Keep the money at home: the illusory promise of contract audits.

In recent years, a limited number of property tax assessing jurisdictions have hired contract or third-party agents to audit business personal property tax returns and records. The initial promise of increased revenue with no out-of-pocket cost appears highly attractive to tax administrators who must use every tool at their disposal to collect maximum revenues while minimizing staffing salary expenses. A thorough review of this contract audit however, clearly reveals the promise to be false and the practice to be poor public policy.

The proponents of contract audits primarily rely on fiscal arguments to support their point of view. Many contracted personal property tax audits are now financed by contingent fees; the contract auditor is paid a specified percentage of any additional taxes assessed. Thus, the auditor is paid only if a tax deficiency is found and no out-of-pocket expenses are incurred by the assessing agency. This is a particularly attractive features of contract audits during hard economic times when budget limitations are demanded by overburdened taxpayers.

Contract audits of large corporations can be especially attractive because many of these taxpayers maintain books and records outside the jurisdiction, thereby requiring travel to perform the audit. Since travel expense can be included as part of the contingency fee, the contract audit eliminates this out-of-pocket expense and further eases budget pressures. Simply stated, tax administrators may find contingent fee contract audits attractive because (1) revenues can be increased without all the related expenses since the auditor is paid on a contingent fee basis, (2) pressures to hire additional staff to conduct audits is alleviated, and (3) out-of-state travel cost can be reduced or eliminated from an agency's budget if it is covered by the contingency fee.

Although these factors give contingency fee audits the appearance of an attractive alternative, such audits not only epitomize poor public policy, but can also unnecessarily increase the taxpayer's compliance costs and the expense for assessors to administer the audit process efficiently. Contract audits also raise concerns about confidentiality. This article outlines these areas of concern.

PUBLIC POLICY

* The tax assessor is directly accountable to the taxpayers for all acts required by law including adherence to technical and ethical standards by those to whom authority is delegated. The use of the contract auditor calls into question the ability of the assessor to assure compliance with these standards, for only by using a common-law employee relationship can an assessor fully maintain control.

* Audits communicate policy and interpretation of laws and regulations, ultimately setting future reporting requirements and record-keeping standards. These policy standards should be established by a common-law employee directly accountable to and controlled by the assessor -- not a third party who could have only a short-term relationship with a given assessor and possibly only a cursory understanding of the assessor's policies and procdures.

* The primary purpose of an audit is uniform compliance with the tax law to ensure equalization of the tax burden. Additional taxes are a result of the process and should not be the motivating purpose. The compensation of the assessor's common-law employee supports this purpose because it is independent of any audit determination or the amount of time spent to audit the taxpayer's records. In contrast, the contract auditor's compensation depends solely on issuing an assessment and, often, on the payment of the assessed amount. This association between audit results and compensation causes the auditor to be perceived as a bounty hunter whose primary consideration is the dollars produced by audits, rather than ethical and uniform administration of tax laws.

* The savings from contingency fee audits are illusory and costly to the public. If a jurisdiction believes there is substantive underreporting of personal property and audits will result in material revenues, there is no reason for an administrator to surrender a substantial portion of these tax deficiencies to the contract auditor in the form of contingency fees. Such fees are significant (generally ranging from 25 percent to 35 percent of any additional tax assessed) and assuredly exceed the cost of performing the audits since firms would otherwise be unwilling to conduct contract audits. The assessor's costs of staffing and training would be recovered in the audit assessments and, at the same time, enhance the expertise of the staff.

AUDIT EFFICIENCIES AND TAXPAYER COSTS

* Third party audits may prolong the audit process and spawn unwarranted hearings because the contract auditor's only authority is to secure cost numbers. The contract auditor often gathers facts without explanation to or from the taxpayer. Resolving the underlying tax issues is left to the assessor after the audit has been completed. An assessor with minimum staffing may be reluctant to become involved in the audit or interfere with the contract auditor's work until it is completed. This situation eliminates any exchange on issues between the taxpayer and the assessor during the audit process. When a staff employee performs the audit, an exchange of information and ideas occur. The auditor and the taxpayer often are able to gain an understanding of each other's position that can result in resolving issues. In addition, documentation necessary to support a resolution of a problem is readily available and the assessor's staff is prepared and knowledgeable of the facts supporting the audit results in the event a formal hearing is necessary to resolve outstanding audit issues.

When the assessor's built review begins with the numbers supplied by the contract auditor (following completion of the auditor's field work), a duplication of effort may result. This occurs when the assessor requires additional documentation and development of facts to understand the issues involved. The taxpayer must retrieve and review records originally given to the auditor, which may take as long as the original audit to satisfy the assessor's request. To obviate this duplication of effort, the taxpayer may choose the remedy of a formal hearing rather than prolong the audit.

* When personal property audits are performed for a contingent fee, the auditor may be motivated to propose an assessment even if it is highly speculative. Additionally, specific issues can become more difficult to settle with the auditor because the resolution of any issue in the taxpayer's favor reduces the auditor's compensation. Since the cost of protesting a questionable audit deficiency frequently approaches the amount of the related tax amount, questionable audit assessments may not be challenged.

* Most of the shortcomings with contingent fee audits are also present where third-party auditors are paid on an "hourly basis". This fee arrangement can motivate the auditor to extend the length of the audit. Symptoms of this problem are requests for an overabundance of records, progressing at a slow pace, reluctance to settle issues in a timely manner, and the raising of questionable issues. These delays are costly for both the taxpayer and the government.

* Statutory authority to hire contract auditors may be questionable in some jurisdictions. Consequently, taxpayers may initiate lawsuits to test the validity of the contract audit concept. These suits will not be inexpensive for either the taxpayer or the taxing agency.

CONFIDENTIALITY

* Contract audits (regardless of the fee arrangement) create concern regarding the confidentiality of records, business practices, concepts and system designs. Contract auditors often offer their services to the public as well as to government. In offering business advice to clients, ideas obtained in the course of conducting audits on behalf of the government may be inadvertently communicated. Although confidentiality is also a concern with agency-staff audits, these auditors must change jobs before utilizing any confidential information, which minimizes the immediate risk.

CONCLUSION

It is clear that any fiscal savings from reduced government audit staffing and travel are speculative if not illusory. Taxing jurisdictions lose revenues because of hefty contingent fees and incur additional legal fees to defend questionable assessments and threshold authority to employ contract auditors. Finally, contingent fee audits, with their bounty hunter image, diminish the public's regard for the fair administration of tax policy.

These above principles were upheld by the Georgia Supreme Court's decision in Sears, Roebuck and Company v. Parsons, Docket No. 590A1678 (Feb. 21, 1991) where the court held a contingent fee audit illegal for reasons of public policy. The Court stated "[t]he people's entitlement to fair and impartial tax assessments lies at the heart of our system, and indeed, was a basic principle upon which this country was founded. Fairness and impartiality are threatened where a private organization has a financial stake in the amount of tax collected as a result of the assessment it recommends."

In short, the tax assessor, who is empowered by law for administering personal property taxation should meet these responsibilities with common-law employees so that the confidence and trust of the public can be maintained. Additionally, all tax monies collected will remain within the taxing jurisdiction -- at home.