This busy season may be the perfect time to perform a state and local tax checkup for your clients.
I know this is probably the last thing you want to do right now, but given the current tax climate across the U.S., proactively advising your clients about state and local tax matters should be a critical part of managing their tax exposure, as well as providing good customer service. Addressing the following three points will help you identify potential liabilities or mistakes and give you the opportunity to minimize or correct these issues before further damage can be done.
Identifying where your client is “doing business” is the first step to evaluating their filing responsibilities for state and local taxes. Nexus is the minimum connection or link between your client and a state seeking to tax them.
Historically, this connection was established through physical presence (i.e., employees, independent contractors or affiliates soliciting sales or performing services; owning or leasing real or tangible personal property; storing inventory in a warehouse, etc.). The extent of your filing requirements in a state largely depended on the nature of your business activities within that jurisdiction.
Times have since changed and physical presence is no longer necessary for many businesses to sell or market their goods and services. Many states now consider having an economic presence within their borders a sufficient enough connection to allow them to tax income.
The states also contend that advances in technology and electronic commerce have made the physical presence standard obsolete for sales and use tax purposes as well. For apportionment purposes, you should request sales, property and payroll dollars for all states, not just those states where your clients currently file returns.
This information is essential to determining whether your clients have exposure in other states. Further analysis may need to be done to assess whether these elements create nexus based on economic presence or statutory apportionment factors.
A growing number of states are turning to gross receipts taxes in lieu of income-based taxes as the nexus threshold for these taxes is minimal. For sales and use tax purposes, physical presence is still the “law-of-the-land” for the time being.
However, states are doing their best to expand this definition. If your clients sell products and services that are generally considered taxable in many states, you should determine what factors create nexus for sales and use taxes, and ask your clients questions about their business activities in these states.
If your clients are using a marketplace facilitator such as Amazon to sell their products, additional questions should be asked about these sales, especially if these clients are using Fulfillment by Amazon (FBA) services, and their inventory is stored in Amazon fulfillment centers across the country.
If your clients are filing returns for state and local income/franchise, gross receipts, sales and use, excise, licensing, payroll or property taxes in various jurisdictions, you should consider evaluating the quality and consistency of these returns, if they are being prepared and filed internally. Most of these returns have periodic filing deadlines (monthly, quarterly, etc.) and they often require an extensive amount of data from financial reporting systems or other information prepared by your client’s employees. You should also ask:
- Who is responsible for ensuring these returns are accurate or filed and paid in a timely manner? Does anyone reconcile the amounts being reported to the books and records? How are discrepancies or questions resolved?
- Are the correct sales tax rates being charged on sales? Are they sourcing revenue or income properly?
- Did they register with the Secretary of State to do business? If so, they may be required to file income/franchise returns.
State taxing authorities do not have sympathy for taxpayers whose defense for filing incorrectly is that they were unaware of the law or did not understand filing instructions. If your client is regularly paying large tax assessments resulting from audits or receiving notices for late or unfiled returns or calculation errors, these are all indications that there are shortcomings in the compliance process that need be addressed.
3. Audit Readiness
You need to prepare your client for the inevitable fact, that at some point, they will likely be audited by state taxing authorities. Audits can be an effective tool to generate revenue and improve compliance.
Audits are regularly performed in the field by agents who visit the client’s offices, but as more states start utilizing technology to review returns and identify discrepancies, taxpayers will be subject to desk audits about specific issues or asked to provide documentation to substantiate their returns. Audits can be difficult and time consuming, but they can be resolved efficiently as long as you prepare your clients upfront and make sure they are well organized and prepared for the auditors, their information requests and questions.
Reviewing the tax returns that were filed during the audit period will help you identify potential problems and serve as a guide for where you should focus your time. If the client has taken any aggressive positions on their income tax return, be prepared to defend this position and argue your case. Additionally, do not miss the opportunity to present potential refunds or credits to offset any tax that maybe assessed.
It is impossible to be an expert in all areas of the tax law. Know when it is time to consult a third party who specializes in a particular area of taxation, who is more adept than you or your client to resolve the audit issue.
Utilizing a more experienced resource in these circumstances will typically lead to a better result for your client. Reviewing these state and local tax matters with your client will give you the opportunity to identify potential issues that need to be addressed.
Some of these matters will likely require you to spend additional time reviewing tax returns, researching tax laws in various states and meeting with your client. However, investigating these matters now, when you have your client’s attention, can lead to additional client-service opportunities later on in the year.
It is in both yours and your clients’ best interest that areas of potential exposure are investigated and addressed, considering the financial implications of noncompliance. The professional liability risk practitioners face for not properly advising their clients on state and local tax matters can be considerable if you do not take action to mitigate this risk.