A CFO and a tax expert detail how to avoid some of the pitfalls of state audits.
As chief financial officer of Business Wire, a San Francisco company with operations in 13 states, Connie Cummings has had little choice but to become an expert at surviving state tax audits. She handled her first--from Massachusetts's tax authority--back in 1983.
Since then, Cummings notes, "it seems as though anytime a state sets up its own tax office in California, we get audited. And once they audit your company on one point, they'll find something else to audit you about." She laughs, a bit ruefully. "There have been times when states seem to have audited us for no other reason than that they were auditing one of our vendors and our name popped up. State tax audits are just a fact of life for companies that do business in multiple states."
For many entrepreneurs, it comes as a surprise that today's biggest tax problems are likely to come from revenue-starved state agencies. In comparison, the IRS currently seems to lack the resources or the motivation to pursue most small businesses so aggressively. The trade-off is not a good one for owners of small companies, since they must cope with a mass of complicated and sometimes inconsistent state tax regulations.
Consider the experience of Business Wire, which operates a media-relations news wire and has faced simultaneous audits from different states. "I've taken a fair number of continuing-education courses so that I can try to stay on top of multistate tax trends," Cummings says. "But different states have such different rules--which sometimes even conflict with each other. And the states tend to audit companies at such different rates that most courses can't begin to give you specific state-oriented information." Business Wire's state audits are complicated by the company's S corporation status. "When the state decides to do a corporate audit, it usually throws in a personal income-tax audit as well," she confides.
Since it's almost impossible to predict what might trigger a state's interest, Cummings has developed a general defensive approach. She uses the same strategy whether the audit is completed in person or by phone and by mail. "You've just got to document everything you can and be prepared to respond to state tax inquiries with as much information as possible," she explains.
Cummings has learned from experience that Business Wire's state tax audits frequently focus on the way the company divides its revenues and expenses--and thus its tax liabilities--among states. To deal with those "apportionment" issues, the CFO has prepared "a huge spreadsheet, complete with plenty of documentation about our apportionment rationale," which she sends to any tax authority that has questions.
Cummings says her approach has helped Business Wire ace all but one of its state tax audits. As for that one exception, she reports that Business Wire is contesting the state's decision--and the accompanying $80,000 tax bill. The issue involved: sales-tax liabilities on electronically transmitted information, one of the thorniest state tax problems today.
Meanwhile, Cummings strives for tranquillity amid a tax situation that's becoming ever more stormy. "There's no way to deal with state tax audits except on a case-by-case basis. So I file the most carefully prepared tax returns I can and then forget about them until questions arise. Otherwise, you could drive yourself crazy."
Have state taxes become excessively costly or time-consuming for your company? Please send your experiences or questions to Inc. finance editor Jill Andresky Fraser at email@example.com by E-mail.
Have state tax audits become excessively time-consuming or costly? In a recent survey by accounting firm Coopers & Lybrand, 18% of the 434 fast-growing companies surveyed said they avoid placing operations in certain high-tax states. The list below highlights the states most frequently cited as problems.
Massachusetts Washington Oregon Minnesota California Pennsylvania New York Colorado North Carolina Kansas Florida
How to Survive a State Audit
At a time when revenue-hungry states and local municipalities are becoming ever more aggressive, audit risks abound. For some tips about ways to respond, Inc. interviewed Joe Donovan, a multistate tax expert and partner at the Boston office of accounting firm Coopers & Lybrand.
Q. What are some of the biggest state audit threats right now?
A. Different states have different priorities. But the issues that now seem to get challenged most frequently include revenue apportionment between states; transfer pricing, which involves the prices charged for transactions between different subsidiaries of a company; nexus, which refers to a state's ability to tax business activities within its borders and sales and use taxes, especially in cases in which research and development or electronic transfer of information is involved. Unfortunately, there's no general rule of thumb about how the states will interpret those issues or about which practices will trigger an audit.
Q. Let's say your company receives an audit notice. Can you generalize about the best course of self-defense?
A. It can be very helpful to get in touch with local sources--which most companies should be able to do with the help of their accounting or legal firms--to get some basic information about the way this particular state's audits work. Do local auditors have the ability to negotiate settlement deals on their own? Is the state notorious for conducting painstakingly long audits with companies in your industry? Sometimes you can even gain some useful tips about dealing with your particular auditor.
Q. Are there any similarities between handling a state tax audit and a federal one?
A. Just as with a federal audit, with a state audit it's essential to appoint one person--either at your accounting firm or within your organization--to handle all questions. That way you can control the flow of information and avoid creating any new complications. It's also important to remember that your point person should try to build a cordial, businesslike relationship with the auditor.
Q. Any final tips?
A. If you decide to challenge a state audit decision in court, it helps to remember that many states have Freedom of Information Acts that are equivalent to federal protections. Before you enter a courtroom, your company may be entitled to see its entire audit file, including any questions or reservations the auditor may have had about the case.