For example, Texas Tax Code Chapter 151 governs Texas Sales Excise and Use Tax, and exemptions are carved out in Subchapter H of Chapter 151. An exclusion from tax—whether a transaction is taxable or nontaxable—requires proof by a preponderance of the evidence. A taxpayer seeking to meet that burden must show that the greater weight of the evidence supports the taxpayer’s position. Establishing a preponderance of the evidence does not necessarily require the taxpayer to bring more witnesses or more pieces of evidence; nonetheless, when all the evidence is weighed and compared, the taxpayer’s evidence must hold greater weight, even if only by a slight amount.
A higher standard generally applies to exemptions. In Texas, that standard is “clear and convincing” evidence. “Clear and convincing” generally indicates that the thing to be proved is highly probable or reasonably certain.” 1 This is a greater burden than preponderance of the evidence, the standard applied in most civil trials, but a lesser burden than “beyond a reasonable doubt,” which is the evidentiary norm for criminal trials.
When an exemption is involved, the higher burden of proof for “clear and convincing” evidence generally requires that documentation be provided, such as completed resale or exemption certificates, to further support an exempt sale. In Texas, taxpayers are given 60 days after receiving official notice to produce or complete any additional resale or exemption certificates that may support an untaxed sale.
When penalties or individual assessments are involved, the taxing authority generally also bears a burden of proof by “clear and convincing” evidence. 2
Presumptions and Shifting the Burden of Proof
The burden of proof can shift from one party to the other in many instances.
As a general matter, all of a taxpayer’s receipts or deposits are presumed taxable unless the taxpayer can show—through contemporary business records, accounting data, or other evidence—that the source of income is nontaxable or exempt. A state taxing authority’s assessment, once final, generally bears the presumption of validity.
In Texas, a presumption of taxability applies to sales of tangible personal property, but no such presumption applies to sales of services. Some states do not impose sales tax on services at all. Other states, like Texas, impose sales tax on listed services. 3 The Texas Comptroller bears the initial burden of proving that a particular service fits into one of the categories of taxable services enumerated by statute. Then the burden shifts to the taxpayer to carve out an exclusion from tax or prove an overriding exemption.
Burden-shifting provisions may also be written into statutes or interpretive regulations. For example, Texas applies a 5% rule to mixed services. The 5% rule is generally established by rules promulgated by the State Comptroller. If more than 5% of a mixed or bundled charge pertains to taxable goods or services, the entire charge is generally presumed taxable. The taxpayer may overcome the presumption by producing evidence such as bid sheets, photographs, blueprints, plans, cost analysis, testimony, or other evidence indicating the portion, if any, that should be subject to tax.
The Multistate Tax Commission promulgates universal forms taxpayers in various states may issue to vendors providing services that benefit multiple locations. Multistate exemption certificates and direct payment permit exemption certificates also shift the burden of proof from the vendor to the purchaser. Once a vendor accepts a completed certificate from a customer in good faith, the burden then shifts to the customer to accrue and remit tax, either to multiple states, as in the case of a multistate exemption certificate, or in accordance with its reporting agreement with the state taxing authority, as in the situation involving a direct payment permit exemption.
Statutory Changes Can Also Shift or Modify the Burden of Proof
The legislature may promulgate statutory changes that shift or modify the burden of proof. In 2017, the Texas legislature changed the law regarding the sales and use tax obligations of taxpayers selling and purchasing temporary help services.
Historically, the Texas Tax Code under section 151.057(2) has excluded from sales tax charges for services performed by employees of temporary employment services. Temporary employment services were defined by reference to Labor Code section 93.001: this provision allowed an employer to supplement an existing work force on a temporary basis when the service is normally provided by the employer’s own employees, the employer provides all supplies and equipment necessary, and the help is under the direct or general supervision of the employee to whom help is furnished. For these services to be excluded from tax, the Comptroller imposed on the seller and purchaser of the service the burden of proving the services at issue met all of the requirements of a temporary help service.
Senate Bill 745, passed by the Texas Legislature in the 8th Regular Session, changes the exclusion from tax into an exemption with a higher burden of proof (by clear and convincing evidence) and imposes additional requirements on businesses seeking to qualify as host employers, effective September 1, 2017.
These statutory changes were prompted by a lawsuit involving taxable insurance services. Claims adjustment services are a type of insurance service, which is included on the statutory list of taxable services in Texas Tax Code section 151.0101. In Allstate Insurance Co., 4 the court determined the insurance carrier owed tax on claims adjustment services provided by outside independent contractors because the taxpayer didn’t provide all of the services and equipment necessary for the contractors to perform their work (e.g., electronic voice mail, cell phones, laptop computers, estimating systems, etc.) and therefore they didn’t meet the qualifications of temporary employment service workers. Insider claims adjusters’ services, in contrast, were not taxable because they were stationed within the carrier’s own facilities.
Under the revised statute, which transitioned the exclusion of Texas Tax Code section 151.057 to an exemption under Subchapter H of the Texas Tax Code section 151.3503, a service performed by an employee of a temporary employment service for a host employer to supplement the host employer’s existing work force on a temporary basis is exempt if:
(1) The service is normally performed by the host employer’s own employees;
(2) The host employer provides all supplies and equipment necessary to perform the service, other than personal protective equipment provided by the temporary employment service pursuant to a federal law or regulation;
(3) The host employer does not rent, lease, purchase, or otherwise acquire for use the supplies and equipment, other than personal protective equipment, from the temporary employment service or an entity that is a member of an affiliated group of which the temporary employment service is also a member; and
(4) The host employer has the sole right to supervise, direct, and control the work performed by the employee of the temporary employment service as necessary to conduct the host employer’s business or to comply with any licensing, statutory, or regulatory requirement applicable to the host employer.
The revised statute imposes a higher burden of proof on the service provider to show that the service is exempt. That higher burden may shift to the purchaser claiming an exemption to prove that all of the required statutory elements existed during the time frame during which the purchaser was acquiring the services of the temporary employment service. Under Texas law, “[a] sale is exempt if the exemption certificate is accepted in good faith at the time of the transaction and the seller lacks actual knowledge that the claimed exemption is invalid.” 5 Therefore, a temporary help service provider accepting a completed certificate in good faith at or around the time the transaction occurred should be able to rely upon its customer’s representation that its customer (the host employer) met all of its requirements to provide tools, equipment, supervision, and resources referenced in the statute.
Burden of Proof Versus Burden of Production
Taxpayers should not become too complacent when the state taxing authority bears the burden of proof. A taxpayer is generally required to offer adequate books and records for audit; otherwise, the state taxing authority is granted the leeway to estimate an assessment based on alternative information.
For example, Texas Tax Code section 111.0041 provides that a taxpayer must produce contemporaneous records and supporting documentation appropriate to the tax or fee for the transactions in question to substantiate and enable verification of the taxpayer’s claim related to the amount of tax, penalty, or interest to be assessed, collected, or refunded in an administrative or judicial proceeding. Contemporaneous records and supporting documentation appropriate to the tax or fee may include, for example, invoices, vouchers, checks, shipping records, contracts, or other equivalent records, such as electronically stored images of such documents, reflecting legal relationships and taxes collected or paid. The legislative history indicates that summary records would be insufficient to substantiate a claim without supporting contemporaneous records.
If a taxpayer fails to produce records, or fails to produce adequate business records, the statute authorizes the Texas Comptroller to estimate tax liabilities based upon any information available. 6 Estimation includes sample projections based upon a review of a sample of transactions within a population and extrapolation of those values to the population as a whole. Estimation also includes using third party records to calculate the amount the Comptroller alleges the taxpayer owes.
In a 2013 case, FM Express Food Mart, 7 the court upheld a Comptroller assessment against a convenience store based upon an estimate of sales calculated using third-party purchase records reported to the Comptroller by its alcohol and tobacco vendors. The auditor examined a sample of the records, applied a standard markup, made adjustments for spoilage and food stamp purchases, and assessed tax on the difference between the estimated sales and the reported sales. The taxpayer challenged the estimation methods and contended it had not received adequate notification of the sampling methodology, but the taxpayer was unable to present summary judgment evidence showing that the estimate was “unreasonable, excessive or that it was reached arbitrarily and capriciously,” so it was determined to be within the Comptroller’s authority to uphold the estimate.
In Ayeni, 8 another 2013 case, the court further held that a Comptroller’s certificate of delinquency satisfied the taxing authority’s initial summary judgment burden, shifting the burden to the taxpayer to raise a fact issue in order to avoid an adverse summary judgment. The taxpayer’s verified denial in answering the lawsuit was insufficient to shift that burden without evidence controverting the alleged liabilities. Conclusory affidavits merely asserting that the taxpayer’s amounts were correct and the Comptroller’s amounts too high did not provide sufficient proof to overcome the assessment.
Knowing the burden of proof and which party bears that burden for each element of a case is critical to effective trial preparation. In evaluating trial strategy and gathering evidence it is important for clients to understand who bears the burden, the standard applying to evaluate that burden, and what evidentiary deadlines might restrict a taxpayer’s ability to provide relevant evidence to establish the burden. State tax cases may, especially at the administrative level, shift on the burden of proof. Beware of legislative changes, as well: they may impose a higher burden on the taxpayer, such as additional documentation or exemption requirements. ■
1 Black’s Law Dictionary (10th ed. 2014) (defining evidence standards).
2 See, e.g., 34 Tex. Admin. Code Ann. § 1.40, which imposes a burden of proof by “clear and convincing evidence” when the Texas Comptroller seeks to impose the 50% additional tax penalty for willful or fraudulent failure to pay tax.
3 Tex. Tax Code Ann. § 151.0101.
4 Allstate Ins. Co. v. Hegar, Tex. App. – Austin (Feb 18, 2016), Cause No. 03-13-00351-CV (pet. denied Mar. 31, 2017).
5 Comptroller Rule 3.287 (d)(2).
6 Tex. Tax Code Ann. §151.503.
7 FM Express Food Mart, Inc. v. Combs, ___ S.W.3d ___ (Tex. App. – Austin 2013), Cause No. 03-12-00144-CV.
8 Ayeni v. State, ___ S.W.3d ___ (Tex. App. – Austin 2013), Cause No. 03-11-00604-CV.