Legislation and audits: changing trends?

• Author: Naghavi, Faranak
• Position: State and local taxes

Recent economic trends have resulted in fiscal crises for both business aid government. At the state and local level, budget deficits have become the rule--rather than the exception--as governments struggle to maintain employee rolls, invest in new technology and infrastructure mid provide vital services to their citizens. However, unlike private enterprise, government entities cannot resolve their fiscal woes by declaring bankruptcy or going out of business. They must find revenue to maintain operations and taxes remain the primary source of funding.

To compensate for shrinking state and local tax revenues, governments are making substantial legislative and regulatory adjustments--from disallowing Federal deductions, to restricting use of net operating losses (NOLs), to broadly proscribing perceived "abusive tax shelters," to expanding the tax base and/or tax rates for transactional taxes. These new laws and regulations often are a reaction to state judicial and administrative decisions or to gaps in the state tax code. (For example, Mass. Gen. L. ch. 62C, [section] 3A, which allows the commissioner of revenue (COR) to "disallow the asserted tax consequences of a transaction by asserting the application of the sham transaction doctrine or any other related tax doctrine," was enacted in March 2003 as a response to a taxpayer victory in an expense disallowance challenge before the Massachusetts Supreme Judicial Court; see Sherwin-Williams Co. v. MA COR, 778 NE2d 504 (MA 2001). North Carolina recently established an "Efficiency and Tax Loophole Closing Commission," whose purpose was to identify potential tax code loopholes; see "COST Comments: Avoiding the Hypocrisy of Loophole Closing," 2003 State Tax Today (STT) 183-3 (9/15/03).) In any event, such measures reflect the pressure state legislatures feel as budgetary shortfalls loom.

In addition to the passage of increasingly restrictive legislation, state audit activity has risen dramatically and there is a growing trend towards more aggressive audits. Auditors have begun to take a more expansive approach as to including items in audit workpapers, forcing taxpayers to prove that each item under scrutiny should be excluded from examination. It is uncertain whether this activity stems from policy shifts by state revenue departments or is a product of the rapidly growing "contract audit" market, in which private entities contract with the state to provide taxpayer audit services, and are paid a fixed percentage of the revenue they generate. Regardless, such state activity has dramatically increased taxpayers' compliance burden and has caused the tax service provider's role to shift from proactive planner to reactive advocate.

The tax adviser's role is to provide clients with sound advice, to ensure not only compliance with the tax laws, but also that the taxpayer is not paying more than is required under the law. Understandably, given the dire financial situation at the state and local levels, revenue authorities often take a dim view of the latter function, occasionally seeing tax advisers as peddlers of tax motivated shelters and schemes unsupported by business purpose or economic substance. To underscore this contention, 40 states and the District of Columbia recently agreed to exchange information with the IRS to prevent duplication of efforts in combating perceived "abusive tax avoidance schemes and transactions"; see IRS,"40 States Partnering to Fight Abusive Tax Avoidance Schemes," 2003 STT 180-1 (9/17/03). Accordingly, tax advisers must walk a fine line between limiting client tax exposure and being viewed by state tax administrators as fostering tax evasion.

The Challenge to State Governments

For state and local governments facing current and continuing budget deficits, two solutions exist: reduce spending or increase revenue streams. With many government programs already sharply scaled back, further cuts in spending are politically sensitive. Thus, governments would prefer to collect more revenue. The main sources of state and local government revenue are Federal aid and taxes. With the Federal government currently operating at a deficit due to increased spending requirements, Federal aid cannot be counted on as a significant source of state and local government funding, leaving only taxes.

State governments have long claimed that tax revenues are decreasing, largely due to tax evasion schemes. In a recent study by the Multistate Tax Commission (MTC), "Corporation Tax Sheltering and the Impact on State Corporate Income Tax Revenue...