Legislation and audits: changing trends?
To compensate for shrinking state and local tax revenues, governments are making substantial legislative and regulatory adjustments--from disallowing Federal deductions, to restricting use of net operating losses (NOLs), to broadly proscribing perceived "abusive tax shelters," to expanding the tax base and/or tax rates for transactional taxes. These new laws and regulations often are a reaction to state judicial and administrative decisions or to gaps in the state tax code. (For example, Mass. Gen. L. ch. 62C, [section] 3A, which allows the commissioner of revenue (COR) to "disallow the asserted tax consequences of a transaction by asserting the application of the sham transaction doctrine or any other related tax doctrine," was enacted in March 2003 as a response to a taxpayer victory in an expense disallowance challenge before the Massachusetts Supreme Judicial Court; see Sherwin-Williams Co. v. MA COR, 778 NE2d 504 (MA 2001). North Carolina recently established an "Efficiency and Tax Loophole Closing Commission," whose purpose was to identify potential tax code loopholes; see "COST Comments: Avoiding the Hypocrisy of Loophole Closing," 2003 State Tax Today (STT) 183-3 (9/15/03).) In any event, such measures reflect the pressure state legislatures feel as budgetary shortfalls loom.
In addition to the passage of increasingly restrictive legislation, state audit activity has risen dramatically and there is a growing trend towards more aggressive audits. Auditors have begun to take a more expansive approach as to including items in audit workpapers, forcing taxpayers to prove that each item under scrutiny should be excluded from examination. It is uncertain whether this activity stems from policy shifts by state revenue departments or is a product of the rapidly growing "contract audit" market, in which private entities contract with the state to provide taxpayer audit services, and are paid a fixed percentage of the revenue they generate. Regardless, such state activity has dramatically increased taxpayers' compliance burden and has caused the tax service provider's role to shift from proactive planner to reactive advocate.
The tax adviser's role is to provide clients with sound advice, to ensure not only compliance with the tax laws, but also that the taxpayer is not paying more than is required under the law. Understandably, given the dire financial situation at the state and local levels, revenue authorities often take a dim view of the latter function, occasionally seeing tax advisers as peddlers of tax motivated shelters and schemes unsupported by business purpose or economic substance. To underscore this contention, 40 states and the District of Columbia recently agreed to exchange information with the IRS to prevent duplication of efforts in combating perceived "abusive tax avoidance schemes and transactions"; see IRS,"40 States Partnering to Fight Abusive Tax Avoidance Schemes," 2003 STT 180-1 (9/17/03). Accordingly, tax advisers must walk a fine line between limiting client tax exposure and being viewed by state tax administrators as fostering tax evasion.
The Challenge to State Governments
For state and local governments facing current and continuing budget deficits, two solutions exist: reduce spending or increase revenue streams. With many government programs already sharply scaled back, further cuts in spending are politically sensitive. Thus, governments would prefer to collect more revenue. The main sources of state and local government revenue are Federal aid and taxes. With the Federal government currently operating at a deficit due to increased spending requirements, Federal aid cannot be counted on as a significant source of state and local government funding, leaving only taxes.
State governments have long claimed that tax revenues are decreasing, largely due to tax evasion schemes. In a recent study by the Multistate Tax Commission (MTC), "Corporation Tax Sheltering and the Impact on State Corporate Income Tax Revenue Collections," it was estimated that states "lost" approximately $12.4 billion in corporate income tax revenue alone, which represents 35% of all 2001 state corporate income taxes collected (see "Corporate Tax Sheltering and the Impact on State Corporate Income Tax Revenue Collections," 2003 STT 140-4 (7/22/03); see also "Abusive Tax Shelters Should Be Curtailed, But the MTC's Exaggerated Numbers Aren't Helpful to the Debate" 2003 STT 144-6 (7/28/03) (criticizing the MTC report by charging that estimates of the cost of shelters are inflated)).The study also noted that revenue was "lost" in 45 of the 50 states and the District of Columbia.
Corporate income taxes are not the only source of tax revenue that states claim are being eroded. More recently, many state and local taxing authorities have cited declining sales tax receipts as a factor in their budget crises, identifying Interact sales as the main culprit. At least one recent study estimated that such sales cost approximately $13 billion in states' sales tax revenue in 2001. This estimate was based on the fact that online sales do not yield sales or use tax revenue if the seller does not have nexus with the taxing state (a result that can be engineered by the taxpayer), and the purchaser does not "self-assess"; see "State and Local Sales Tax Revenue Losses from E-Commerce: Updated Estimates," 2001 STT 207-39 (10/25/01).
Despite these claims, a recent study performed on behalf of the Council on State Taxation (COST) found that U.S. businesses actually experienced a 5.3% tax increase compared to 2002, which amounts to an additional $20.3 billion in total taxes paid for fiscal 2003; see "Total State and Local Business Taxes: Fiscal Year 2003 Update" 2003 STT 179-1 (9/16/03). The study also indicated that business taxes, on the whole, have increased in the past three years. (The MTC counters this point by asserting that the average effective corporate income tax rate, which was approximately 9% for 1980-1989,shrank to 5.4% for 2001, a 34% decline; see 2003 STT 140-4 (7/22/03). This decline, the MTC mad the states argue, is based in part on increases in the sophistication and complexity of state corporate income tax planning, including the use of special-purpose and nontaxable entities.)
Finally, states are finding that tax credits and incentives, two of the main tools used to attract new business, are creating unintended effects. Typically, states enact credits and incentives to stimulate economic activity within their borders by attracting nonresident businesses, thus expanding the tax base. However, such measures often result in state residents taking advantage of the tax breaks, as opposed to nonresident companies. The state's tax base is thereby reduced, with little or no offsetting increases flora new economic activity.
These factors make it clear that states will continue to alter their tax laws, targeting specific planning transactions and increasing taxpayer penalties. While this development is significant, taxpayers should also expect states to begin to increase the scope and intensity of their audit activity--a trend that ultimately could have a greater effect on taxpayers' operations than new tax laws. Thus, in addition to monitoring state legislative and administrative developments, taxpayers need to expect and prepare for state audits by scrutinizing their tax treatment of certain audit "red flag" items, such as NOLs and related-party transactions.
The States Respond: Legislation
State tax legislation in recent years has focused on three main areas: prohibiting perceived abusive transactions; altering or strengthening enforcement of existing rules; and application of penalties. While each new measure varies in scope and detail, the goals are identical--to increase tax revenue. As discussed below, these legislative and administrative measures can encompass a wide variety of taxes and transactions and are often broader than required to achieve the parallel state objectives of fostering tax law compliance and preventing tax evasion.
Targeting abusive transactions: In California, recently enacted legislation (AB 1601 and SB 614) expands the definition of "reportable transactions" (i.e., transactions that must be disclosed to the California Franchise Tax Board (FTB)), penalizes investors and the promoters of these tax shelters (retroactive to Feb. 28, 2000), and extends the statute of limitations for audits from four to eight years. California also suspended the carryforward of NOLs for tax years ending Dec. 31, 2002 and Dec. 31,2003 (in AB 2065 (signed 9/11/02)) and increased the standard fee for limited liability companies to $12,000 per year.
New Jersey enacted major legislation in 2002,labeled the Business Tax Reform Act (BTRA), to address declining corporate income tax revenues, which had dropped from 15% in 1982 to just 6% of total revenue collected in 2001. In addition to overhauling the state's income tax laws by expanding the corporation business tax nexus standard and imposing an addback of interest and intangible expenses paid to related members, the BTRA disallowed NOL carryforwards for tax years 2002 and 2003.The BTRA also closed several perceived gaps in the law. For example, it implemented a throwout rule for sales made to jurisdictions in which the taxpayer is not taxable. Under prior law, sales to such jurisdictions resulted in "nowhere" sales, and reduced the taxpayer's New Jersey apportionment factor.
Further, the BTRA instituted a $150 per owner passthrough-entity-return processing fee, which also applies to professional corporations with professional licenses in New Jersey, and suspended the phaseout of the tax on S corporations until 2006. Finally, the BTRA created the alternative minimum assessment (AMA) tax, which requires corporations to pay the greater of the AMA tax or the regular income tax. Previously, the state required corporations exempt from the state's Corporation Business Tax (by virtue of P.L. 86-272) to pay a $200 minimum tax. Under the new law, such corporations have to pay the AMA.
Administration and enforcement: In Texas, Tex. Laws 2003, Rider 11 to HB 1, includes provisions sharply limiting taxpayers' ability to claim refunds. Under this new law, taxpayers with refunds over $250,000 will not receive them until the state legislature has appropriated the refunds as a separate line-item in the state budget. The new law applies to any tax, fee, penalty, charge or other assessment collected or administered by the comptroller of public accounts. Given that the Texas legislature meets once every two years, this creates, at a minimum, a timing challenge and raises many questions about whether the legislature will ever appropriate a retired in the budget.
In Illinois, proposed legislation (Ill. HB 18 (introduced 1/8/03)) would expand the department of revenue's (DOR's) authorized method to collect delinquent taxes to include the use of private-collection entities. In addition, the DOR could make public any personal information about a delinquent taxpayer after providing 30 days notice. Pennsylvania developed the Vendor Enforcement Program, which will work with the state department of motor vehicles to interview truck drivers at roadside stops to determine nexus for sales, corporate and personal taxes; see PA DOLL, News Release No. 103 (January/February 2003).
Penalty provisions and amnesties: All states have penalty and interest provisions for noncompliant taxpayers; however, implementation and enforcement of these provisions varies, in that they may be used by the states as a punishment or an inducement. Specifically, state DOR's may implement penalty procedures to force taxpayers to comply with the tax law out of fear of additional assessment, or to entice compliance by offering amnesties and other waivers to taxpayers that have failed either to file the proper returns or pay the appropriate taxes due.
For example, in Colorado, the frivolous-return penalty is the greater of $150 or 150% of the tax. A frivolous return is one that: (1) does not contain information that allows the return's correctness to be judged; or (2) contains information that, on its face, indicates the return is substantially incorrect. In addition, the taxpayer's conduct must be due to either a frivolous position or a desire to delay or impede the administration of state income tax laws; see Colo. Laws 2002 HB 1219 (effective 8/2/02).
Conversely, Louisiana recently amended its penalty waiver provisions (La. Admin. Code 61:III.2101 (amended June 2003)), which allow the secretary of revenue to excuse penalties for failing to timely file a return or pay tax, absent negligence, if the taxpayer is current in filing all returns and paying all taxes due. The goal of this provision, and similar state penalty-waiver rules, is to foster taxpayer compliance with the state tax laws and encourage voluntary compliance. Although the state forgoes the right to additional penalty assessments, achieving voluntary compliance generally proves to be cheaper than pursuing the audit process or litigation.
In addition to penalty-waiver provisions, most states offer amnesty programs. Under such a program, a state will allow taxpayers to report and pay delinquent taxes without imposing interest or penalties for the years covered. Essentially, the difference between amnesty programs and penalty-waiver provisions is procedural. Under amnesty, a taxpayer generally need not have permission to participate, and penalties are waived if all conditions are met; penalty-waiver provisions generally are applied only at the DOR's discretion. Nevertheless, amnesty programs typically last only a few months; taxpayers need to be aware of state filing deadlines and procedures. Tax advisers with clients operating in states offering an amnesty program need to review clients' compliance as to all taxes imposed by the amnesty jurisdiction.
Adoption of new legislation and rules will continue at the state level as long as there are perceived shortcomings in the tax laws, or if strict enforcement of the laws ultimately proves to be too costly. As a result, new measures will continue to be introduced and compliance programs (such as amnesties) will continue their popularity.
The States Respond: Audits
To deal with immediate revenue demands, states often do not have the luxury of waiting for new laws to take effect or hoping that amnesty programs will yield actual benefits. Accordingly, in addition to enacting broad tax legislation, states have expanded their audit activity. However, given that budget shortfalls have reduced government workforces, states have had to explore more cost-effective ways of implementing this increased enforcement, most notably through the use of contract audits and self-assessment programs; see "Tax Departments Face Layoffs, New Leaders, Officials Say at NESTOA," 2003 STT 193-5 (10/6/03).
Contract audits: Contract audits are taxpayer examinations private entities conduct on behalf of a state for a percentage of the revenue recovered; see Ariz. Laws 2002, HB 2243 (signed 4/29/02); Tenn. Laws 2003, Ch. 118, HB 1808/SB 1753 (effective 5/12/03); 34 Tex. Admin. Code [subsection] 3.3 (effective 2/28/02) and 3.368 (adopted 3/1/02). In general, contract audit firms tend to be smaller companies with fewer resources than state governments. Thus, contract auditors typically are more aggressive--and less willing to settle--than state-employed auditors and taxpayers often find them less approachable than state auditors in discussing issues or negotiating possible resolution.
Self-audit: Alternatively, under most self-audit programs (which include managed audits), a taxpayer does the initial review under an agreement with the state. In a typical self-audit, the taxpayer performs a review without state help. The taxpayer gives the audit results to the state in exchange for an agreement from the state related to performing a separate audit for any of those years or charging interest or penalties. Alternatively, in a managed audit, the state auditor first agrees that a self-audit is feasible, then develops a plan that is performed by the taxpayer. The taxpayer gives the results to the state auditor, who verifies them and agrees not to perform a separate audit for those periods, and to reduce or waive all interest and penalties.
The leading state for managed audits is Ohio, which allows businesses with tax deficiencies to audit their own records tinder the guidance of a state tax agent, and to ascertain and resolve the liability by voluntary payment of tax mid interest without penalty. California recently established such a program for sales and use taxes, effective until Jan. 1,2009.To be eligible, the taxpayer's business must have only limited statutory sales and use tax exemptions, and a single or small number of clearly defined taxability issues. Eligible taxpayers also must have the resources to comply with the managed-audit program; see Cal. AB 1043 (approved by Gov. 7/21/02).
In Maryland, the Comptroller's Office has implemented a managed-audit program for sales and use tax and unclaimed property audits. If, after an initial appointment, the state auditor recommends a managed audit, a representative of the business and a state auditor execute a managed-audit agreement, specifying the period to be audited and the audit length. The taxpayer is provided with customized written procedures and instructions for performing the audit; see MD Comptroller's Office, MD ReveNews (Winter 2002). Florida recently extended its certified audit program until 2006. Under this program, taxpayers are provided the opportunity to hire (at their own expense) qualified CPA firms to review their tax compliance. As an incentive to participate, the state agrees to waive penalties and abate interest if taxes are owed after the audit. In addition, unless there is fraud or misrepresentation, the DOR will not audit taxpayers for the same period or tax covered by the certified audit period; see Fla. Stat. Ann. [section] 213.285.
Traditional audits: Standard audit activity, in which the state performs the examination, has also increased. For example, in California, the FTB recently stated that it would target taxpayers using tax shelters, and mailed approximately 150 audit-contact letters to taxpayers suspected of abusing the tax laws. In addition, the FTB currently is auditing 265 tax shelter cases, focusing on the following issues: (1) basis shifting--using foreign corporations (in tax haven countries) and instruments to artificially increase and shift the basis of foreign shareholder stock (not subject to U.S. taxation) to stock owned by U.S. shareholders; (2) inflated basis--using transactions that are "contingent" (i.e., not completed) to inflate an owner's basis (ownership interest/true economic risk) in a passthrough entity investment; and (3) commercial domicile--incorporating in a non-income-taxing state (e.g., Nevada, Delaware) to avoid California income taxes.
These actions coincide with the finalization of a Memorandum of Understanding with the IRS's Small Business/Self-Employed Division to share information on tax shelters, including names of investors involved in abusive tax schemes. Further, the FTB allowed taxpayers to use the IRS's voluntary compliance initiatives to file amended returns by Oct. 15, 2003, to avoid civil fraud and criminal prosecutions.
States are finding that their efforts may be paying off. The June 2003 edition of State Revenue Report, published by The Nelson A. Rockefeller Institute of Government, noted that state tax revenues grew by 1.4% from January 2003--March 2003, compared to the same period for 2002. In addition, corporate income tax revenue increased by 10.3%, extending growth for a third straight quarter following seven straight loss quarters. The publication also reported that state governments had enacted new net tax increases for the fifth straight quarter, expected to generate an additional $2.6 billion in state tax revenue.
However, these successes have not translated into a more taxpayer-friendly environment, as state legislatures and revenue agencies continue to pass restrictive statutes and regulations that affect how items are treated for tax purposes. In addition, audit activity has sharply increased and become more aggressive. Thus, taxpayers need to monitor business developments and work with their tax service providers both to ensure compliance before receiving an audit notice and to properly manage the audit and defend their positions once the audit process has begun.
Editor and Co-Author:
Faranak Naghavi, CPA
Principal State and Local Tax Group
Ernst and Young LLP Washington, DC
Mark D. Fishman, CPA
Senior Tax Manager
Habif, Arogeti & Wynne, LLP Atlanta, GA
Karl Nicolas, Esq.
Ernst & Young LLP Washington, DC
Editor's note: Ms. Naghavi chairs the AICPA Tax Division's State and Local Tax Technical Resource Panel (TRP). Mr. Fishman is a member of the TRP.
For more information about this column, contact Ms. Naghavi at faranak.naghavi@ ey.com or Mr. Fishman at firstname.lastname@example.org.
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|Title Annotation:||state and local taxes|
|Publication:||The Tax Adviser|
|Date:||Dec 1, 2003|
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