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What You Do Not Know About State and Local Taxation Can Hurt You

Date

September 1, 2006

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7 minutes

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Many businesses have state and local tax obligations and may not know it. Some businesses are not focused on the issue, some don’t want to spend the time or expense to figure out what their liabilities are and then comply with the various filing requirements, and some just assume that a tax would not apply.

State and local taxing jurisdictions are becoming increasingly aggressive and sophisticated in finding potential taxpayers (especially those out-of-state) and potential tax due. Understanding your state and local tax obligations is not only important, it could actually save you money. A business may be paying tax it does not need to, it may be entitled to certain credits or offsets, and it may be able to validly pass on the tax to someone else. Proactively addressing these obligations could also save a business significant amount of grief and aggravation (not mention potential back taxes, penalties and interest) if an audit occurs.

Types of Taxation

Although there are many types of state and local taxes, three of the most common are income, sales,and use taxes – which may have a different name depending on the jurisdiction. Income tax may be referred to as a franchise, privilege or a business tax. Sales tax may be referred to as a gross receipts, occupation or a transaction privilege tax.

Income Tax:
State income tax is generally a percentage of net income (i.e., gross income less certain deductions), but some states have a gross income tax or a value-added type tax. A multistate business, either individually or as a “unitary group,” will generally be required to allocate and apportion its income to all of the jurisdictions in which it has nexus (discussed below). As a result, if a company does business in several states but only reports its income to one state, each of the other states could seek to collect their respective share of the tax due. If a business is audited, it could have significant tax liabilities in a jurisdiction that could have likely been offset by not allocating all of its income to the first jurisdiction. By the time an assessment is received from another jurisdiction, it may be too late to amend a return and seek a refund for the overpayment of income tax in the first jurisdiction.

Sales Tax:
Sales tax is generally a percentage of the gross selling price. If a business is not focused on its sales tax obligations, it could be costly both on the selling side and on the buying side. On the selling side, a business must know if its products and services are taxable because the seller is generally responsible for remitting sales tax to the taxing jurisdiction whether or not tax was collected from the purchaser. Some jurisdictions have a very broad sales tax that subjects certain transactions and services not traditionally thought of as being subject to sales tax. For example, intellectual property licensing, data processing and certain business consulting services may be subject to sales tax. In addition, there are a number of sales tax credits and exemptions that an informed taxpayer could be using.

Because sales tax is a percentage of the gross selling price, a business could have lost money on a transaction but still owe sales tax to the applicable government. Worse, if a business knew its sales were subject to sales tax, it could have passed the tax on to the buyer, or at a minimum, factored it into the selling price. Once a sale is made however, it is generally difficult to collect the sales tax from the buyer, especially in a later year when a seller may be subject to an audit. If the business is lucky enough to get reimbursed by the purchaser for the sales tax due, the business will still generally have to pay penalties and interest as well as other internal and external costs for managing and defending an audit.

Use Tax:
Use tax is a compliment to sales tax and is based on the use or possession of an item in a jurisdiction for which no sales tax was paid. For example, if a business buys an item from an out-of-state vendor, does not pay sales tax on the purchase, and has it shipped into the state, the business will likely owe use tax to the state where the item is used. Because use tax is typically the same rate of tax as the state sales tax, the taxpayer will have likely negated any savings by not paying the sales tax initially. In addition, if audited by a taxing authority, the business will generally be subject to penalties, interest and other internal and external costs for managing and defending an audit, further negating any perceived savings.

Nexus

The central concept to state and local taxation is that a person cannot be taxed unless it has “nexus” (i.e., a taxable connection) with a jurisdiction. Nexus arises in many ways, and states are keenly interested (and sometimes aggressive) in finding that nexus exists to impose taxation. Although there are certain exceptions and limitations, a business will generally have nexus with a taxing jurisdiction if it has some presence or physical connection to that jurisdiction. Having one or more employees, independent contractors or agents in a jurisdiction acting on behalf of the business in that jurisdiction is one of the most common ways of creating nexus. These people need not work on a full-time basis nor for a particular period of time. Other common ways of creating nexus is owning or leasing property in the jurisdiction, maintaining a stock of goods (even for a short period of time) in the jurisdiction, having a satellite office and/or registering to do business in the jurisdiction. The threshold for creating nexus is generally low. Some courts have held that a taxpayer must have more than a de minimus or “slightest” presence in the taxing jurisdiction.

Voluntary Disclosure / Amnesty

If a business has nexus with a jurisdiction and tax liabilities as a result of its activities in that jurisdiction, the business needs to evaluate what to do about it. If the business does nothing and hopes for the best, the liability becomes a ticking time bomb because there is no statute of limitations for assessment if a return is never filed. Auditors could go back 20 years or more if they want. Besides the potential tax due, finding the documents to disprove a proposed assessment is oftentimes problematic.

Alternatively, a taxpayer, in consultation with its advisors, could come forward voluntarily and disclose its liability. Many taxing jurisdictions have either a formal or informal voluntary disclosure or amnesty program. The advantage to coming forward voluntarily is that, in most cases, the jurisdiction will only go back a few years, forgive tax for prior periods and will generally abate all penalties. Some may even waive interest.

Taxing jurisdictions encourage voluntary disclosure not only for the current revenue but, more importantly, to have another taxpayer in the system on a going forward basis. For these reasons, taxing authorities are generally willing to work with prospective taxpayers.

Audit and Appeal

If a business is audited, it should contact its tax advisors as early as possible. There are many things that a business should and should not do before, during and after an audit, and there are things that can be done to either eliminate a proposed assessment or to set the tone and position the audit for a successful appeal. If the audit is not handled properly, however, the appeal may be more difficult as a result of the actions (or inactions) taken during the audit.

Conclusion

Multistate taxation can be daunting and challenging for a business, but it should not be for its advisors. Understanding the issues and proactively addressing them could help avoid unintended, adverse and costly consequences.

 


David Blum is a partner in the Corporate Practice Group and the Taxation Service Group.
Circular 230 Notice Nothing contained in these materials was intended or written to be used, can be used by any taxpayer or may be relied upon or used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer under the Internal Revenue Code of 1986. Any written statement contained in these materials relating to any Federal tax transaction or matter may not be used by any person to support the promotion or marketing of or to recommend any Federal tax transaction. Any taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.


Filed under: Tax Planning

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