Here’s a hint: it’s the same tax that requires local tax officials and taxpayers to navigate more than 60 different exemptions and caps housed in multiple chapters of state and federal law to determine exactly how much tax is owed for a particular business activity. 

If you guessed privilege license taxes, it’s your lucky day.

Of course if you got this question correct it means you are probably the unlucky person charged with administering this tax.  Which means you are the person responsible for counting vending machines and restaurant seats and defining the term “bowie knife” and distinguishing between the sale of sandwiches and the sale of crackers with peanut butter filling and answering a hundred other seemingly trivial questions on which local privilege license tax obligations often rest.

I’ve blogged about the administration of local privilege license taxes here, here, and here.  Those posts dealt mostly with privilege license taxes based on gross receipts, meaning they are calculated as a percentage of a business’ income.

But not all businesses can be subject to gross receipts privilege license taxes.  That approach is permitted only for businesses that are not covered by Schedule B, the nickname given to a collection of statutes that either exclude a particular type of business from local privilege license taxes or set the maximum level for local privilege license taxes on a particular type of business. 

Repealed But Not Forgotten

To make things even more confusing, most of the Schedule B statutes were repealed in 1997 but remain effective because they are specifically incorporated into the statutes that authorize city and county privilege license taxes.

G.S. 160A-211, the authorizing statute for city privilege license taxes, lists 30 different repealed Schedule B exclusions and limitations, while G.S. 153A-152, the authorizing statute for counties, references 11 repealed Schedule B provisions. 

One reason privilege license tax administration can be so confusing is that the text of these repealed-but-still-effective statutes cannot be found in the current N.C. General Statute listings. To learn exactly what level of taxes these repealed statutes permit, tax officials either need to hunt down an old copy of the statutes or read a School of Government publication such as this one. (Try this compilation of the repealed statutes or the privilege license tax treatise authored by my former colleague Bill Campbell that explains each of these restrictions.)  This extensive reliance on repealed statutes—unique in North Carolina local government law—does great harm to the transparency and efficiency of the privilege license tax scheme.

Local privilege license taxes are also limited by several Schedule B statutes that were not repealed and remain in Chapter 105 of the N.C. General Statutes. Additional restrictions reside elsewhere in state and federal law.

A Floor, Not a Ceiling

It is important to note that local governments are not required to levy privilege license taxes on Schedule B businesses at the maximum levels created by those statutes.  Schedule B imposes a ceiling on these taxes, not a floor, meaning cities are free to set their taxes on the covered businesses at lower levels or even exempt those businesses entirely.   Most of those ceilings are very low, however ($12.50 for the sale of gasoline, $10 for building contractors), and as a result most local governments that levy privilege license taxes adopt the maximum tax permitted on Schedule B businesses.

The privilege license tax’s reliance on repealed statues creates some seemingly illogical results.  For example, farmers who sell their own produce at roadside stands or other temporary locations are excluded from Schedule B’s definition of itinerant merchants in the repealed-but-still-effective G.S. 105-53.  This means they are not subject to the $100 maximum tax permitted on itinerant merchants. 

But the fact that farmers selling their own produce fall outside of any Schedule B category means that cities may tax them any way they deem appropriate.  This may result in these farmers being taxed as “regular” retailers and paying a higher tax (often on a gross receipts basis) than they would have if they were classified as itinerant merchants.  While this was clearly not the intent of the General Assembly when it originally adopted the itinerant merchant provisions, the plain language of the relevant statutes leaves little room for any other conclusion. 

A city could choose to exempt farmers selling their own produce from all local privilege license taxes, which would more closely reflect the General Assembly’s likely original intent.  None has, as far as I know, meaning that in many North Carolina cities farmers selling their own produce are subject to “regular” retail privilege license taxes.

A Master List

Linked here is my attempt to list all exclusions and maximums for local privilege license taxes. Most of these restrictions are created by Schedule B. But a mishmash of other state laws and even some federal laws also restrict local privilege license taxes.  On the attached list, the non-Schedule B restrictions are distinguished by highlighted text.

This list of privilege license tax restrictions remains a work in progress and would benefit greatly from your input.  There might be more restrictions lurking in different corners of the General Statutes (or U.S. Code) that I missed.  Let me know if you find any errors or omissions and I will happily update the list.

First, the good news: home sales, home prices, and home construction starts are up. 

The North Carolina Association of Realtors reports that home sales through the end of March rose 22% compared to a year ago.  Prices also increased, up 7% from 2012.  Inventory is tight, which is encouraging more new construction both nationally and locally:  home construction across the country is at its highest pace in 5 years, while residential building permits issued in Mecklenburg County have increased more than 300% since 2011 in both number and dollar value.  

Now, the bad news.  Property tax bases in North Carolina communities are still suffering.  

For decades, local governments in North Carolina reasonably expected increases of 20% to 35% in their tax bases after reappraisals.  Those expectations evaporated following the Great Recession of 2008.  Since then, numerous counties have suffered drops in their tax bases following reappraisals.  This trend continues in 2013. 

An informal survey of the counties that conducted reappraisals effective January 1, 2013 produced this list of estimated changes to county tax bases: 

 The two counties with the largest tax base losses are of course coastal counties with lots of high-end vacation homes.  Currituck and Dare counties got huge bumps in their tax bases when they last reappraised their real property in 2005 and since then have maintained two of the lowest property taxes in the state. Currituck’s rate has been $.32 for years while Dare’s rate was $.26 immediately after its 2005 reappraisal and $.28 since 2010.  

Not any longer.  The two counties have yet to set their tax rates for 2013-2104, but they are sure to jump up closer to the statewide average of $.62.  Consider the situation in neighboring Brunswick County, which increased its property tax rate by 80% following a 2011 reappraisal in which the county’s real property tax base dropped by nearly a third. 

In the past two years tax rates also increased subtantially in Carteret County ($.23 to $.30 in 2011) and New Hanover County ($.46 to $.55 in 2012).  Nor is this phenomenon is limited to the coast.  Up in the mountains, Henderson and Rutherford counties raised their tax rates by more than 10% after recent reappraisals.  

As the list above proves, not every reappraisal since 2008 has resulted in a a lower tax base. Plenty of counties continue to experience modest tax base growth.  But five years after the Great Recession it is now clear that local government officials can no longer depend on a substantial tax base increase following a reappraisal. And this state of affairs is not likely to change any time soon.

Despite some positive trends, North Carolina’s real estate market has a ways to go before it regains the ground it lost in 2008.  The average sale price of an existing home at market peak in 2007 was $223,000; that same figure year-to-date 2013 is $192,000.  Based on these statistics, it seems certain that upcoming reappraisals will continue to produce negative or very flat tax base growth. 

Ten counties are scheduled for reappraisals effective January 1, 2014, including three (Mitchell, Onslow, and Watauga counties) with high proportions of vacation homes that tend to rise and fall in value more dramatically than other types of real property.  Onslow County might be able to escape the negative tax base trend, given the strong growth around Camp Lejuene and the county’s recent reappraisal in 2010.  But the other counties had best prepare for shrinking tax bases. 

When a local government’s tax base shrinks, its revenue neutral tax rate will be higher than its existing tax rate because it will require a higher tax rate to produce the same revenue next year on the new (lower) tax base as this year’s tax rate did on this year’s tax base.  Local governments are required only to publish the revenue neutral tax rates, not adopt them for the coming year.  But when its tax base shrinks, a local government usually has only two choices: reduce the amount of services it provides or raise its tax rate to make up for the lost tax base.  (Click here for more details on the often confusing revenue neutral tax rate.) 

Higher tax rates can cause political as well as economic problems for local governments, especially in jurisdictions with large amounts of high value vacation homes owned by non-residents.  When the assessments of those vacation homes drop precipitously, the resulting tax rate increase has a much greater relative impact on owners of modest homes than it does on the owners of the expensive vacation homes.  And the owners of the more modest homes tend to be residents and voters in the county, not folks from away. 

Consider two hypothetical houses in Brunswick County, an oceanfront mansion owned by a rich lawyer from D.C. originally assessed at $3 million and a modest in-land bungalow owned by a local retiree originally assessed at $150,000.  In 2010 the county tax rate was $.305, meaning the taxes on the mansion would have been $9,150 while taxes on the bungalow would have been $457.  

After the 2011 reappraisal, assume that the mansion was assessed at $1,800,000 (a drop of 40%) while the bungalow assessment remained unchanged at $150,000 (not unusual for more modest homes in coastal communities).  At the county’s new tax rate of $.54, taxes on the mansion would be $9,720, while taxes on the bungalow would be $810.  

The wealthy D.C. lawyer saw his property taxes increase only 6%, while the county resident who owns the bungalow saw his property taxes rise by 77%. How well do you think the county’s voters will react to that change of affairs? 

Sure, county officials can try to explain to their voters that for years the county was able to balance its budget mostly on the backs of those rich folks from away. But it’s unlikely that explanation will do much to each the pain of a tax bill that grew by 77%. 

Unless and until the North Carolina real estate market replicates its healthy annual growth of the mid-2000’s, local government officials will continue to face trying property tax troubles.

After much number crunching and bracketology, I’ve identified the four most popular tax questions I get from local governments across the state.  Here they are, listed along with the “region” they won to make it to my version of the Final Four

Champion of the “[Ir]responsible Taxpayer” Region:

Can a shareholder be held responsible for taxes owed on a corporation’s property?

Champion of the “But I Never Owned That Property!” Region:

When should the tax lien on subdivided lots be released?

Champion of the “Uh Oh, We Really Messed Up” Region:

How may a local government recapture property taxes that were never billed?

Champion of the “I Hate Privilege License Taxes” Region:

Are non-profit businesses exempt from privilege license taxes?

The short answers are: probably not, maybe, likely through immaterial irregularity, and maybe.  What’s that you say, a bit more detail would be helpful?

Read on for my more complete answers to each regional champion question. And feel free to use the comment section to vote for your favorite or offer up another common tax question that you think should be in the running for the overall championship.

Question 1:         Can a shareholder be held responsible for taxes owed on a corporation’s property?

Usually not.  Corporations are distinct legal entities from their shareholders, members (for limited liability corporations), officers, directors, employees, and incorporators.  That means a corporation is a distinct taxpayer from those individuals, and vice-versa.  Just as I cannot be held responsible for your property tax obligations, a shareholder or other individuals related to a corporation cannot be held liable for a corporation’s property tax obligations.

Sometimes this result will seem patently unfair, especially when one individual completely controls a corporation that repeatedly ignores its property tax obligations.  Or when a corporation dissolves or simply stops operating without formally transferring its property to another owner.  I describe how a tax office might be able to “pierce the corporate veil” and hold an individual responsible for corporate tax debts on page 7 of this bulletin.  But tax collectors who pursue this option must proceed with caution and recognize that courts are usually very hesitant to allow creditors to ignore the corporate structure.

Question 2:         When should the tax lien on subdivided lots be released?

Here’s how this question usually arises: Parcel A is subdivided in Parcels 1 and 2 sometime after January 1, 2013, the date on which the 2013 property tax lien attaches.  Taxpayer buys Parcel 1 at a point when the taxes on Parcel A, the parent parcel, remain outstanding. Taxpayer wants to extinguish the 2013 tax lien on Parcel 1 by paying only the portion of the Parcel A taxes that relate to Parcel 1.  How should the tax collector respond?

This issue is one of the very few for which the Machinery Act grants the tax collector discretion.  GS 105-362(a)(2) states that the collector “may” release the lien on a subdivided parcel in return for payment of only the taxes owed on that subdivided parcel and not on the entire parent parcel “after the assessed valuation of the part to be released has been determined.”  In other words, the release can occur only if the assessor has determined how much of the taxes on the parent parcel are attributable to each of the subdivided parcels. 

But remember that the statue says “may” and not “must.”  It’s fine for a local government to decide it will never release liens on subdivided parcels, or will always do so, or will do so only when certain factors are present (owner of parent parcel owes no delinquent taxes, sufficient security exists for the rest of the taxes on the parent parcel, etc.).  My only advice is for the tax office to develop some objective procedures for this decision so that the tax office is less likely to be accused of playing favorites when it makes these decisions.

Question 3:         How may a local government recapture property taxes that were never billed?

If the taxes were never billed because the property was never listed (or received an exemption for which it did not qualify), then the tax office should use the discovery rules in GS 105-312 to recover the lost taxes.  But if the property was listed by the assessor but for some reason some or all of the property taxes that should have been levied on the property were not, then the tax office should not and may not use the discovery process. Instead, the lost taxes can be retroactively billed (plus interest!) under the “immaterial irregularity” provisions of GS 105-394.

The most common situation in which “immaterial irregularity” retroactive billing arises is when a city learns that a parcel that everyone assumed was outside of its borders is in fact part of the city.  Similar issues arise in counties for property that was inappropriately omitted from a rural fire district or a special service district.  Whenever these situations occur, the tax office should bill all of the lost taxes without regard to the five-year limitation on discoveries (because these situations are not discoveries). 

I discuss the “discovery vs. immaterial irregularity” issue at length in this bulletin and in chapter 11 of my property tax collection book.

Question 4:         Are non-profit businesses exempt from privilege license taxes?

Is a church bookstore liable for privilege license taxes? How about those cute little Girl Scouts selling cookies outside of the grocery store?  As is often true with privilege license tax questions the answer is, “Check your ordinance.” 

State law does not exempt churches, schools, charities or other non-profits from local privilege license taxes.  The fact that a business may be exempt from federal and state income taxes or local property taxes does not automatically mean that the business is also exempt from local privilege license taxes.

Instead, the question depends entirely on whether the city or county in question created an exemption for non-profits in its privilege license tax ordinance.  The model ordinance included in Bill Campbell’s privelige license treatise (the “blue book”) includes such an exemption, but not every local government adopted that model ordinance in its entirety. 

So . . . check your local ordinance.  If you don’t see an exemption for non-profits, they are not exempt. If your elected officials want non-profits to be exempt, suggest to them that they amend the ordinance to include this type of exemption.

Consider a building used for worship services by a religious congregation.  That building would be exempt under G.S. 105-278.3 only if it were also owned by that religious congregation.  If the religious congregation rented that building from another owner, it would not be exempt. 

Unfortunately the exemption statutes don’t define exactly what constitutes ownership. Usually the issue is clear, as in the above example. But what about situations in which there is a complicated corporate ownership structure involving both qualifying and non-qualifying owners?  The absence of clear statutory guidance means we need to turn to the courts to resolve those situations.

The N.C. Court of Appeals recently tackled one of those complicated exemption situations in the Appeal of Blue Ridge Housing case. The March 23 opinion offers for the first time a court-approved test for determining what type of ownership is needed to qualify for an exemption.

 The Blue Ridge Housing appeal involved the taxability of Cane Creek Village, a 24-apartment low-income housing project in Bakersville, the county seat of mountainous Mitchell County, N.C.   

In 2000, the county granted Cane Creek Village an exemption from property taxes under G.S. 105-278.6(a)(8). That provision exempts property “owned by . . .  a non-profit organization providing housing for individuals or families with low or moderate incomes.” 

In 2011, the Mitchell County assessor reconsidered Cane Creek Village’s exempt status as part of his statutorily required review of the county’s exempt properties.  The assessor determined that Cane Creek Village did not qualify for an exemption because it was not “owned” by a non-profit. 

Cane Creek Village appealed the assessor’s decision first to the Mitchell County Board of Equalization and Review and then to the state Property Tax Commission, which ruled in its favor and reinstated the exemption.  The county appealed to the state court of appeals, which affirmed the Property Tax Commission and ruled that the property should retain its property tax exemption.  

To understand the court’s decision, we first need to understand the complicated ownership structure of Cane Creek Village.  Title to the property is held by Blue Ridge Housing of Bakersville LLC (“Blue Ridge Housing”).  That limited liability company has two members, the equivalent of shareholders. 

One member is Northwestern Housing Enterprises, Inc. (“NHE”), a non-profit corporation.  It owns 0.1% of Blue Ridge Housing.  The other member is a for-profit partnership named the North Carolina Equity Fund III Limited Partnership (“NCEFIII”).  It owns 99.9% of Blue Ridge Housing.

NHE, the non-profit, was created for the purpose of assisting the Northwestern Regional Housing Authority (“NHRA”) to provide low-income housing in northwestern North Carolina. For property tax purposes, NHRA is considered a governmental unit.  If NHRA owned the Cane Creek Village itself, the property would be exempt under G.S. 105-278.1, the governmental property exemption. But for reasons that I don’t completely understand, NHRA cannot be the owner of a low-income housing project that is receiving both federal tax credits and housing subsidies.  As a result, NHRA does not own NHE and therefore has no ownership interest in Cane Creek Village.

That said, NHE itself is a non-profit and therefore may qualify for a property tax exemption under G.S. 105-278.6(a)(8) if it owns low-income housing.  Problem is, NHE owns only a minute percentage of Blue Ridge Housing (and therefore Cane Creek Village).  NCEFIII, the for-profit partnership that owns the remaining 99.9% of the project, is itself owned by a consortium of for-profit investors including banks and insurance funds.   

Are you with me so far? We have a low-income housing project that is associated with a regional governmental housing authority.  Title to the project is held by a limited liability company that is owned by both a non-profit and a consortium of investors.  The non-profit owns only a teeny-tiny slice of the LLC that owns the property.

So…should this property be exempt under G.S. 105-278.6(a)(8)? That statute doesn’t tell us what it means for a non-profit to “own” a particular low-income housing project.  Is 100% ownership required? 50.1%?  Could 0.1% possibly satisfy the ownership requirement?

Surprisingly, North Carolina courts had never faced this issue before the Blue Ridge Housing case. The closest an appellate court had come to the issue of “how much ownership is enough ownership?” was when the Court of Appeals held in 2008 that legal title is not determinative for property tax considerations.  Appeal of Fayette Place LLC, 193 N.C. App. 744 (2008).   That case concluded that a property tax exemption should not be denied simply because title to the property in question is held by a non-qualifying entity, if that entity is in turn owned by a qualifying entity.  

The decision in Fayette Place means that Mitchell County could not deny the property tax exemption for Cane Creek Village simply because title to the property is held by a for-profit corporation, Blue Ridge Housing.  The county was required to look beyond that first level of ownership to see if a qualifying non-profit organization possessed a “sufficient interest in the property” to justify an exemption.

Importantly, the Fayette Place case did not explain exactly what constituted a “sufficient interest” because in that case a government agency owned 100% of the property in question through a variety of subsidiary entities.  The case offered no insight as to whether an exemption would be justified if the qualifying entity co-owned the property with a non-qualifying entity.

In the Blue Ridge Housing case, the Mitchell County assessor did as required and looked beyond the title holder to see who actually owned the low-income housing project.  Quite reasonably, I think, the assessor decided that the 0.1% ownership interest held by NHE, the non-profit corporation, was not sufficient to justify an exemption under G.S. 105-278.6(a)(8).

The Court of Appeals disagreed.  Noting that prior cases had not provided test for defining “ownership” for purposes of property tax exemptions, the court created one: 

If 100% ownership interest ultimately vests in an entity otherwise satisfying statutory exemption requirements, then the property is exempt from taxation.  When an otherwise-qualifying entity has an ownership interest in less than 100% of the property, we balance the actual ownership interest with other factors indicative of ownership.  If other factors strongly suggest ownership, they can outweigh even a diminutive actual ownership interest.  These factors may include, but are not limited to: (i) the entity’s control of the venture’s operations; (ii) the entity’s status as trustee of LLC property; (iii) the possibility of future increased actual ownership interest; and (iv) the intent of the participating parties.

The court applied this test to the ownership structure for Cane Creek Village and concluded that NHE, the non-profit corporation, “owned” the property for tax purposes despite the fact that NHE owned only 0.1% of the corporation that held legal title to the property.  

In the court’s eyes, NHE’s control of Cane Creek Village’s operations, its role as trustee of the property, its right of first refusal to buy the property, and the intent of NHE and the for-profit investors all argued in favor of a finding that NHE had sufficient ownership interest in the property to justify a property tax exemption.

I find the court’s opinion to be well reasoned and consistent with the motivation behind ownership structures like that of Cane Creek Village and common to other low-income housing developments.  The for-profit investors are not investing in the projects to actually earn a profit on the projects themselves; they do so to gain access to the federal low-income housing tax credits that they can use to offset income earned on other investments and operations. The non-profit entity truly controls the project and will almost certainly gain 100% ownership once those tax credits expire.

What does this mean for other low-income housing projects across the state? If those projects possess ownership structures similar to that of Cane Creek Village, then the counties in which the projects reside should be exempting them under G.S. 105-278.6(a)(8). 

But not all low-income housing projects will be exempt.  If there is no ownership at all by a non-profit, or if the non-profit that owns a percentage of the project does not control the project or otherwise demonstrate the same interest in the project as NHE did in Cane Creek Village, then GS 105-278.6(a)(8) should not apply.  Those projects should be taxable under the special appraisal rules mandated by G.S. 105-277.16.

One final note: remember that all property tax exemptions other than the one for government property requires properties to satisfy both ownership requirements and use requirements.  See this blog post for more details.

Why was this result so surprising? Mostly because the court abandoned its traditional deference to policy makers when evaluating the appropriateness of taxes.  For decades before Friday’s ruling the court had always granted elected officials great freedom to set tax rates so long as those rates were not so high as to eliminate all opportunity for the businesses subject to those taxes to operate at a profit. 

I also found it surprising that the court seemingly misinterpreted Lumberton’s privilege license tax system when it calculated the difference between city taxes levied on video sweepstakes and city taxes levied on other businesses.  Had the court calculated this difference correctly, the outcome of the case might have been different.

Here’s my take on the court’s decision and what it means for other cities that levy privilege license taxes on video sweepstakes. 

The Lumberton Decision

The court based its decision on the provision in Article V, Section 2(1) of the N.C. Constitution, that requires the power of taxation to be “exercised in a just and equitable manner.” This clause was added to the state constitution in 1935 and had not been examined in depth by the court prior to the Lumberton case. 

Historically, challenges to the amount of taxes levied by the state or local governments were resolved under a common-law (in other words, judge-made) standard that barred only “unreasonable and prohibitory” taxes.  So long as a tax did not effectively prohibit an otherwise legal business by eliminating all opportunity for that business to earn a profit, the court deferred to the legislative branch on the specific tax rate.  Here’s a more detailed analysis of this standard of review.

In the Lumberton case, the court first concluded that it was not bound by the “unreasonable and prohibitory” common-law standard because that pre-dated the “just and equitable” constitutional provision. The court decided to replace that standard with . . . well, some other standard of review that the court didn’t really define.  Instead, the court basically emulated United States Supreme Court Justice Potter Stewart when he attempted to define hard-core pornography in a First Amendment case: “I know it when I see it.”    

Without offering an objective test to determine when a tax violates the “just and equitable” requirement, the Lumberton court concluded that the city’s tax was unconstitutional because it was just too much of an outlier as compared to the city’s other privilege license taxes.  Specifically, the court pointed to the nearly 60,000% increase in Lumberton’s privilege license taxes on video sweepstakes from 2009 to 2010 ($12.50 to a minimum tax of $7,500).  The court concluded that this increase was “wholly detached from the moorings of anything reasonably resembling a just and equitable tax. If the Just and Equitable Tax clause has any substantive force, as we hold it does, it surely renders the present tax invalid.” 

But the court was quick to point out that not every large tax increase violates the state constitution.  It requires a case-by-case analysis, said the court, which should include a look at the disparity between tax rates charged by a particular jurisdiction on different businesses. 

In the Lumberton case, the court justified its decision to strike down the city’s tax on video sweepstakes in part on the “start difference between the amount of tax levied on cyber-gambling establishments and the amounts levied against other economic activities.”  According to the court, the city’s second highest privilege license tax rate was the $500 levied on circus and animal shows. In the court’s view, that $500 tax was simply too small relative to the $100,000 privilege license tax bills charged to several of the city’s video sweepstakes operators.

Problem is, I don’t think the court interpreted the city’s privilege license tax correctly.  The court ignored the fact that Lumberton levies privilege license taxes on general retail and service businesses on a gross receipts basis.  Businesses taxed under this category are charged between $.25 and $1 per $1,000 of revenue, with no annual cap on their tax liabilities.  A typical Super Target or Walmart store would pay tens of thousands of dollars in privilege license taxes to Lumberton each year, very similar to the privilege license taxes paid by several of Lumberton’s video sweepstakes operators. 

Because Lumberton’s privilege license taxes on retailers were roughly equivalent to its privilege license taxes on video sweepstakes, the “stark difference” that the court identified simply didn’t exist.  And without that stark difference, a large part of the court’s justification for its “I-know-it-when-I-see-it” conclusion also disappears.

But the court has spoken and the ruling is final. There won’t be any appeal, because the case involved a state constitutional provision and not a federal one.  The United States Supreme Court will not even consider hearing an appeal from a state supreme court unless the case involves a federal statute or constitutional provision.

What the Decision Means for Other Cities

The Lumberton decision does not directly affect any privilege license taxes other than those levied by Lumberton on its video sweepstakes operators.  Privilege license taxes levied by other cities on video sweepstakes remain enforceable, regardless of the rate, unless and until a court rules otherwise.

That said, cities that levy privilege license taxes on video sweepstakes at rates similar to those levied by Lumberton ($5,000 per location, $2,500 per machine) are now on notice that those taxes might be held unconstitutional if they are challenged in court.  I think this risk is especially acute for cities that levy substantial taxes on video sweepstakes operators but do not levy gross receipts taxes at equivalent levels  on other businesses.  In such a city, the “stark difference” that the court mistakenly identified in Lumberton will in fact exist and the city’s video sweepstakes taxes would likely suffer the same fate as Lumberton’s.

Cities that find themselves at risk of a Lumberton-like challenge might want to lower their taxes going forward.  But I don’t think a city may change taxes retroactively, meaning a city is probably prohibited from refunding privilege license taxes from prior years absent a legal challenge to those taxes.   Cities with taxes substantially lower than those levied by Lumberton probably don’t have much to worry about. 

Taxes aren’t the biggest issue involving video sweepstakes, of course.  Law enforcement and local government officials are still wrestling over whether and how to enforce the criminal law ban that was upheld by the N.C. Supreme Court last December.  The ban was intended to eliminate these businesses entirely, but that didn’t happen. Many video sweepstakes operations remain open, some because they changed their sweepstakes systems to (allegedly) avoid the technical requirements of the ban and others because local law enforcement has not taken any steps to enforce the ban.    

Two lawsuits have already been initiated by sweepstakes operators challenging the enforcement of the ban on their new sweepstakes systems, one in Davidson County and one in Lee County. Neither case resulted in an injunction against enforcement of the ban, but more litigation on this front is likely.  

The bottom line is that video sweepstakes aren’t going to disappear any time soon.  Nor are the legal and policy questions associated with those businesses    Stay tuned for more developments . . .

My first reaction was, “No way!”  The general rule of local government authority in North Carolina is that if a statute does not explicitly authorize local governments to engage in a particular activity then local governments may not engage in that activity.   Nothing in the Machinery Act or elsewhere in the General Statutes explicitly authorizes a local government to refuse recreational services to delinquent taxpayers.  Then cities must not be able to do this, right?

But as I thought more about the issue and bounced it off of my colleagues for their thoughts, I realized the answer wasn’t quite that simple. 

Both cities and counties are granted general authority to administer their taxes “in a manner not inconsistent with the statue authorizing that tax.”  G.S. 153A-146 and G.S. 160A-206.  Read expansively, this language could authorize local governments to look beyond the Machinery Act for creative methods to encourage payment of delinquent taxes.

But those same statutes also place limits on that creativity.  Local governments are free to impose “reasonable penalties” of their own creation for the failure to pay a particular tax unless the statute authorizing that tax includes penalty and interest provisions.  In other words, if the General Assembly identifies the specific penalties and interest charges that apply to a particular tax, local governments are limited to those penalties and interest charges and cannot create their own.

The Machinery Act clearly and explicitly provides for a variety of specific penalties and interest charges relating to property taxes.  See G.S. 105-312 (10% discovery penalty), G.S. 105-357 (10% bad check penalty), and G.S. 105-360 (interest).  It also specifies exactly which costs of collection may be passed along to the taxpayer.  See G.S. 105-364 (10% outside collection fee), G.S. 105-367 (levy fees & costs), G.S. 105-368 (service fees for attachments), G.S. 105-369 (advertising costs), and G.S. 105-374 & -375 (foreclosure costs).  

The limitation on additional penalties and interest beyond those identified in the Machinery Act most certainly prohibits local governments from charging taxpayers additional costs or fees for the non-payment of property taxes.  The N.C. Attorney General said as much in a 2001 opinion objecting to an additional administrative fee imposed by a county for the late payment of property taxes.

That opinion concerned additional financial penalties for non-payment of property taxes.  What about collection efforts that do not create additional financial obligations for taxpayers? Does the prohibition on additional “penalties and interest” extend to efforts by the taxing unit that are coercive but not financially so?

In my view, local governments have some room for creativity outside of the Machinery Act. I’ve suggested in past blog posts (here and here) that counties could employ unusual approaches to shame property owners into paying their taxes so long as the counties don’t pass along the cost of those efforts to the taxpayers. For example, if a county wanted to rent one of those electronic billboards on Route 40 and flash the name of a different delinquent taxpayer on the billboard every 5 seconds, I think it could do so—assuming that it didn’t charge the delinquent taxpayers for the cost of the billboard rental.

Similarly, a local government could refuse to appoint delinquent taxpayers to government boards or commissions.  It could even make timely payment of property taxes a requirement for city or county employment (assuming it has not enacted a “just cause” personnel ordinance).

But the denial of government services for the failure to pay property taxes is more problematic.  For some services, it simply cannot be done. 

My colleague Kara Millonzi explains here why local governments may not refuse to offer public enterprise services such as water, sewer or trash service based on a customer’s failure to pay property taxes (or any other tax or fee unrelated to the service in question). 

For other services, state law prescribes requirements for the provision of those services which do not include the payment of property taxes.  Access to a county library, for example, must be free to residents if a county chooses to fund a library. Similarly, local governments may not refuse to record deeds or issue building permits due to delinquent property taxes unless they receive authority through local legislation to add to the statutory requirements for those services.

That leaves us with services that are neither public enterprises nor subject to statutory requirements.  Certainly recreational services fall into this category.  So do police and fire, I think.  And I cannot locate a statutory or common law prohibition against tying the provision of these services to the payment of local taxes.  

Constitutionally, this type of discrimination would be subject only to “rational basis” review by the courts because it does not involve a fundamental right or a suspect class.  In other words, delinquent taxpayers don’t benefit from special constitutional protection.  Rational basis review requires great deference to elected officials and will condone a government action so long as it is rationally related to a legitimate government purpose. 

It seems rational to me for a government to decide that the provision of services that are funded with general fund revenue be tied to the payment of property taxes, which of course provide the bulk of that revenue.  Assuming the courts agree, discrimination against delinquent taxpayers in the provision of certain government services would pass constitutional muster.

Assuming this approach is legal, I can still think of a long list of other reasons why it might be less than ideal.  At the top of that list would be the risk of headlines like this one: “Family Home Burns While Firefighters Watch.” 

Even the refusal of less essential government services such as access to a recreation center could lead to negative PR for a local government.  Some might think it unnecessarily harsh to refuse a family fitness and recreational opportunities (kids kept out of youth soccer leagues?) due to financial hardships that prevent them from paying their tax obligations. But I know plenty of other folks would find this approach perfectly reasonable.

I’ll leave those types of policy decisions to elected officials.  My only advice to local governments considering creative approaches to property tax collection is to tread carefully and consider both legal and non-legal implications before adopting new policies.

1.  Taxpayer is taxed for property that did not have a taxable situs in the jurisdiction.

2.  Taxpayer is taxed for a house that burned the prior December.

3.  Taxpayer has vacant land but is taxed for the land plus a house.

4.  Taxpayer has an unfinished attic but was taxed for a finished attic.  Finish was never verified by appraiser.

5.  Taxpayer has a 1,500 square-foot house but the assessor appraised it at 1,750 square feet based on the size of similar houses in the same neighborhood. 

Most property tax professionals would agree that a refund is justified in situations 1, 2 and 3.  So do I.  But situations 4 and 5 are tougher nuts to crack. 

Property tax refunds and releases are governed by G.S. 105-381, which limits them to circumstances in which the tax either was levied due to clerical error or was illegal.  While those terms are not defined by the statute, they’ve been analyzed several times our state courts.

The most detailed of these opinions came from the N.C. Court of Appeals when it analyzed the meaning of the term “clerical error” in the 1997 case Ammons v. Wake County.   As I discussed in this 2010 post, the court concluded that to qualify as a clerical error the mistake must be that one produces an unintended result and is apparent from the face of the documents, such as a transcription mistake (for example, recording 5,200 square feet instead of 2,500 square feet.)  The term “clerical error” does not include errors in judgment or law on such issues as market value, quality of construction, or eligibility for a property tax exclusion.  These types of non-clerical errors must be resolved through the annual appeal process and may not be corrected retroactively under G.S. 105-381.

Applying the Ammons analysis to the five situations above, I don’t think any qualifies for a refund due to clerical error.  In each situation, the appraisal was that intended by the assessor.  None of the situations involved an unintended appraisal—in each instance the assessor produced an appraisal that he/she thought was appropriate at the time.

But clerical error is only one of two justifications for a property tax refund. Might any of the five situations above qualify as “illegal taxes”? 

Here’s our court defines that term: “[G.S. 105-381] and our case law recognize a distinction between an erroneous tax and an illegal tax or invalid tax. An illegal or invalid tax results when the taxing body seeks to impose a tax without authority, as in cases where it is asserted that the rate is unconstitutional or that the subject is exempt from taxation.”  Redevelopment Comm. V. Guilford County, 274 N.C. 585 (1968). 

I think it’s clear that situations 1 and 2 would constitute illegal taxes because the taxing unit had no authority to tax property not in its jurisdiction (situation 1) or that did not exist as of January 1 (situation 2).   Similarly, situation 3 seems to be an illegal tax because a taxing unit has no authority to tax property that never existed. 

In contrast, situations 4 and 5 involve property that did exist in the taxing unit’s jurisdiction as of the listing date but that received inflated appraisals.  Is a tax on non-existent market value illegal and subject to a refund under G.S. 105-381?

Not normally.  In Kinro, Inc. v. Randolph County, 108 N.C. App. 334 (1992), the court of appeals concluded without analysis that “over assessed values of personal property” do not constitute an illegal tax.  If the taxpayers in situations 4 and 5 were complaining only of market value errors—let’s say they thought that the assessor ignored relevant sales of comparable properties—clearly they would not be entitled to refunds.  Market value judgments may be challenged only during the appeal process for the current tax year.

But that’s not really the case in situations 4 and 5.  The taxpayers don’t claim that the assessor simply made a poor estimate of what the properties would have sold for on January 1.  Instead, the taxpayers claim that the assessor appraised and taxed physical property features (a finished attic, additional square feet) that did not exist in the taxing unit’s jurisdiction as of the listing date (and in fact never existed at all). 

That sounds pretty darn similar to situations 1,2, and 3, doesn’t it? If refunds are justified in the first three situations of non-existent property, aren’t they also justified in the last two?  

I think the best answer is no.  A valuation error cannot justify a refund as an illegal tax even if that error was caused by the valuation of property features that never existed. 

Very few appraisals are based on actual physical inspections of the property at issue.  Instead, assessors rely on the mass appraisal process which requires countless judgment calls about specific physical features and their market value. 

If we open up every one of those judgment calls to retroactive review for five years under G.S. 105-381, we would do serious harm to finality of our local government tax bases. And without that finality, budgeting for local governments would become far more difficult than it already is.

No doubt, some valuation errors make compelling arguments for refunds.  Consider an example similar to situation 5 above, but assume that instead of mistakenly appraising a 1,500 square-foot house as 1,700 square feet the assessor appraises it at 5,000 square feet.  Is a refund justified when the judgment error is so egregious?

Despite the size of the error, I still don’t think it qualifies as an illegal tax because at the end of the day it was a judgment error.  And once you start refunding any judgment error, you open the door for countless retroactive appraisal reviews. 

But my veteran assessor SOG colleague Ken Joyner thinks when an appraisal error is so large—appraising a house at more than 3 times its actual square footage, for example—the result must have been unintended.  If so, then a refund would be justified under the clerical error criterion even if we conclude that it was not an illegal tax.   In other words, any truly egregious appraisal error must have been unintended and therefore should be eligible for a refund.

Similarly, a county could adopt a rule of reason: if an appraisal error is large enough, then a refund is justified. For example, a county might adopt a policy under which appraisal errors of greater than 10% justify a refund, but errors smaller than that do not.

Both suggestions sound reasonable.  But neither the Machinery Act nor property tax case law from state courts make any distinction for refunds based on the size of the error involved.  If an error truly was clerical, as Ken suggests a huge error likely would be, then clearly a refund is justified.  But if the error was truly one of judgment, then I don’t think a refund is justified regardless of how big the error was.

Remember that the General Assembly sets policy, not mere mortals such as you and me.  I can’t in good faith recommend a policy, no matter how reasonable, if it contradicts the black-letter statutory law.  Unless and until the law is changed or we get more guidance from the courts, my advice remains the same: local governments should construe the refund provisions in G.S. 105-381 very narrowly.  Taxpayers can use the appeal process to correct erroneous value judgments for the current tax year going forward, but they cannot attack those judgments retroactively.

(Hat tip to my friend Lee Harris of Orange County for raising this interesting issue.  Lee’s wise counsel has been invaluable during my time at the SOG.)

For a longer answer, take a look at last week’s opinion from the N.C. Supreme Court in Appeal of Ocean Isle Palms, LLC,  a case involving undeveloped residential lots in Brunswick County.   The opinion offers helpful guidance about the distinction between correcting errors in the application of an existing appraisal methodology, which is permitted, and creating an entirely new appraisal methodology, which is not. 

The general rule is that a county must set its real property tax appraisals at “true value” as of January 1 of the year in which a county-wide reappraisal (more commonly called a “reval”) is made.  Those appraisals remain effective until the next reval, which must occur within eight years. 

In between revals a real property tax appraisal can be changed only under the limited circumstances described in GS 105-287(a).  The most common justification for a non-reval-year adjustment is a physical change to the property.  If a home burns down or is doubled in size thanks to a renovation in between revals, the county must change that property’s tax appraisal to reflect the physical changes.  Likewise, zoning changes which affect the permitted uses of a property may cause the property’s tax appraisal to change in between revals. 

Last week’s Supreme Court opinion in Appeal of Ocean Isle Palms, LLC dealt with a more ambiguous basis for non-reval-year changes to tax appraisals.  GS 105-287(a)(2) permits a county to “correct an appraisal error resulting from a misapplication of the schedules, standards, and rules used in the county’s most recent general reappraisal.” 

In other words, if the county believes it messed up the appraisal of a particular property then it doesn’t need to wait until the next reval to correct the mistake.  This correction must be based on the “true value” of the property as of January 1 of the last reval year and must use the same appraisal methods used in that reval. 

For example, assume that in 2010 Carolina County appraised my home at $300,000. I think that appraisal is too high but I am not motivated enough to appeal. In early 2013 I learn from my neighbor that he bought his house, which is identical to mine, for $200,000 in late 2009.  I march down to the Carolina County tax office, show proof of my neighbor’s transaction, and ask that my tax appraisal be lowered.  If the assessor agrees that my house’s true market value should have been $200,000 as of January 1, 2010, the assessor has the authority lower my tax appraisal for 2013 and future years.  This adjustment would correct a “misapplication of the schedules, standards, and rules” used in Carolina County’s 2010 reappraisal and therefore be permitted by G.S. 105-287.

Similarly, assume that in 2010 Carolina County appraised Roy’s home as if it had a full finished basement.  Roy’s home does not have a full finished basement, but he was too busy to file an appeal.  In 2013 Roy finally visits the tax office to complain about his appraisal.  If he proves to the county that his home never had a full finished basement, the county may (and should) correct his appraisal for 2013 and future years to reflect the true physical characteristics of his home.  The original appraisal represents a misapplication of the county’s schedule of uses and values and therefore can be changed in between revals under G.S. 105-287.

That said, the county has no authority to change erroneous tax appraisals for prior years.  G.S. 105-287 and other statutory provisions that provide for changes in tax values all limit that authority to the tax appraisal for the current year.  If a taxpayer sits on her right to appeal a tax appraisal in a particular tax year, that right is waived.  She can still appeal her appraisal in subsequent years but she cannot obtain retroactive relief for the years she failed to appeal.

Back to the Ocean Isle Palms case. In 2007 Brunswick County appraised Ocean Isle Palms’ 109 undeveloped lots at between $45,000 and $60,000 per lot.  These appraisals were based on a “condition factor” that allowed for comparison between the market values of similarly situated developed and undeveloped lots.   Here’s how the court described the county’s use of condition factors:

“For example, a property without water, sewer, other utilities, or paved roads could be assigned a condition factor of .20 . . . The sales comparison value of a developed but otherwise similarly situated parcel would be multiplied by .20, yielding a true value for the undeveloped lot  of 20% of the base value of comparable  developed property. . . . As infrastructure was added to such property, the condition factor would increase, reflecting the rising true value of the property.  This condition factor method had been used in Brunswick County  since “at least since 1976”  and was applied in a manner consistent with past practices during the 2007 revaluation.”

In 2008 Brunswick County’s newly appointed assessor decided to abandon the use of condition factors and reset the tax appraisals of all undeveloped lots at 100% of their base value.  Not surprisingly, the 2008 tax appraisals of Ocean Isle Palms’s undeveloped lots jumped substantially to between $190,000 and $700,000 per lot.

Ocean Isle Palms did not appeal its new tax appraisals until 2010, when it argued that the 2008 tax appraisal increases were not permitted under G.S. 105-287.  The taxpayer lost its appeal before the Brunswick County Board of Equalization and Review, which found that the 2008 changes were permissible corrections of misapplications of the county’s schedules of uses and values.

The taxpayer appealed to the state Property Tax Commission (“PTC”), where it won. Then the county appealed to the N.C. Court of Appeals, which decided that more evidence was needed at the PTC level to determine whether the county’s decision to change appraisals in between revals was legal. 

Ocean Isle Palms appealed again, resulting in last week’s opinion in its favor from the N.C. Supreme Court.  The basic issue before the court was whether the county’s decision in 2008 to stop using condition factors was an effort to correct a misapplication of its 2007 reappraisal methodology or instead constituted an entirely new reappraisal methodology.  The former is acceptable under G.S. 105-287, the latter is not.

The county argued that after the 2007 reval was finished more data from the sale of undeveloped lots in late 2006 became available.  This additional data demonstrated that the 2007 appraisals of Ocean Isle Palms’ undeveloped lots were well below market value.  The county also claimed that not all undeveloped lots in the county were appraised using conditions factors, resulting in inconsistent appraisals of similar properties.

Not quite, replied the Supreme Court.  It found that in 2008 the assessor ordered all lots to be appraised without regard for how much or how little the lots had been developed, which was an entirely new approach:

“In other words, the County’s response to the alleged shortcomings  of the 2007 appraisals of Ocean Isle Palms’ lots  was not to correct the application of the condition factor to reflect new information but to throw out the condition factor altogether.  Consequently, the county’s reaction to the perceived erroneous revaluations cannot be seen as a mere correction of a methodology used with approval in the past. Instead, the County imposed a revised system of valuation.”

Once the court reached this conclusion, the outcome of the case was clear.  G.S. 105-287 prohibits a change in appraisal methodology in between revals.  If Brunswick County wanted to institute a new appraisal methodology for undeveloped lots, its only option was to conduct a new reval under a new methodology and a new schedule of uses and values. 

What lesson does this case offer to North Carolina assessors? A county making changes to appraisals in between revals need to be sure that it does so within the boundaries of the methodologies and standards that were used for its most recent reval.  Even if the county later realizes that its appraisal methodology for certain properties was flawed, it is likely stuck with that methodology until the next reval. 

That doesn’t mean that counties are always stuck with inaccurate appraisals until their next revals, however.  In the Ocean Isle Palms case, I think Brunswick County could have adjusted its use of condition factors in the appraisal process and raised the appraisals of undeveloped lots without running afoul of G.S. 105-287.  For example, lots without utilities and roads could have received a condition factor of .60 instead of .20, if that change better reflected the evidence of true market value the county says it discovered after January 1, 2007. But to jettison the use of condition factors entirely in between revals was a fundamental change to the appraisal process that could not survive a challenge under G.S. 105-287.

So the long and winding saga finally ends, right? Video sweepstakes machines disappear from the state, never to return again, along with the jobs they created and the risk of Grandma blowing her grocery money playing pseudo slot machines.

Not so fast. Plenty of video sweepstakes operators closed their doors after the ruling.  But not all of them. And some that have closed may reopen after changes to their operating systems, more legislation, or additional court rulings.

Because the case involves a federal constitutional claim, the video sweepstakes operators can ask for a review before United States Supreme Court. The odds are against them, however.  Our nation’s highest court agrees to hear fewer than 2% of all cases seeking review.

A successful appeal might not be necessary for the video operators to remain in business. Even before the state supreme court issued its ruling, lawyers for some of the companies providing video sweepstakes technology informed local governments that if the ban were upheld they planned to tweak their systems so as to conform with the newly enforceable law. 

As my colleague Jeff Welty explains here, the ban does not prohibit all video/computer/internet sweepstakes, only those that use electronic machines to reveal the result of a sweepstakes entry via an “entertaining display . . . that takes the form of actual game play or simulated game play.”  G.S. 14-306.4.  Presumably the video sweepstakes operators could still use computers to inform their customers whether their “free” sweepstakes entries are winners—so long as those computers used some method that was not a game or a simulated game.

One approach that might avoid the ban is a plain-vanilla reveal.  The sweeepstakes computers could ask the customers how many entries they wish to reveal, then simply state how much money those entries did nor did not win.  Sounds pretty boring to me, but who knows? Maybe some customers would still enjoy the process enough to continue losing their money on the sweepstakes.

More entertaining approaches might also skirt the ban.   For example, the computer could show a digital dart flying toward a wall of digital balloons. When the dart “hits” a digital balloon, the balloon pops and reveals whether or not the customer wins any money.  Is this method of revealing the result of an entry “actual game play or simulated game play”?  If the customer cannot control where the dart flies or which balloon it hits, it sounds more like a film clip than a game to me.   But others might disagree.

The N.C. Attorney General’s office has declined to offer an advisory opinion as to what types of video sweepstakes, if any, can continue to operate under the ban.  Which means it’s going to be up to local law enforcement to decide when and how to enforce the ban.  We won’t know for sure what activities remain legal until an operator is cited for violating the ban and a court is forced to address the issue of just what constitutes a “game” in the context of video sweepstakes. And then we’d certainly be in for another year or two of appeals before the N.C. Supreme Court had the final say. 

Then again, the state legislature could reword the ban to eliminate the reference to games and then (potentially) prohibit all types of video sweepstakes. Or, as former governor Bev Perdue proposed last year, the General Assembly could legalize video sweepstakes and heavily tax the industry.  It wouldn’t be a huge leap to imagine a state-sanctioned video sweepstakes industry, considering that we already have a state-sanctioned lottery.

Recent comments from newly inaugurated Governor Pat McCrory suggest that he prefers strengthening the ban rather than legalizing the sweepstakes.  “I think they ought to enforce the law,” McCrory said, “There seems to be so many loopholes the industry is looking for to go around the current laws…This is kind of ridiculous at this point in time.”

 It’s clear from feedback I’ve been receiving that not every local government wants video sweepstakes businesses to disappear.  A number of cities and towns are generating substantial revenue through privilege license taxes on these businesses and have not experienced increased crime or other problems with their local sweepstakes parlors.  Roanoke Rapids, for example, hopes to rely on video sweepstakes machines to rescue its financially troubled and publicly funded theater.  That city’s attorney has already reviewed the “new” version of the video sweepstakes systems and pronounced them legal, an opinion that is newsworthy but certainly not binding on local law enforcement or the courts.

As I’ve discussed before, the legality of cities’ taxes on video sweepstakes is currently under review by North Carolina courts. In the spring of 2012 the N.C. Court of Appeals issued rulings that upheld the cities’ authority to tax video sweepstakes but left open the question of how high those taxes can rise before they become unconstitutional.  One of those cases is now pending before the N.C. Supreme Court and another was sent back to the trial court, meaning more case law on the tax issue is sure to arrive sometime this year.

 So what’s a local government to do about video sweepstakes amidst all of this uncertainty?

 First, local law enforcement needs to determine how it plans to enforce the newly effective ban.  Just as they do with any other potentially illegal activity, law enforcement officers and prosecutors should take a look at local video sweepstakes operators that remain in business and decide whether they are operating legally.  If not, law enforcement would be obligated to enforce the ban by issuing criminal citations.

 Second, local government tax and zoning officials generally should pretty much continue with business as usual.  It might be appropriate for tax and zoning officials to inform video sweepstakes operators seeking zoning permits or privilege licenses of the newly enforceable criminal ban.  But these officials should not be charged with the responsibility of determining if these applicants are violating the ban; that’s the role of law enforcement.  Unless and until a particular video sweepstakes operator is found to be violating the ban, zoning and tax officials should assume that they are legal and proceed as they would for any other business.  And city privilege license taxes remain legal unless we get contrary guidance from the N.C. Supreme Court.  (For more details on how the criminal ban might affect zoning regulations, please see this excellent post from my colleague Rich Ducker.)

 Third, cities who levy privilege license taxes on video sweepstakes operators should not provide refunds to businesses that close in response to the ban unless the tax ordinance for a particular city calls for partial-year refunds—and no ordinances of which I am aware contain refund provisions.  Cities don’t generally refund taxes to businesses that close mid-year due to fires or bad economies or other reasons; they shouldn’t refund taxes to businesses that close due to a change in the law either.  If a city were to provide a refund to video sweepstakes operators when its tax ordinance does not call for refunds, that action could constitute an illegal use of public funds. 

Absent a provision for refunds in your city’s tax ordinance, I think the only situation in which a refund might be justified is after an operator who paid a city tax is convicted of violating the ban on video sweepstakes.   G.S. 14-307 prohibits local taxes on illegal gambling machines, meaning if a city taxed illegal gambling those taxes were probably illegal themselves.  But right now there isn’t a single video sweepstakes operation that has been found to be operating  illegally.  And G.S. 14-307 doesn’t justify a refund of privilege license taxes simply because a video sweepstakes operator might have been operating illegally. 

 Finally, local governments should stay tuned for more legal and legislative developments concerning video sweepstakes.  This story is far from over.

How may a local government determine a taxpayer’s gross receipts?

My past two posts (here and here) provided background about when local privilege licenses may be based on gross receipts and when taxpayers should be permitted to apportion their receipts among the various towns in which they do business. But neither of those posts answered the very basic question of how those gross receipts should be determined.

Taxpayers are expected to self-report their gross receipts if their businesses fall under a privilege license tax category that is taxed based on gross receipts.  If taxpayer fails to do so or if the gross receipt total reported by the taxpayer is suspicious, local governments may and should require taxpayers to make their financial records available for inspection by tax officials.

Local governments possess the authority to require this inspection under G.S. 160A-206, the statute that grants cities general taxation authority.  This provision states in part, “The power to impose a tax shall also include the power to provide for its administration in a manner not inconsistent with the statute authorizing the tax.” (The same statement exists in the statute authorizing county taxes, G.S. 153A-146, but it is less relevant because counties do not levy privilege license taxes on the basis of gross receipts.)   The power to administer a tax clearly includes the power to audit taxpayers and confirm that they are satisfying their obligations under that tax.

With this in mind, the model privilege license ordinance included in Bill Campbell’s privilege license treatise (“the Blue Book”) creates a duty on behalf of all taxpayers to “permit the tax collector to inspect the business premises during normal business hours to determine the nature of the business conducted there and to examine the books and records to determine the nature and amount of business transacted.” In other words, if the tax collector does not think the taxpayer is accurately describing its business or its gross receipts, the tax collector has the authority to inspect the taxpayer’s premises and records to ensure that the tax levied on the taxpayer is appropriate.

The model ordinance also includes a procedure for the tax collector to follow if a taxpayer refuses to permit an inspection of its records.  Essentially, the tax collector should make a best estimate of the taxes owed and force the taxpayer to produce evidence to the contrary. If taxpayer fails to do so, the tax estimated by the tax collector becomes final and subject to enforced collections.

Internet Sweepstakes Judicial Update

 I recently attended oral arguments in the two internet sweepstakes cases pending before the N.C. Supreme Court.  In October, the court heard the case involving the state’s attempt to ban internet sweepstakes entirely using criminal law.  Previously, the court of appeals had struck down the ban on First Amendment grounds.  In November, the court heard the case involving local privilege license taxes levied by Lumberton on internet sweepstakes.  Previously, the court of appeals had found the taxes levied by the city on these businesses to be lawful.

Predicting the outcome of a case based on questions from the justices during oral argument is never easy.  That is especially true when the justices question each side with equal parts enthusiasm and skepticism, as they did in the criminal law case.

Were I forced to make a prediction, I would guess that the Supreme Court affirms the court of appeals ruling that struck down the ban. If that happens, then internet sweepstakes would remain legal unless the state were to successfully appeal to the U.S. Supreme Court or the General Assembly were take another shot at legislating these businesses out of existence.

The court’s questions were far more revealing in the privilege license tax case.  From what I heard, it seemed that the justices were much more sympathetic to the internet sweepstakes operators than they were to Lumberton.  While I think it is likely the Supreme Court will rule in favor of the operators, I’m not sure that the court will give them everything they ask for.

The operators seek to have Lumberton’s privilege license taxes declared unconstitutionally too high based on the face amount of those taxes.  Failing that, the operators seeks a chance at trial to prove that the taxes are so high as to unconstitutionally deprive them of the opportunity to earn a profit.

I don’t think the court will invalidate Lumberton’s tax without a trial.  My bet is that the court grants the operator’s alternative request and sends the case back to superior court for a trial.  Were that to occur, we’d all get a good lesson on just how profitable (or not) internet sweepstakes can be. As I’ve written before I think it will be awfully tough for the operators to prove that the taxes eliminate their ability to earn a profit.  Plenty of internet sweepstakes operators have paid taxes similar to those charged by Lumberton without being forced out of business.

Another privilege license tax case involving the city Fayetteville is also pending before the Supreme Court but has not yet been scheduled for oral argument.

When will the court rule on these cases? Your guess is as good as mine. The N.C. Supreme Court has not been overly prolific in recently.  It’s been averaging about 4 opinions a month, less than half the average from 10 years ago.  We’ll be waiting several months, at least, before we know the future of internet sweepstakes and related local taxes.

 Internet Sweepstakes Webinar

While waiting for the Supreme Court to rule, join us at the School of Government in January for a comprehensive examination of local government responses to internet sweepstakes.  My faculty colleagues Rich Ducker and Jeff Welty will share their respective zoning and criminal law expertise as it relates to these businesses, while I’ll cover taxation issues.  You can register for the event here.