Cleaning Up Your Tax (Obligations) with Voluntary Disclosure Agreements (article)

Cleaning Up Your Tax (Obligations) with Voluntary Disclosure Agreements (article)

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While paying taxes might not be our favorite pastime, the overwhelming majority of taxpayers strive to file and pay all of their tax obligations. However, sometimes taxpayers' best efforts to comply with their tax obligations are not enough, especially in the state and local tax world. Although it may be an innocent mistake, such non-compliance may be very costly if it is first discovered by the state or local taxing jurisdiction, because the taxpayer will not only be subject to tax and interest but also harsh penalties (up to 25 percent or more). On the other hand, the taxpayer does have options to come forward and minimize its exposure if the taxing jurisdiction is the first to discover any non-compliance. Voluntary disclosure agreements, or "VDAs," are a popular and generally effective method for taxpayers to clean up their state tax compliance issues.

How Did You Not Pay Your Taxes?

Ben Franklin once said that the only two certainties in life are death and taxes. So how is it possible that a taxpayer can be unaware of its tax liabilities? In the complicated world of state and local taxation anything is possible. One big factor contributing to non-compliance with state tax filing obligations is the application of ambiguous nexus rules that lack bright-line standards and uniformity among states. Not only are there different nexus rules among states (physical presence, economic presence, factor presence, etc.) but also among taxes. For example, the temporary presence of a salesperson soliciting sales of tangible personal property for five days in a state will likely create nexus in that state for sales tax purposes, but not income tax purposes. These differences are further exaggerated when considering the large number of taxing jurisdictions (there are close to 10,000 sales tax jurisdictions in the United States!).1        

Nexus rules can be complex to the most seasoned state and local tax practitioner, much less the average corporate tax department that lack the expertise and resources to keep track of all of its business activities that may contribute to establishing nexus in a state. Not surprisingly, many taxpayers are not able to keep up with all of their required state and local tax filings.

VDAs to the Rescue

Taxpayers have two options when they are the first to discover their non-compliance: do nothing and play the audit lottery or come forward and enter into an agreement with the taxing agency to settle their past liabilities. The upside of playing the audit lottery is that you may never get caught. If the exposure is material, however, it is a risky proposition. A taxpayer could face stiff penalties for noncompliance of up to 25 percent. Further, the tax agency can look back to assess tax as far back as the date nexus was established since the statute of limitations doesn't begin to run until a return is filed.   

The more advisable option is to come forward and enter into a deal with the taxing agency to settle any outstanding liabilities relating to non-compliance. Fortunately, most states offer VDA programs where taxpayers, through their representatives, can anonymously approach the taxing agency to self-report their unpaid taxes (some states do require taxpayers to initially disclose their identity). VDAs are contractual agreements whereby the state makes concessions to the taxpayer by offering the abatement of all penalties, limitations on the look-back period to three or four years and the opportunity to become current on their tax obligations in exchange for the taxpayer promising to come forward and pay its tax obligations under the look-back period. The process is typically initiated by a representative of the taxpayer, who either submits a letter or application form to the state taxing agency. After both sides have reached a preliminary agreement, the taxpayer must disclose its identity and file returns.  VDAs are effective because they provide benefits to both the taxpayer and the taxing agency. The taxpayer benefits from a reduction in exposure and overall liability due to a potentially shorter look-back period and the abatement of penalties, while the state benefits from additional revenue with minimal cost.

VDAs are frequently used in furtherance of mergers and other acquisitions. Acquiring entities will usually require their targets to provide documentation that those entities are in compliance with all of their state tax obligations to avoid potential successor liability issues (see Let the Buyer Beware: Sales Tax Issues Associated with Acquiring a Business in the July 2014 edition of InTouch). As a result, entities being acquired will often perform nexus reviews to uncover potential nexus exposure in states they are not filing returns or paying tax. Once any such exposure is discovered, VDAs allow these entities to come forward to the state and resolve any past liabilities thereby preventing potential transactions from being delayed or even cancelled due to state tax issues. We recommend, however, that taxpayers thinking of selling their businesses perform a nexus review and corresponding VDAs prior to finalizing a deal with another party. VDA programs do differ on how long it takes to complete the program. Therefore, getting the VDAs completed early will help to expedite the transaction once a buyer is identified.

VDAs can also be helpful in implementing changes in corporate policies and practices. For example, a taxpayer hires a new CFO who prefers to take a more conservative approach regarding state taxes than has been previously taken. Other times, a VDA allows a taxpayer to correct an uncertain nexus position it took in the past that was later clarified by a court opinion or an administrative ruling.

Note that VDAs are similar to tax amnesty programs but are not the same thing. Tax amnesty programs may offer greater incentives such as reduced interest but are typically only offered on a limited basis. Therefore, tax amnesty programs are generally not available in most states. If a tax amnesty program is available, then the taxpayer should carefully evaluate which program is more advantageous.

So What Could Go Wrong?

The biggest downside to VDAs is that not all taxpayers are eligible to participate and if a taxpayer initiates the process but later is deemed ineligible after disclosing its identity, it may have exposed itself to the state without the protections of the program. In light of this risk, taxpayers and their tax representatives should carefully perform their due diligence to gather all of the relevant facts surrounding the potential states where the taxpayer may want to enter into a VDA. Typically, this can be achieved when a nexus review is performed prior to the initiation of VDAs. Further, eligibility requirements need to be researched to ensure acceptance into the program.

Although the requirements vary among states, common requirements include that the taxpayer not be under audit or litigation for the tax periods at issue and not have previously registered/filed in the state for the taxes in question. Taxpayers, however, need to be aware of the nuances of each state's requirements especially when multiple VDAs are pursued at the same time. For example, most states allow taxpayers that have previously registered or filed returns with the state for income tax purposes to enter into a VDA for sales tax. There are a few states, however, that will disallow a VDA for sales tax once the taxpayer registered or filed returns with the state for income tax. Many times the taxpayer is unaware of previously registering in a state due to misplacement of records or changes in personnel.   

Taxpayers and their representatives also need to have a good understanding of their overall tax situation. For example, if a taxpayer wants to become current with its sales tax obligations in states in which it is currently not filing, then it should also consider income tax obligations. A taxpayer with nexus in a state for sales tax will likely also have income tax nexus as well, and participation in a VDA may bring more scrutiny to potential income tax exposure. Further, taxpayers should be cognizant of the fact that states often enter into information sharing agreements with other states. As a result, it is always important to negotiate confidentiality provisions into the agreement.

While VDAs theoretically represent contractual negotiations between the taxpayer and the state, in reality taxpayers have very little leeway to negotiate the terms of the agreement. The parameters of the programs are usually established by the state taxing agencies which rarely deviate from their standard set of terms regarding look-back period, abatement of interest, and other terms. Furthermore, some of the terms may take away certain rights available to the taxpayer, such as the ability to file amended returns or prevent the usage of loss carryforwards from before or during the established look-back period. Although the state may not be receptive to negotiating terms, it would still behoove the taxpayer to suggest alternative terms in attempt to procure a more favorable outcome.

Conclusion

Taxpayers engaged in a multistate business can run the risk of not being in full compliance with all of their state tax obligations for several different reasons. There can be harsh consequences for this non-compliance if discovered by the state. We encourage taxpayers that discover state tax exposure from non-compliance to consider entering into a VDA with the state or states in question. These programs are the most effective way for taxpayers to eliminate the state tax exposure while getting current with their tax obligations and responsibilities. We advise taxpayers to proceed with caution, however, when entering into these programs because there are potential pitfalls for the unwary. For more information concerning VDAs, contact your local CBIZ MHM tax advisor.

 

Joseph Henchman, Richard Borean; State Sales Tax Jurisdictions Approach 10,000; TAX FOUNDATION (2014), available at http://taxfoundation.org/blog/state-sales-tax-jurisdictions-approach-10000.


Copyright © 2014, CBIZ, Inc. All rights reserved. Contents of this publication may not be reproduced without the express written consent of CBIZ. To ensure compliance with requirements imposed by the IRS, we inform you that-unless specifically indicated otherwise-any tax advice in this communication is not written with the intent that it be used, and in fact it cannot be used, to avoid penalties under the Internal Revenue Code, or to promote, market, or recommend to another person any tax related matter. This publication is distributed with the understanding that CBIZ is not rendering legal, accounting or other professional advice. The reader is advised to contact a tax professional prior to taking any action based upon this information. CBIZ assumes no liability whatsoever in connection with the use of this information and assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.

CBIZ MHM is the brand name for CBIZ MHM, LLC, a national professional services company providing tax, financial advisory and consulting services to individuals, tax-exempt organizations and a wide range of publicly-traded and privately-held companies. CBIZ MHM, LLC is a fully owned subsidiary of CBIZ, Inc. (NYSE: CBZ).

Cleaning Up Your Tax (Obligations) with Voluntary Disclosure Agreements (article)While paying taxes might not be our favorite pastime, the overwhelming majority of taxpayers strive to file and pay all of their tax obligations. However, sometimes taxpayers' best efforts to comply with their tax obligations are not enough, especially in the state and local tax world....2014-10-14T14:38:00-05:00

While paying taxes might not be our favorite pastime, the overwhelming majority of taxpayers strive to file and pay all of their tax obligations. However, sometimes taxpayers' best efforts to comply with their tax obligations are not enough, especially in the state and local tax world.