Addressing Prior-Year Exposure Issues Voluntary Disclosure Agreement Versus Tax Amnesty
Nexus is a concept that many businesses do not understand from sales/use tax and income/franchise tax perspectives or in relation to those states which impose some type of entity-level tax on business receipts. Let’s define nexus: The degree of business activity or connection that an out-of-state business must have before a state can enforce a right to file and either collect or pay taxes. Nexus is established when a business has a physical connection with (or in some cases an economic presence in) a state through employees, property, volume of sales, or other action. The December 16, 2014, SALT-ED article, SALT-ED Q&A: When do I pay taxes in another state?, addressed the nexus topic. This article will address the remedies that are available to businesses when they have been doing business in a state in past years and not filing the proper returns. Before we get to the remedies, we must briefly cover the necessary steps that lead up to quantifying potential risk for not filing the necessary multistate tax returns.
Nexus Study: Analyzing Business Activities
The first step in understanding a business’s risk related to past noncompliance of filing tax returns is to conduct a nexus study. The primary goal of a nexus study is to identify the potential risk (tax, interest, and penalties) a business might face in not being compliant with state tax filings. A nexus study is a detailed review of the businesses activities conducted outside of the business’s home state to identify to potential tax filing requirements. Generally a nexus study will identify the potential tax risk associated with the non-filing of state tax returns. Remember, if no return(s) has been filed in a taxing jurisdiction, there is no statute of limitations. If the statute of limitations has not yet begun to run, a state can require the company to file the necessary returns, for as many years as it likes. Some states are allowed by statute or administrative rule to only go back shorter periods of time such as six or eight years. The look-back period for noncompliant returns varies from state to state.
Nexus Study: Quantifying Risk
Once the relevant states in which a business is noncompliant have been identified, it is time to quantify the potential exposure, which generally includes tax, interest, late-filing fees, and non-filer negligence penalties. It is important than any potential exposure include not only sales/use tax or income/franchise tax, but also any taxes imposed on the business’s gross receipts (i.e., Washington’s B&O tax, Ohio’s commercial activities tax, or Nevada’s commerce tax). From a sales tax exposure perspective, it is important for a business to determine whether it has made taxable sales of products or services to customers in states where no returns have been filed. Reach out to customers where no certificates are on file or for which there are missing/incomplete exemption certificates. Many times customers will not be able to provide a valid exemption certificate and will inform you they are taxable. If this situation arises, reach out to the customer and inquire about whether the customer paid use tax to the state or has gone through a sales and use tax audit and paid use tax on the transactions in question. Obtain documentation/support for your files for your customers’ paid use tax. Sales to customers for which use tax was paid directly to a taxing authority can be excluded from the exposure computation.
Nexus Study: Follow-up
Action Plan Once the potential risk has been quantified for noncompliance, the last step is to put in place an action plan to ensure compliance not only for past years, but prospectively as well. It is extremely important for the business to understand the risks of conducting business activities in a state and not filing the required returns. At this point, a business may decide to do nothing and continue with the status quo. The tax risk, as well as added interest and penalties, for unfiled tax returns will continue to grow. A business may also decide to file tax returns on a prospective basis and not address prior years. Note that the unfiled tax returns for prior periods generally will not go away, since the statute of limitations has not begun to run. The other risk in this situation is completing a tax registration form for a state that asks “date began business in the state.” The registration document is generally signed by someone from the business under penalties of perjury.
Many businesses will address prior risk through either a voluntary disclosure agreement or a tax amnesty program and then register at the same time to ensure compliance on a prospective basis. Let’s discuss each one below.
Voluntary Disclosure Agreement
Most states offer a Voluntary Disclosure Agreement (VDA) in which businesses, through their representatives, can come forward to a taxing jurisdiction on a no-name basis to self-report their unpaid taxes (some states do require the company name to be disclosed up front) and become compliant prospectively. Note, most VDA programs are contractual agreements whereby the state will allow a business to come forward to settle unfiled obligations with a limited look-back period of three or four years in exchange for the business becoming current on its tax obligations. The voluntary disclosure process is typically initiated by a representative of the business sending a letter or application form to the state. After a preliminary agreement is reached by both sides, the business must disclose its identity and file the necessary returns. Often with sales tax voluntary disclosures, the process can be simplified by submitting to the state a spreadsheet with the required information instead of having to prepare individual sales and use tax returns. The business benefits with a limited look-back period, reduced interest, and no late-filing negligence penalties, while the state benefits from receiving additional revenue not only for prior years, but prospectively as well, with minimal cost. For example, in the Texas VDA program, the state will waive not only negligence penalties, but assessment interest as well (as long as the VDA does not involve sales tax charged to and collected from a customer but not remitted to the state).
The savings in not having to file returns beyond a three- or four-year period can be significant for some businesses. During the VDA process, it is important for all of the relevant facts to be disclosed in good faith to the taxing agency. If a taxing jurisdiction were to audit a business that voluntarily came forward and intentionally misrepresented the facts, it is quite possible the state could revoke the VDA, require the business to file returns for additional periods, and possibly pursue fraud penalties.
VDAs are frequently used to resolve unfiled returns involving mergers and acquisitions. The buyer will usually require the seller to provide documentation that the seller is in compliance with state tax obligations to avoid potential successor liability issues. (See the July 30, 2015, and October 15, 2015, SALT-ED articles listed in the related insights section for more information.)
A drawback of the VDA process can potentially occur when the business submits the request directly to the taxing authority rather than an outside representative. At this point, the business has been identified to the state, and if for some reason the business it is not happy with the terms and conditions of the agreement, it would be extremely difficult to back out of discussions with the taxing jurisdiction.
Tax Amnesty Program
A state tax amnesty program is generally a limited-time program administered by a taxing authority in which a business (and individuals) can come forward voluntarily to satisfy its delinquent tax obligations. In exchange for the business coming forward, the taxing authority will generally abate penalties and all or a portion of the interest. When tax liabilities remain unpaid, the amount of interest and penalties that can accrue over time can be substantial. Filing delinquent taxes during an amnesty program allows taxpayers to come forward to the taxing jurisdiction to clean up past obligations and get a fresh start. There are certain drawbacks that businesses need to be aware of when participating in an amnesty program. A business coming forward under amnesty will likely be required to file and pay delinquent taxes for all prior periods in which the taxes are a liability.
In most tax amnesty programs, there are not limited look-back periods. Another drawback is that there is less leeway to make a settlement offer or negotiate the amount of tax that is due. The entire delinquent tax amount must be paid in full. Furthermore, if a state has issued tax due notices for prior periods, the business is generally required to pay the tax amount due, whether it believes the tax amount is correct or not. Once this tax amount is paid under an amnesty program, the business generally cannot file a claim for refund in the future to recover any of the incorrect tax amounts paid to the taxing authority.
The other trend we are seeing with amnesty programs is that those businesses which do not come forward during the amnesty program to settle past due liabilities can be subject to a penalty of 5%, 10%, or more of the tax that is deemed to be due when it is identified by the taxing jurisdiction at some point in the future.
As of now, Pennsylvania is the only state that has announced a tax amnesty program in 2017. The tax amnesty program will run from April 21, 2017, through June 19, 2017. Taxes eligible for the tax amnesty program include: corporate net income tax; personal income tax; sales and use tax, including local sales and use tax for Philadelphia and Allegheny County; among others.
Note that VDAs are similar to tax amnesty programs but are not the same thing. Again, tax amnesty programs may offer greater incentives (such as no penalties or no or reduced interest) but are typically offered on a limited-time basis only. Tax amnesty programs are generally not offered by all states on a regular basis.
The consequences of a business not understanding the nexus rules and not reviewing its situation annually can be very costly. A business could face stiff penalties and interest charges that over time could likely exceed the amount of tax due on unfiled returns. Nexus is a very complicated issue and can have a significant impact on a business’s bottom line.
When a business is evaluating its options for coming into compliance with a taxing jurisdiction for unfiled tax returns, a voluntary disclosure agreement or tax amnesty program can be a useful tool to help with not only prior years, but also prospectively as well. Each business situation involving unfiled tax returns is unique, and all options must be carefully reviewed in order to bring that business into compliance.
Wipfli’s SALT professionals are knowledgeable about nexus and can help evaluate the options that are available to a business for coming into compliance.