State and Local Tax Strategies and Solutions for Remediation

Bill Gentilesco:

Hi, Gary.

GB:

Before we get into things, why don't you give a little background on what remediation is?

BG:

Sure. When it comes to state taxes, remediation is usually coming to terms with prior tax exposures, and that might be an exposure that you just found out about or something that you've known about for a little while.

GB:

And why would companies need remediation or why would they have exposure?

BG:

Well, most companies do their best to file taxes and pay taxes where they're supposed to be, but laws change very quickly and sometimes you might have a growing business that goes from a few million dollars of sales in a couple of states to $25 million of sales in most states over a short period of time. Those are a couple of examples where state tax filing obligations can grow very quickly and management might not be aware that they should be filing income tax or sales tax in new states.

GB:

Can you give a couple examples of changes in law or circumstances that might've happened recently and that might give rise to companies not knowing they have a nexus or exposure somewhere?

BG:

Sure. There's many, but a couple of examples. The first one was in 2018. The US Supreme Court heard a sales tax case involving Wayfair and South Dakota. Wayfair had no physical presence in South Dakota, no property, no employees. Under the old rules, they didn't have a sales tax requirement, but South Dakota had a law that included what we call economic nexus and their law said, "Well, if you're just selling into our state and you have sales of over a hundred thousand dollars or 200 or more transactions, you have sales tax nexus in South Dakota."

Wayfair challenged that because that goes against the historical rule. Well, South Dakota won that case. And so, from that point forward, economic nexus was enough for a state to impose sales tax and that was in June 2018, and shortly thereafter, of course, most of the other states modeled their own nexus rules to include economic nexus. So that really expanded the profile of a typical out-of-state business that only has sales into a jurisdiction. They now have nexus if they have sales of over a hundred thousand or transactions of 200 or more, depending upon the state.

Another one is really more cultural. With COVID, of course, people were working from home and they got used to it. In some cases people said they worked better from home. People can debate that issue, but the end result is that companies now have employees working in various states. Sometimes they're close to home, maybe the next state over. Other times they might be, if you're based in New York, you might have employees in Texas and California and Florida. And so, post-Wayfair, you have a lot of employees that are physically working in states where the company didn't have an office or doesn't have an office, and the employee in that state generally will subject the company to an income tax file as well as a sales tax file.

GB:

Yeah, I've talked to some companies where they didn't even know their employees moved until the end of the year. The employee notified them several months later or maybe over a year later of that fact, so I'd imagine that could be an issue for a lot of companies.

BG:

Right. And so, it sort of gets into how does a company find out? There's a few ways. Some are better than others, but sometimes as part of preparing the tax return, the preparer will say, "Oh, I see you have an employee in these four or five states. You didn't have that last year. We should file returns, [inaudible 00:04:31] filing and get on the right track there." That's one example.

Another example might be a company receives a notice from a state. Says, "Hey, we have some information that looks like you might have an obligation here. Can you fill out this questionnaire?" And they conclude that you have nexus. That might cause a company to say, "Well, gee, where else do we have nexus? Maybe we should look more closely then."

Probably the best way if a company had concerns is to do what we call like a nexus study. From time to time you have a SALT professional, state and local tax professional, send out an information request and they'll look at all of your data, where your property is, where your payroll is, where your sales are, company travel, business registrations. They'll do a detailed analysis of that and come up with a report that says you should be filing and this and this state and so on.

GB:

I know I've seen a lot of those in due diligence processes. With a lot of mergers and acquisitions, it seems to be one of the first things a lot of companies look at, and it seems like we've gotten a lot of remediation work out of those sorts of projects as well where the buyer wants the target company to clean up all of its prior exposure or at least be aware of it and clean up as much as it can prior to making another investment or buying the company.

BG:

That's true. Due diligence, yeah. If you're buying the stock of a company or even sometimes even the assets of a company, as the buyer, you want to make sure you're not buying a sales tax exposure that's about to go off under your ownership. Sometimes it can be several million dollars. And you're right, in that case, sometimes the buyer will say to the seller, "Well, you need to remediate this, and in the meantime we're going to put a few million dollars in escrow to pay these liabilities that we need to come clean on."

Other times, if you're a seller, you might want to do your own kind of review to make sure that you're not going to have to deal with that and slow down the sale. You want to clean up your act before you actually go to market [inaudible 00:06:42]-

GB:

And be a little more proactive in the process, sure. So once, let's say, a due diligence or you did an nexus study and you've identified that you should have been filing in some additional states for income tax or sales tax, what should a company do next?

BG:

Yeah, the first step is, well, if you're looking at one state, you want to calculate what that exposure is. Generally, what the worst case exposure is, that's your starting point and there's usually no statute of limitations for a non-filing. And so, if a company says, "Oh my gosh, we've had inventory in Illinois for the last seven, eight years and we haven't been filing, what do I do now?" The first thing you want to do is calculate what's your worst case.

Calculate the tax interest and penalties that might be due, and if it's substantial, well, first of all, if it's immaterial, a company might want to just say, "All right, I'll put a reserve up on my balance sheet and I'll start filing today." And if the state catches you, yeah, they can go back to day one and assess the full boat for taxes, interest, and penalties. If it's minimal, you might want to go that route, but if it's a big number, then there's another alternative, oftentimes, and that's a voluntary disclosure agreement with the state.

A voluntary disclosure, well, let's put it this way. The states know that there's companies out there that want to come clean and states also want them to come clean. They want to bring in more revenue and they want to put more taxpayers on the rolls with as little cost to the state as possible. And so, most states have what we call a Voluntary Disclosure Program where it's a formal program that sort of specifies, "Gee, if you're a non-filer and you come to us voluntarily without us having to track you down, we'll knock off the number of years that you owe." We refer to that as the lookback period. Instead of in our example, seven or eight years of Illinois exposure, if I did a voluntary disclosure, I could probably get three years of prior years paying the taxes. Any interest, anything pre-lookback period would be waived and all penalties are waived.

GB:

That's a pretty big benefit.

BG:

Absolutely. Absolutely. But you have to qualify, and usually the qualifications are pretty easy of, just generally speaking, the state cannot have contacted the company previously with respect to that particular tax. So, if you're trying to come clean on an income tax, Illinois couldn't have contacted you for income tax. That's number one. Number two is you can't have filed. You can't file a return and then say, "Oh, I want to do a VDA." You got to decide what approach you're going to take and then go that way.

GB:

Let me put it this way. Are the benefits the same in every state? Is every state's VDA process the same and procedure's the same and their programs the same, or does it differ, like everything, it seems?

BG:

Yeah. When it comes to states, there's more similarities than differences. Most states use a three year lookback period. That's the number of years you're going to be on the hook for if you do a VDA. But there's some that are four, some that are five, some that they determine how many years you're going to have to go back based upon how credible your reasons are for not filing in the first place. So like New York City wants to understand why you didn't file. And you want to put things in the most favorable light when you request a VDA.

And another thing. Usually they're anonymous. When I say anonymous, I mean usually a company will hire an expert to do a voluntary disclosure agreement for them, and the application can usually be done without disclosing the company's name until the agreement is finalized, so that if something doesn't work out, you can back out. It doesn't happen too often that you have to back out, but sometimes it does.

GB:

So, once we've identified the states and we have a material exposure and decide we want to actually enter into a voluntary disclosure agreement with the state, walk us through a little bit of the process from end to end. How long it takes, what the procedures might be. Is there any back and forth? Is it pretty straightforward or what?

BG:

Yeah. Well, it really depends upon how many states, but let's say you're doing one. Most states have an application that needs to be filled out or a letter that needs to be written that kind of gives some general background of the company. A lot of states want to know when the exposure first started, what gave rise to the exposure. You mail in the application. In my experience, states are pretty quick at turning them around. They usually want to get taxpayers paying tax as soon as possible, but some states that are really big that might have more bureaucracy could take a bit longer, but it's not unusual if you request a VDA to get a response back within a couple of weeks.

I'm working on one now and any given time, we usually have a handful of VDAs in process across the US. I'm working on one with Connecticut right now. They responded to us within a day of our [inaudible 00:12:22]. Yeah, I'm shocked. And so, now we're working on the returns. We have to do three prior years. That took some time to get the data and all that, but that's probably taking about 30 days or so. The returns are very close to being done. We'll send those into Connecticut, we'll get a bill, we'll pay the bill. We filled out a registration already. It was all done through email and online. Beginning to end, in this case, 60 days.

GB:

Wow, that's pretty quick.

BG:

Yeah. I mean, they're not all going to be that quick and it's one thing to have one state, but oftentimes when we do a real thorough nexus review, we may find four or five or more states where we might be doing VDAs. That could take a little longer just because there's more paperwork.

GB:

Sure.

BG:

There's more data that the client needs to give us unless we have it already in our file.

GB:

Okay. What's the longest time usually the VDA takes? More like six, eight months?

BG:

It could take that long. I haven't seen too many go to full six months, but it could happen. It's usually on the taxpayer side. They may need to dig out data for us to comply with the VDA. The states, they're usually pretty quick on their end.

GB:

Okay. And are there any other paths for remediation other than voluntary disclosures?

BG:

Yeah. People may have heard in the news that sometimes states have amnesty programs. These are programs where oftentimes state wants to bring in some more money. They need cash. Maybe the collections aren't keeping up with projections, or it could be any number. Maybe they're in a recession and the state says, "Well, we still need to bring in similar to what we would normally bring in the good times." They might offer an amnesty program as a way to juice up their revenues.

An amnesty program, in most cases, they waive penalties. They might give you reduced interest for any taxpayer that comes forward. And it's not just non-filers in an amnesty. You could have made a mistake on your tax return, forgot to add back something or maybe your apportionment was too low or any number of mistakes. Amnesty programs, you can usually clean up any kind of a tax issue with the state. The problem with amnesty programs, as far as non-filers, they usually do not have a limited lookback. So, if I have a choice between an amnesty or a VDA, if I owe a lot of years, I usually want the VDA.

If I've been filing and I've made some mistakes on my tax return or left out some income, then an amnesty might work for me, but they don't come up often. They're few and far between.

GB:

Okay. Are there any downsides to doing a voluntary disclosure or an amnesty that you can think of as to why a company may not want to do it if it's a material amount?

BG:

I can't off the top of my head think of a downside. In most cases, when you do a VDA, part of the agreement is you will continue to be a filer for a certain number of years, and it might be right in your agreement that you'll continue to be compliant for at least the next three years. I don't really consider that a downside, assuming you're still going to continue to do business in that state. If you're not going to be doing business in the state, if somehow you're confident that you're not going to be, then maybe we need to think about that.

GB:

Do states ever reneg on the Voluntary Disclosure Program or nullify it in any way?

BG:

I haven't seen that, but most of the agreements have language that says if there's a material misstatement or intentional misstatement of facts, then it's subject to repeal. Not too many companies that we work with are going to knowingly or intentionally mislead in that [inaudible 00:16:40] so I haven't really seen that backfire-

GB:

Okay. Okay, great. Thank you very much, Bill. That was really informative. I appreciate it.

BG:

Thank you ...

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