Property Taxes on Internet Sweepstakes

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Chris McLaughlin

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One of my favorite movies turns 30 this year.  I love “The Untouchables” because it’s loaded with big stars (Costner, Connery, DeNiro), teaches key life lessons (don’t bring a knife to a gun fight) and–most importantly from my geeky perspective–taxes play a prominent role in the plot.  In the movie as in real life, gangster boss Al Capone is eventually imprisoned not for smuggling, extortion, or murder, but for income tax evasion.

Why am I talking about Al Capone and his tax problems? Because internet sweepstakes parlors seem to be making a comeback in North Carolina. And the dubious legality of those businesses raises important questions about a local government’s authority to tax illegal activity.

Wait, you say.  Didn’t North Carolina ban internet sweepstakes years ago? Yes, the General Assembly did ban these businesses. Or at least tried to. As I explained in this post, most internet sweepstakes parlors shut down after the ban was passed in 2010 and was finally upheld by the North Carolina Supreme Court in 2012.

But some sweepstakes businesses continued to operate, claiming that their software systems did not violate the new law.  Four years later, we are still reading about law enforcement raids on sweepstakes parlors, confusion over injunctions against the law’s enforcement, and inconsistent results when sweepstakes operators are prosecuted for violating the law.

I’m no criminal law expert.  I can’t tell you whether any sweepstakes parlors operating in your area are illegal. That’s a question for law enforcement, the district attorney, and eventually the courts to decide.  But I can offer some thoughts on the taxation issues involving these businesses.

Originally, the big tax question about sweepstakes parlors concerned local privilege license taxes.  Many towns had begun levying substantial taxes (up to a couple thousand dollars per machine) on these parlors under their general business privilege license tax authority in G.S. 160A-211.  The North Carolina Supreme Court eventually ruled that at very high amounts these taxes were unconstitutional.

The privilege license question is now moot, because the General Assembly eliminated almost all local privilege license authority as of July 1, 2015.  Cities and counties may not levy privilege license taxes on internet sweepstakes businesses.

Some local governments have adopted business registration systems to replace the information-gathering aspect of the now defunct privilege license tax system.   While fees are likely permitted as part of those registration systems, they need to be minimal ($10 or $20, perhaps?) and not be intended to raise substantial revenue beyond the cost of administering that registration.

If your locality operates a business registration system, I think it is appropriate to register internet sweepstakes businesses just as you would any other business.   It’s possible those businesses may be operating illegally.  But that’s not a fact unless and until the operator is convicted of violating the law.  Until then, we need to assume that the business is legal and is entitled to register assuming it satisfies all zoning and other local requirements for new businesses.

What about property taxes?  A county tax collector emailed me this week questioning whether his office should be listing and taxing business personal property used in internet sweepstakes parlors.  He was concerned about the appropriateness of taxing illegal businesses and the possibility that listing the property might legitimize an otherwise illegal business.

A great question.  My answer is yes, absolutely. Counties must list and tax all real and personal property used in an internet sweepstakes parlor business, even if that parlor might be operating illegally.

Here’s how I reach that conclusion. First, state law does not prohibit the taxation of property used illegally.  G.S. 14-307 bans local governments from levying taxes “for the privilege of operating” illegal gambling machines, which presumably would include computers used for illegal internet sweepstakes.  But that statute doesn’t mention property taxes, which are levied on the value of property and not on the privilege of using or operating that property.  I don’t think G.S. 14-307 has any relevance to property taxes.

Absent a prohibition elsewhere in state law, the Machinery Act requires counties to tax all property that is not exempt or excluded by the General Assembly.  G.S. 105-274.  There is no exclusion or exemption for property being used illegally.  The exclusion for non-business personal property covers only property that is “used by the owner of the property for a purpose other than the production of income and is not used in a business.”  G.S. 105-275(16).  The legality of the income or business in question has no relevance to the taxablility of the property involved with that income or business.

If state law doesn’t prohibit the taxation of property used in illegal activities, what about federal law or the United States Constitution? That’s where Al Capone becomes relevant again. Eliot Ness and his fellow federal agents decided to go after Capone for tax evasion after the Supreme Court ruled in 1927 that there is no constitutional prohibition against taxing illegal activity.  That principle has since been used to target big time defendants such as CIA-agent-turned-KGB-spy Aldrich Ames as well as countless small-time drug dealers.

If the Constitution allows governments to tax income produced by illegal activities it seems certain that it would also permit governments to tax the property used to produce that illegal income.

What about the argument that listing and taxing illegal property might legitimize the owner’s activities? The successful prosecution of defendants like Ames of both a crime (espionage) and tax evasion for the income earned from that crime (payments by the Soviets to Ames for his espionage) defeats that argument.  The existence of a tax obligation on certain income or property does not eliminate the potential illegality of that income or property.

Which brings me to the bottom line: in North Carolina all property used in the production of income, both legal and illegal, should be listed and taxed unless that property is otherwise excluded or exempted from taxation. For many illegal activities, there won’t be much taxable property involved.  For example, the most valuable personal property used in an illegal drug dealing business is likely the drugs themselves, which would qualify for the inventory exclusion.  G.S. 105-273(8a).

An internet sweepstakes parlor may be that rare (potentially) illegal business that involves valuable taxable property.  The computers and cash registers used in an internet sweepstakes are all taxable, either to the sweepstakes operator or, if they are leased, to the leasing company.  And of course the real property occupied by the sweepstakes parlor is taxable, regardless of whether it is owned by the sweepstakes operator or by another taxpayer.

Would a refund be justified if an internet sweepstakes business is later shut down by law enforcement? Does it matter if the business owner is later convicted of violating the ban on internet sweepstakes?

My answer is “no” to both questions.  As discussed above, nothing in state or federal law prohibits the taxation of property involved in illegal activity.  So long as the business owns taxable property as of January 1, that property should be listed and taxed for the coming fiscal year regardless of whether the business later shuts down for any reason–including criminal conviction. (See this blog post for more on the importance of January 1 for property tax assessment.)

So remember: they bring a sweepstakes machine to your town, you tax it.  It’s the Chicago–err, North Carolina–way.


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