State & Local
Surviving a State Tax Audit

Among the most unwelcome news for any company is that its tax return has been selected for audit. While the mathematical odds of a company finding itself in that position at any given time are relatively slim, corporate audits by state tax departments are on the rise.

The major factor behind that trend is what CFO magazine described as “financial desperation” on the part of many states. The Multistate Tax Commission (MTC), in which 45 states participate, claims that corporate tax-sheltering reduces state corporate income tax revenues by more than a third, and that proposed federal legislation to liberalize corporate income-shifting would create new revenue shortfalls in 40 states.

Closer Scrutiny of Corporate Returns
The Council on State Taxation (COST), a business-sponsored organization, hotly contests MTC’s claims, noting that the $447 billion businesses paid in state and local taxes in 2004 represented a 10% jump over the previous year, and that businesses pay 43% of all state and local taxes. However, both groups agree that states have begun scrutinizing business tax returns more closely than ever.

Among the most militant states in that regard are both New York and New Jersey, according to a 2004 survey of corporate tax officials by CFO. When it comes to asserting nexus positions for corporate income tax, for example, New Jersey ranks as the most aggressive state, and New York is third. New York ranks second in aggressiveness for assessing additional tax on forced combinations and de-combinations, and New Jersey is fourth.

Nexus, also known as sufficient physical presence, is the pivotal factor in determining whether a company conducting business transactions in another state is required to pay income or collect sales and use tax on behalf of the state where the customer enjoys the benefit of the product or service. For more information about nexus, www.gellerco.com/tax.html/TaxView/Summer05/TaxView_Summer_05_state.htm" target="_blank">click here.

Possible Red Flags
States, like the federal government, are reluctant to reveal the “red flags” most likely to trigger tax audits, but statistical research and the experience of veteran tax professionals shine a light on some likely candidates:

• Misclassification of employees: Outsourcing continues to grow as a legitimate and effective means of reducing costs and increasing productivity for many businesses. However, some companies have stepped over the line in making the distinction between salaried employees and independent contractors. This has become a major audit trigger.
• Non-compliance with the throw-out rule: This is an issue for corporate multi-state taxpayers in New Jersey, one of only two states (West Virginia is the other) that currently have a throw-out rule on the books. The rule requires a corporate taxpayer to exclude a receipt from the denominator of its receipts factor if it is sourced to a state where the corporation is not subject to tax. The New Jersey Division of Taxation has publicly acknowledged that it is targeting this portion of tax returns because non-compliance has been so high.
• Sales/use tax red flags: These can include sudden drops in remittances, fluctuating use tax reporting and new filers.
• Inconsistent apportionment factors: Use of payroll and property factors that are dissimilar, for example, or returns reflecting a lack of consistency in the factors used across multiple tax years may catch an auditor’s eye.

Others:

• Treatment of unusual corporate receipts.
• Inclusion/exclusion of gains or gross receipts in the receipts factor.
• Improper distinction between business/non-business issues.
• Characterization of receipts and application of different sourcing rules.

The Audit Process: What to Expect
While each state has its own procedures for selecting returns, notifying the taxpayer and conducting the audit, they are generally similar in nature. In New York, for example, an audit may entail a review of income, receipts, expenses, credits and/or other business records. Most business audits are conducted at the taxpayer’s place of business, with an auditor contacting the taxpayer by phone at least 15 days in advance and following up with a letter to confirm the appointment and describing the books and records to be made available. Extensions up to 30 days can generally be obtained by phone; longer delays require a written request substantiating the need for extra time.

Taxpayers have the right to represent themselves, be accompanied by a representative or have a representative appear on their behalf for an audit. A representative must have proper written authorization (Power of Attorney) to act on the taxpayer’s behalf. Taxpayers have the right to retain representation at any time during the audit and to suspend an interview at any time in order to obtain representation. Geller & Company recommends that representatives be retained when there are positions taken on the returns that are less than 80% supportable, or when the corporation has never had an audit before in the jurisdiction, the return is in a new state or is a final return in the state.

For more information, please contact Carolyn Makuen at cmakuen@gellerco.com.

INDIVIDUAL
Basic Estate Planning Techniques: Estate-Splitting Strategies May Reduce Taxes
Part 4 in a Series

Married couples have a number of strategies available to them to help minimize the tax bite ultimately taken out of their combined estate. How ownership of their combined assets is split between them while they are alive can play an important role in determining just how effective their estate plan will be.

Spouses can directly pass to each other any property, regardless of value, without it becoming liable for estate taxes. The marital deduction can be taken for property whether it passes through a will or living trust, is owned jointly or has beneficiary designations.

Making Use of the Unified Estate and Gift Tax Credits
In many cases, however, making maximum use of the marital deduction is not advisable. Doing so may leave the surviving spouse saddled with the sole responsibility for subsequent estate- and tax-planning—a burden he or she may not be up to bearing. Overuse of the marital deduction may also prevent the estate from capitalizing on the full unified credit available to the couple while both spouses are alive.

Under current tax law, each individual is entitled to a lifetime credit for gift and estate taxes. The unified estate tax credit amount for 2006 through 2008 is $2 million per person, rising to $3.5 million in 2009. This credit is in addition to the annual gift tax exclusion of $12,000 (beginning in 2006) per recipient to which each individual is also entitled. A husband and wife can give a combined $24,000 to as many recipients as they like each year without incurring any federal gift tax or reducing their unified credit amount. The unified gift tax credit remains at $1 million.

In order to make maximum use of the lifetime exemption, each spouse should hold legal title to assets at least equal in value to the amount of the exemption. If ownership of a disproportionate share of the couple’s combined assets rests with one spouse, the tax-saving benefits of the unified credit for estate planning may be forfeited to a great extent. For example, in 2006, a high-net-worth couple would be entitled to a combined lifetime estate tax exemption of $4 million, but only if each holds legal title to assets worth at least $2 million. If either spouse holds title to assets in a lesser amount, the value of the combined exemption is reduced by an amount equal to $2 million minus the value of the assets held by the less-wealthy spouse. That situation can be fairly common in some households, with one spouse holding a large retirement account, for example, or title to property resting with a single spouse.

Creating a By-Pass Trust
The unified credit can be applied to any property left to any recipient, either outright or in trust. A common strategy employed to make sure the credit is used to full effect is the creation of an exemption or by-pass trust. Typically, a by-pass trust equal to the amount of the individual unified credit is created for the surviving spouse as part of the couple’s estate plan, often with their children named to become beneficiaries of the trust upon the surviving spouse’s death.

The trust can be structured so that its net income is payable to the surviving spouse, and he or she may be able to tap the trust’s principal for specific uses, including health, support, maintenance and education. The surviving spouse may also have the non-cumulative right to withdraw the greater of $5,000 or 5% of the trust’s principal per calendar year for any reason.

Since estates with values less than or equal to the unified credit amount are not subject to any estate taxes, the unified credit can play an important role in estate planning. However, in order to capitalize on its benefits to the greatest extent possible, couples must make sure that ownership of their combined assets is properly allocated while they are still living.

For more information, please contact Sherry Reisch at sreisch@gellerco.com.

CORPORATE
FAS 109 Calculations Provide Greater Accuracy for Business Planning

The objective of FASB Statement No. 109, Accounting for Income Taxes (FAS 109), is to recognize both the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in a company’s financial statement or tax return. Essentially, it seeks to document comprehensive recognition of deferred tax assets and liabilities based on the differences between GAAP (generally accepted accounting principles) treatment of assets and liabilities and tax-basis treatment of the same assets and liabilities.

Basic Guidelines
FAS 109 provides four basic principles for calculating income taxes at the date of financial statements:

• Current tax liabilities and assets are recognized for the estimated taxes payable or refundable on tax returns for the current year.
• Deferred tax liabilities and assets are recognized for the estimated future tax effects attributable to temporary differences and carryforwards.
• Measurement of current and deferred tax liabilities and assets is based on provisions of enacted law, with no anticipation of the effects of future changes in tax laws or rates.
• Deferred tax assets are reduced, if necessary, by the amount of any tax benefits that are not expected to be realized, based on available evidence.

Temporary Differences
FAS 109 recognizes that tax laws often differ from the recognition and measurement requirements of financial accounting standards. As a result, differences can arise between the amount of taxable income and pretax financial income for a year, and between the tax bases of assets or liabilities and their reported amounts in financial statements. When the year in which a transaction affects taxable income differs from the year in which it enters into determination of pretax financial income, the result may be a difference in the tax basis of an asset or liability and its reported amount in financial statements.

Other events, such as business combinations, may also create differences between the tax basis of an asset and its reported amount in financial statements. These differences are collectively referred to as temporary differences. Some examples of temporary differences include book versus tax depreciation and deferred compensation. In general, temporary differences become taxable or deductible when the related asset is recovered or the related liability is settled.

Below are some examples of temporary and permanent differences:

• Deferred Tax Liabilities: A deferred tax liability is recognized for temporary differences that will result in taxable amounts for future years. For example, bonus depreciation taken for tax purposes in the year an asset is placed in service will result in a lesser tax deduction over the remaining life of the asset.
• Deferred Tax Assets: A deferred tax asset is recognized for temporary differences that will result in deductible amounts in future years. For example, a liability for estimated expenses may be expensed for book purposes and not deductible for tax purposes until a future year when settlement of such liability occurs.
• Permanent Differences:Unlike temporary differences, permanent differences are differences in book and tax treatment that will never be recouped. A common example is the 50% limitation on meals and entertainment expenses for tax purposes.

Presenting an Accurate Financial Picture
The calculations used in FAS 109 are important to financial executives for a number of reasons. While they face constant pressure to keep the company’s effective tax rate as low as possible, new federal regulations (SOX 404) also make it mandatory that they provide management, company directors and analysts with the most accurate financial information possible. The calculations also affect how accurate a company’s effective tax rate projections will be for quarterly and longer-range business planning, and whether or not adequate tax reserves are on hand.

At its core, FAS 109 requires a public company to disclose a reconciliation of its reported amount of income tax expense to what that expense would have been if domestic federal statutory rates were applied to pretax financial income. FAS 109 calculations can be complex and challenging because they often involve some subjective analysis along with traditional numbers-crunching. The calculations can also be affected by a host of other issues, including legislative changes, international operations, mergers and acquisitions, internal controls and corporate reorganizations (e.g., goodwill and organization costs related to an acquisition or merger).

Consult a Tax Professional
Tax experts have opined that identifying and effectively addressing all the issues related to FAS 109 calculations can be a challenge, and it is one best met with the help of qualified experts. The payoff for greater accuracy in tax expense calculations is the ability to do a better job of anticipating changes in key business performance criteria, especially earnings.

For more information, please contact Peter Orfanakos at porfanakos@gellerco.com.

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The information contained in TaxView is for general purposes only and is not intended, and should not be construed, as legal, accounting, or tax advice or opinion provided by Geller & Company to the reader. This material may not be applicable to, or suitable for, the reader’s specific circumstances or needs. Therefore, the information should not be used as a substitute for consultation with professional accounting, tax, or other competent advisors.