For most businesses, the likelihood of being audited by the Internal Revenue Service (IRS) is less than 2%, but ask those who have been through one and the response is always the same – it is a long, gut-wrenching process, no matter how good your records are. Concluding an “examination from Hell” often leaves a taxpayer exhausted and frustrated. Unfortunately, the pain does not end by simply acquiescing to an IRS agent’s audit determination. State tax authorities wait in the wings for their piece of the audit pie. Below are some of the prominent state tax issues that may arise subsequent to an IRS adjustment to a business’s Federal income tax return.
A growing number of states have begun enacting some type of economic or factor-presence test for nexus purposes. Nexus laws require some connection between a taxing jurisdiction and the taxpayer on which the state seeks to impose its tax rules. This was easy to do when the US economy was manufacturing-based, because the location of a business’s employees and property was enough to establish state tax nexus. Now, in a service and computer-based economy, states have trouble applying their taxes on providers located outside their boundaries. Enter economic nexus laws, which provide for minimum receipt thresholds as a way of establishing nexus with an out-of-state business that is exploiting the state’s marketplace. For example, California’s corporation franchise tax has an indexed economic nexus standard for 2014 of $529,562. Similarly, Ohio’s bright-line nexus test for Commercial Activities Tax purposes is $500,000 of in-state gross receipts. Accordingly, an IRS audit adjustment on a business’s receipts may cause a change to the entity’s state sales figures. Such a change may lead to sales figures in excess of state economic thresholds, which may create nexus and necessitate a tax return filing.
A Federal tax audit adjustment might also impact a multistate taxpayer’s apportionment factors. Apportionment is the mechanism for properly dividing a business’s revenues among the states in which it operates. Apportionment assigns income to a state through the use of a ratio of in-state factors and total factors, rather than tracing each item of income and deduction to the jurisdiction where generated. Traditional apportionment uses an equally weighted three-factor formula consisting of property, payroll and sales. However, many states have, or are moving toward, a more heavily weighted receipts factor formula or even a single receipts factor formula.
Adjusting a business’s sales at the Federal level will likely affect a taxpayer’s state apportionment. In general, under state statutes and regulations, all receipts from activities within the normal course of business operations are included in the apportionment sales factor. Therefore, a change to the overall sales will almost certainly alter the in-state to total sales factor ratio.
Virtually all states impose a sales tax on receipts from the sale of tangible personal property and some specifically enumerated services. The tax is usually charged to the consumer of the tangible personal property or the recipient of the taxable service. Vendors act as fiduciaries of the state by collecting sales tax from customers and remitting the funds on a periodic basis to the state taxing authorities. However, in situations where a vendor does not properly charge sales tax, state tax departments can assess vendors for the underpaid or unpaid tax. Therefore, a Federal adjustment to a business’s sales for income tax purposes can raise sales tax assessment concerns. For example, if an IRS audit adds a certain amount of sales to the records of a retailor of taxable tangible personal property, sales tax may be due on those additional receipts. It would be difficult, if not impossible, for the business to track down those customers associated with the IRS sales adjustments. The end result may lead to the business having to pay the applicable state sales tax out of pocket with little possibility of recouping the funds.
Since Federal taxable income is generally the starting point for computing state income taxes, state laws often require taxpayers to report tax adjustments resulting from IRS examinations. This is frequently done by filing an amended state tax return detailing the corrections or changes to the Federal taxable income. Depending on the jurisdictions where a business files tax returns, some states will require a reporting of all Federal changes, whereas other states only require reporting if there is a resulting net effect on the particular state’s tax attributes. States also differ in the amount of time permitted to report such Federal changes; generally, somewhere between 30 to 180 days following the issuance of a final determination by the IRS is the norm. Failure to timely report a Federal adjustment to the state taxing authority may cause the imposition of penalties, extend the statute of limitations for state tax assessments, and reduce interest accrual on a refund claim.
If you have any questions regarding the state tax implications of a Federal tax examination, please contact Alan Goldenberg, Manager of Tax Controversy and State and Local Taxation, at firstname.lastname@example.org or 212-897-6421, or your Friedman LLP tax professional. •