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Successful Handling of State Tax Audits

The Kentucky CPA Journal / Issue 1 2010

Tax in the Bluegrass

March 2010


Successfully resolving an audit by a state or local taxing agency like the Kentucky Department of Revenue requires preparation, patience and perseverance.

Marshal appropriate resources

You need the right team. In addition to the taxpayer's in-house representatives (e.g., in-house tax department, controller, owner), this may entail retaining one or more outside tax advisers to help. Think about the skills and abilities you have and those you may lack for each phase of an audit including preparation therefore, discussed below. The savviest taxpayer representatives and advisers know when to seek help from others. Are you knowledgeable in this particular area of the tax law? Do you have the required skills and credentials to protest the audit, settle it, or litigate it?

Preparation for an audit 

Ideally, you should get ready for a potential audit before preparing a tax return. Of course, there is more to do once a taxing agency initiates an audit. 

Know the tax law. To be successful, you must know the rules of engagement. You should familiarize yourself with tax laws that apply to the taxpayer's business and the tax return(s) at issue. And, you must understand the procedural aspects of an audit and your rights to dispute undesirable results (like an assessment). 

Anticipate issues. Issue spotting is a key skill in successfully resolving audits, often honed through experience. Areas in which significant state tax audit issues might arise include: nexus determinations; computation/determination of the tax base; exemptions or deductions; and, tax credits. 

To minimize a taxpayer's tax burden, incorporate the identification of potential tax savings opportunities into the tax return preparation process. Also identify areas at risk for adjustment. Integrate this analysis with the taxpayer's analysis of its tax asset and liability accounts, i.e., its reserves. As securing the benefit of a tax savings opportunity is often not a given, it can also be an area of risk. 

The most convenient place to begin the process of identifying potential audit issues is with a review of prior audits. Auditors, however, sometimes challenge positions that were either not challenged or were agreed upon in a prior audit (which is often quite frustrating to a taxpayer). 
And, the tax law is continually developing. So, it is also important to take a fresh look at the tax returns under audit to identify potential issues. 

Document positions. For each position taken on a tax return, assemble supporting documentation - especially for material (i.e., big dollar) and uncertain positions. Again, this process should dovetail with a taxpayer's analysis for computing its reserves. Consider how to manage the potential that an auditor could attempt to obtain the analysis supporting a position before putting it together. Will it be covered by one or more privileges so that it need not be turned over to a taxing agency? How solid is the privilege? 

Gather documents. A taxpayer must prove amounts and other facts supporting tax return items. When preparing a return, identify key documents that may be needed if it is audited. Always assume that one day you will need to provide supporting documents to an auditor. Locate documents not gathered contemporaneously with the preparation of the tax return when an audit is initiated. Documents often carry the day. 

Identify offsets. One might expect that an auditor would try to determine, a taxpayer's actual tax liability, regardless of whether the audit ' results in an assessment or a refund; however, auditors often look only for underpayments. So, you need to look for offsetting overpayments.

Conducting an audit 

Thoughtful and deliberate preparation makes conducting an audit much easier. But, inevitably, auditors raise new issues and advance unanticipated requests for information or documents. Adhering to a few simple rules can increase the chances for success. 

Be professional. Be yourself, but always deal with an auditor in a professional manner. Most auditors are just doing their jobs. Do not make it personal. Keep your cool. Effective advocacy requires composure. 

Be patient. An audit creates uncertainty. People generally prefer certainty. Of course, you want an audit to be completed as soon as possible - yesterday may even seem too long to wait for the end. But, government moves at the speed of government. Trying to short-cut or rush the completion of an audit has the potential to backfire. It is far easier for an auditor to say "no" rather than "yes" to your deduction, exemption or credit. Make time your ally. 

Be responsive. All audits entail requests for information and documents. Failing to respond to a request can sometimes send up a red flag. Bringing an audit to completion requires being responsive to these requests. Sometimes an auditor will request information that a taxpayer does not have or a schedule that must be created. Consider alternatives. 

Ask questions. Audit requests can clue you into areas of interest to the auditor; so, do not be afraid to ask an auditor questions. What precipitated this audit? Why do you need that document? What are you getting at? Knowledge is power. 

Be truthful. Assume that an auditor will not accept what you say without verifying it by reference to some type of schedule or document. An auditor will often ask for more information when they believe they have discovered inconsistencies or when they believe that you are not being forthright. Bottom line, your reputation for honesty is extremely important. Guard it. 

Stand firm. Know what positions are most important. Pick your battles. Consider bending somewhat on issues that are not worth fighting about. Do not give in if the auditor cannot explain or articulate their position. When you think you are right, hold your ground. 

Work it down. It is almost always possible to work down the amount of a potential assessment. Do not blindly accept the auditor's first pass. Analyze their work papers. Try to find offsetting adjustments. There could be math errors or incorrect assumptions. Remember though that (unlike years ago) an auditor generally has limited or no settlement authority, but they can resolve an issue by agreeing to your position. At the audit level, this generally entails providing additional documentation or a better explanation. 

Options for resolving an audit 

You are not stuck with an assessment resulting from an audit. There are several options for resolving an audit once an assessment has been issued. 

No change audit? When an audit results in no changes, you do not generally receive an assessment. You are done. Congratulations! 

Pay it? If an audit results in an acceptable dollar amount, then you should just pay it, right? Maybe not. Is the statute of limitations still open for assessment? What about the possibility of a re-audit? This does happen. Do not simply pay the assessment without some thoughtful analysis. 

Protest it? If the audit results in an assessment, then you should protest it – provided that you have a basis to contest the audit adjustments. This is your opportunity to resolve issues that you could not with the auditor. Know and take full advantage of all of your protest rights. 

Litigate it? What if you cannot work it out with the state tax agency during the protest procedure to your satisfaction? Litigation is an option. You do not necessarily have to fight all the way to the Supreme Court. Most cases settle before they even go to a hearing. 

Settle it? You can resolve an audit by agreement while protesting it or while litigating it. Taxing agencies are often amenable to settling factual issues and non-continuing legal issues (perhaps, the tax has been repealed or the statutory tax provision at issue has been substantially amended). They are less likely to be agreeable to settling purely legal issues, but will under the right circumstances. Once you settle, get an agreement - in writing. 

About the author: Mark A Loyd, Esq., CPA, is a member of Greenebaum Doll & McDonald in Louisville and chairs its State and Local Tax Team. He is a member of the KyCPA board of directors; chair of the editorial board; member of the industry tusk force; and former chair of the taxation committee. He can reached at mal@gdm.com; 502.587.3552.

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