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It's Not Just the IRS: States Target Taxpayers Too!

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By David Seiden and Anthony Capolino

For the past few weeks, the media has been awash with reports about a scandal involving the Internal Revenue Service ("IRS"). In case you missed it, the IRS recently admitted to targeting certain conservative groups applying for tax-exempt status. Presumably, the reason this story has received so much attention is because of the allegations that the increased IRS scrutiny was politically motivated.

The concept of targeting specific groups of taxpayers is nothing new for most state-taxing authorities. However, the "targeting program" undertaken by states has less to do with politics and more to do with generating revenue. In other words, states want to ensure that their state tax auditors "go where the money is."

The policy of "go where the money is" has led states to aggressively audit business groups that deal with significant amounts of cash and provide products or services subject to sales tax. Examples of "traditional" business groups that have attracted more than their fair share of scrutiny by state-taxing authorities include restaurants, convenience stores, and car washes. Rightfully or wrongfully, state-taxing authorities have concluded that these groups are not always forthcoming when it comes to properly reporting sales transactions. In our experience, it's difficult to tell who is right because these businesses tend to keep inadequate books and records, which heightens the suspicions of taxing authorities.

About 10 years ago, in an effort to raise additional money, cash-strapped states began putting pressure on their tax departments to find new sources of revenue. As a result, tax authorities began looking beyond the "traditional" businesses to audit as well as scrutinize certain taxes that had rarely, if ever, been previously audited.

Historically, professional service companies were rarely, if ever, audited by state-taxing authorities. However, in recent years, businesses such as law firms, investments banking firms, doctors, and architecture firms have been inundated with audit notices because states have determined that many of these businesses have failed to comply with various state tax laws. In addition, unlike many other types of businesses, professional service companies typically have the financial wherewithal to pay an assessment levied by a state's taxing authority.

In addition to identifying new businesses to audit, states have increased audit efforts in tax areas that had previously not been identified for an audit, including use tax, employment tax, and unclaimed property. Many states have found these new audit areas to be an untapped revenue source for the state.

Use tax, an often-overlooked and misunderstood tax, is typically owed by a taxpayer when sales tax was not charged and collected by the vendor. States will typically focus an audit on use tax if the business being audited does not generate taxable sales. For example, if a law firm (whose services are generally not subject to sales tax) purchased software from an out-of-state vendor, there is a good chance the vendor did not charge the law firm sales tax. Assuming the law firm is in a state that imposes a sales tax on software, the law firm would then be required to remit use tax to the state where the software was being used.

In the area of state employment tax, we have seen more audits in the last three years than within the prior 20 years. The primary issue being addressed is whether a company is properly classifying its workers as independent contractors or as employees. The determination of how a company classifies its workforce can have a significant effect on both the worker and company. For example, if a company no longer needs the services of a worker, the worker can receive unemployment benefits if he/she is classified as an employee. However, if the worker is classified as an independent contractor, unemployment benefits would not be available to that person.

Another area states are aggressively auditing (because states have found so many companies not in compliance) is unclaimed property ("UP"). UP refers to property (typically cash) held by a company that has not had contact with the owner for an extended period of time. Examples of UP include uncashed payroll and vendor checks, refunds, security deposits, and gift certificates. When the company that holds this type of property can't locate the owner (the person may have moved without leaving a forwarding address), state laws dictate that the company must turn over the funds to the applicable state agency that handles unclaimed property.

States have reported mixed financial results with respect to whether the increased audit activity has in fact resulted in increased revenues. However, it is clear that the increase in state tax audits has resulted in companies being forced to either devote significant internal resources or spend significant money (hiring a tax expert) or both to properly represent the company during the audit. As a result, even companies that are in complete compliance with state tax laws end up spending scarce resources (i.e., time and money) to defend against aggressive state tax auditors.

David Seiden is a leading authority on state and local tax ("SALT") matters. He is a partner with the accounting and consulting firm Citrin Cooperman, where he leads the firm's SALT Practice. He can be reached at (914) 949-2990 or

Anthony Capolino is a manager in Citrin Cooperman's SALT practice. He can be reached at (914) 949-2990 or

Citrin Cooperman is a full-service accounting and business consulting firm with offices in New York City; White Plains, NY; Norwalk, CT; Livingston, NJ; and Philadelphia.