Most businesses will eventually be involved in an audit by a state or local tax department. Audits can be time consuming and result in significant tax and penalties exposure. There are many ways in which a business or individual investor can mitigate the harsh realities of an extended tax audit. One of the best ways to prepare for the unknown is through diligent planning. Non-audit or pre-controversy planning should begin well before an audit or other notice arrives.
Evaluating current positions
The key to proactive engagement with state and local taxing authorities is understanding current potential tax liabilities and exposures. Businesses often take the same positions on returns year after year without fully considering changes to tax laws or to their operations. A review of those positions on a periodic basis can help identify potential tax and penalties exposure. Position review also provides a great opportunity to evaluate refund opportunities.
Preparation for controversy should not end at current return positions. Businesses should also consider future changes that materially impact current positions or that may draw the attention of a state or local tax department. Is the business planning any large expenditures? Are there significant new positions or revisions of existing positions to consider? Is the business expanding, changing ownership or restructuring? Documenting current and future positions is the keystone of pre-controversy preparation.
Businesses should also be aware of the current audit trends. For example, state transfer pricing audits have increased dramatically in recent years. Some states have adopted and many more are considering allowing businesses to enter into advanced pricing agreements. These agreements substantially mitigate the possibility of a prolonged transfer pricing audit – and subsequent adjustments. Multistate businesses engaged in intercompany transactions should consider entering into such agreements when the facts and circumstances warrant. Increased audit activity coupled with the need to be informed for future intercompany activity will help build a strong foundation to respond to a transfer pricing audit. In addition to transfer pricing, there are, of course, many other areas in which state and local audit activity has increased. It is critical that businesses are aware of ever-changing audit developments.
Getting ahead of exposure
There are many considerations for businesses that identify an exposure through the pre-controversy process. For example, a business may consider pursuing voluntary disclosure agreements, entering into a managed audit where available, and taking advantage of state and local amnesty programs. In some cases, a business may need to request certain other relief directly from a tax department such as alternative apportionment.
Taxpayers may choose to consider a private letter ruling for transactions with complex facts or unclear law. While the rules governing such requests vary widely by state, there are significant advantages from obtaining a ruling. The taxing authority will issue a ruling upon which the taxpayer can rely as long as the facts and circumstances do not materially change. The taxpayer can pursue its business goals with certainty as to the tax consequences – and generally prevent future audits and adjustments.
The methods for proactively mitigating exposure apply to all taxes including employment, income/franchise, and sales and use taxes. Businesses considering or planning significant changes to operations including mergers, acquisitions, or entry into new markets should also consider what avenues are available to mitigate future tax liabilities and audit expense. The right approach to mitigating exposure will depend on many facts and circumstances, including state and local tax laws and the general materiality of the liability.
Equally important, businesses should have a plan in the likely event of notices or correspondence from a state or local tax authority. All notices and correspondence should be taken seriously. In addition to formal notices, tax departments could send activity questionnaires to determine nexus for the business and related entities. These should be treated with care and a heightened due diligence as they often are required to be completed within a certain time period. Haphazardly completing a nexus questionnaire may create risk for the responding business.
Finally, businesses should have a plan to appropriately and quickly respond to communications from the moment they are received. Late responses to notices may result in compounded interest and penalties and failure to meet certain deadlines may result in lost opportunities to challenge the communication.
Don’t go at it alone
Pre-audit controversy preparation is not a single step nor a one-time process. It must be considered as a crucial component of long-term tax planning and incorporated into the tax compliance process. Moreover, state and local tax controversy in the COVID-19 era has added both complexity and opportunity. Taxpayers are encouraged to evaluate their controversy preparation, especially in the COVID-19 environment.