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Mary Bernard
Mary Bernard

State Impact of Increased Federal Audit Activity

What is your responsibility to the states after the Internal Revenue Service closes an audit of the corporate tax return?

December 8, 2011
by Mary Bernard, CPA

After a series of high-profile corporate scandals in recent years, the Internal Revenue Service (IRS) has increased the volume of corporate audit activity. The perceived abuses in the form of strategies or transactions considered to be “listed transactions” have been partly responsible for the increase. The advances in technology have improved the resources available to the IRS to facilitate audits. The sharing of this increased information exposure extends the impact of these audits to the state-taxing authorities.

This increase in federal audit activity will generally result in adjustments to federal taxable income for potentially several issues covering multiple years. As state corporate tax bases generally begin with federal taxable income, any adjustments impacting federal taxable income will affect state tax liabilities. Once a federal audit is concluded and a final determination of the Revenue Agent’s Report (RAR) is issued and accepted by the taxpayer, the process of amending state tax returns begins.

When and How Do You Report the Changes to the States?

There is no uniformity among the states as to when and how the changes from a federal audit should be reported. Typically, anywhere from 30 days to 180 days after the final determination is agreed upon, most states require notice of the changes made by the federal audit. Failure to notify a state of federal changes could extend the state’s authority to assess tax, but may not extend the period for filing refund claims. In some cases, a state may withhold interest if the refund claim is not filed timely. A failure to report RAR changes to a state would reasonably be expected to become available to the state through increased information-exchange programs with the IRS. Improvements in technology and an increase in communication between governmental agencies has given the states an advantage in determining if a taxpayer is avoiding tax in their state.

The method of reporting the changes to a state may be dependent upon the types of changes made to the federal return. If the result of the federal changes only impact a Net Operating Loss (NOL) carryover, the method of reporting is not as critical as a change resulting in a refund of taxes. Some states have specific amended tax-return forms, some use the same forms as used in the original filing, with a box checked indicating an amended return and some states may accept a written narrative attached to a worksheet detailing the RAR changes. In most cases, a copy of the RAR should accompany any report made to the state.

Limitation on Open Items

When the state’s statute of limitations is still open, all issues, including the RAR issues, are generally open and can be adjusted on an amended return. If, however, the RAR relates to a tax year that is expired under state statute, the issues considered to be open to adjustment will vary by state. Some states will not allow adjustment of issues outside the scope of the RAR, once the statute has expired. Assessments and refund claims may be limited to the changes made to the federal return. Other states may extend their statute for six months after the agreement date of the federal RAR.

Other Issues

In reporting federal RAR issues to the states, there are some additional concepts to be considered:

  • State NOLs. The changes could impact the calculation of the state NOL, requiring adjustment to a carryback or carryforward. Also note that some states have declared a moratorium on the usage of NOLs for certain tax periods.
  • Characterization of income. Changes to federal taxable income may be made to capital gain or loss income vs. ordinary income. Be aware that some states treat capital gain/loss income differently than ordinary income. Some states allow capital losses to be recognized fully in the year incurred, rather than limit losses to the extent of gains following federal treatment.
  • Gross receipts states. Several states impose tax on the basis of gross receipts reporting. Some RAR adjustments may have no impact on the gross receipts reported to the state; therefore, no amended report should be required in that state.
  • Apportionment issues. Some RAR changes could impact apportionment formulas, in which changes are made to income recognition or inclusion, employee vs. independent contractor characterization or rent expense. Precluding corresponding adjustments to the apportionment calculations could be considered unfair and inconsistent. There is little uniformity among the states in the treatment of corresponding changes to the apportionment factors to agree with the RAR changes made to income or deductions.

Conclusion

Due to the wide variance among the states regarding timing, methodology and format to report federal RAR changes, it is important to be cognizant of each state’s requirements in order to successfully complete your reporting responsibility. Failure to comply timely and accurately can have unfortunate consequences, resulting in penalties, lost interest income or denial of refund claims. Unique rules in states, as well as administrative rules and judicial decisions, should all be considered throughout the process of reporting RAR changes to the states to ensure proper compliance.

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Mary F. Bernard, CPA, is director -- income/franchise tax, at the Dallas, Texas-headquartered tax services firm of Ryan. Bernard formerly worked as principal, director of State & Local Tax Services, at Providence, RI-basedKahn, Litwin, Renza & Co., Ltd.