Cautionary Tales in State Tax Enforcement

by | Aug 21, 2021 | State and Local, Tax News

Cautionary tales about actual state enforcement

With an up an uptick in enforcement, it is a good time to do an internal health check of the company.

By Meredith Smith and Alexander Korzhen

We’ve been discussing questions from our clients on audits and thought this might be a good time to put out some cautionary tales as to what’s going on from a state tax enforcement perspective.  

The signs of heightened enforcement have been clear for a while. Even though state budgets aren’t as bad off as skeptics predicted in the early stages of the pandemic, states don’t have as much money as they would like (do they ever, though?). We’re seeing some (perhaps) borderline enforcement actions that in less aggressive times might not come up under audit.

Enforcement, in general, was lagging behind during the initial few years since Wayfair was enacted in 2018. The Wayfair decision was a windfall for states, which moved expeditiously to pocket revenue from remote sellers. But States were working overtime to intake all these new taxpayers. And, then the pandemic hit, prolonging the lull in enforcement. We’re seeing a significant uptick in audit activity. For business taxpayers, this means expect the unexpected.  

Curious pursuits 

The volume of audit notices coming through and curiously, what states are trying to accomplish, reveal some interesting trends. We have a California audit for sales tax purposes that shifted from questions about bundling issues to tax software. Misperceptions earlier on in the audit before TaxOps was brought in may have contributed to the change in focus from bundling, specifically a true object position, to unbundling based on whether the software was pre-written.  

On the income tax side, we had a client who kept their sales tax license open but closed their employment license when an employee quit. In our review, we found gross margin typical for the industry that was backed into tax. These missteps resulted in a $300,000 assessment for a taxpayer whose federal taxable income was only $100,000.  

In this case, the state skipped due process and advanced directly to an assessment, forcing the taxpayer to contradict that assessment with a self-audit. The state relied on industry matrices and other related data mining rather than conducting an audit and reviewing books and records. Auditors don’t get to just skip all these steps and assess penalties.  

In another case, a local jurisdiction sent a taxpayer an inquiry that the taxpayer questioned, checking legitimacy. The unexpected inquiry was unexpected and had to do with where the taxable funds collected were being distributed, to the state or local jurisdiction.  

States are also using data mining across agencies to check that, for example, taxpayers with payroll licenses are also filing income tax. Another client received a letter from a Secretary of State (SOS). The letter said the SOS had noticed that the taxpayer had set up an account for sales tax and employee withholding without a corresponding SOS license. The SOS had relied on data mining from the Department of Revenue to cross check licensing.  

The Takeaway 

We’re seeing an uptick in enforcement, so it is a good time to do an internal health check of the company, including: 

  • Review your nexus footprint with fresh eyes 
  • Look at taxability and readdress, as needed, tax code mapping if using an automated sales tax software
  • See where income tax returns are being filed 
  • Review what the apportionment looks like 
  • Make sure there is “one license for one tax type”  

We’re staying on top of these issues and are here to help you resolve tax issues. With the thousands of business taxpayers we work with, there’s a good chance we’ve seen what you are going through and have experience resolving complex issues. Reach out with your questions. 

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