Taxes: State Secrets

Forget the IRS. Those shadowy state tax collectors are the ones who will really drive you crazy

Jackie Reynolds, president of Action Medical Products in San Diego, never thought of herself as a slacker when it came to paying business taxes. So she was "dumbfounded" in 1999, when she got a bill for $101,000 in back taxes from the state of California. "Luckily, I was sitting down at my desk," quips Reynolds, whose three-employee company rents out orthopedic rehabilitation equipment.

According to the state, Reynolds had failed to pay the so-called use tax--a levy on any untaxed goods bought outside the state. Reynolds, who maintains the state made a mistake, is appealing the tax department's decision, saying she can prove she paid the sales tax to her vendors. But the state says it has no record that the vendors passed the money along. Regardless, the amount in question--$120,000, including penalties--could bankrupt her tiny company, she says.

Meanwhile, Ellen Chamberlin, president of Luther Construction Inc. in Albuquerque, fears a tax dispute with Arizona could bulldoze her $20 million company right into the ground. The 50-year-old family business is fighting to overturn a bill for more than $300,000 in back taxes and penalties for work it did on Navajo reservations in Arizona. The dispute: whether the company was required to collect gross receipt taxes on Indian-owned land. In a case now in Maricopa County Superior Court, Luther argues that a previous tax rebate proves the company should not have been required to collect the tax. Counting attorneys' fees, back taxes, and penalties, the total damage could reach nearly a half-million dollars. "To die at the hands of the government is supposed to happen in other countries, not the U.S.," says Chamberlin. "This is just over the top."

And you thought the IRS was your worst nightmare. Things have changed. Under pressure from Congress, the Internal Revenue Service has been defanged, and federal tax audits have hit record lows. What's really making entrepreneurs lose sleep is dealing with state and local tax authorities. They collect more than 50% of business taxes, and nationwide there are 7,000 of them. So far, say tax experts, the push to make revenue collectors customer-friendly hasn't trickled down to this level.

Indeed, as the economy slows, experts expect these already aggressive state agencies to work even harder to make up revenue shortfalls. "State authorities either have to raise taxes, which takes a while, or become more aggressive about tax collection," says Michael Petrecca, tax partner at PricewaterhouseCoopers in Columbus, Ohio. And who's the most likely target of this aggression? You guessed it: small businesses. That's because they lack the big staffs to handle the increased reporting requirements and inquiries. "It takes the same amount of effort to comply with state laws whether you're a $1 million business or $1 billion business. It's just as complex," noted Steve Starbuck, national partner in charge of state and local tax consulting at Ernst & Young in Washington.

Just how bad is it? Some states, such as Michigan, Kansas, Indiana, and Oregon, have turned to private collection agencies to go after delinquent taxpayers. State tax authorities in New York, buoyed by two recent court cases, are pursuing collection of the so-called telecommuter tax, which taxes the earnings of employees of New York-based companies who choose--but aren't required--to work outside the state. And California continues to make extensive use of its out-of-state tax bureaus in New York, Chicago, and Houston to make sure companies in the East, Midwest, and South pay any and all taxes due to California. "If you sneeze, and it gets to California, they think you should be taxed there," laments Mary Lou Pier, president of her own CPA firm in Chicago. To make matters worse, the federal moratorium on Internet sales taxes expires on Oct. 21. Many states already have legislation in the pipeline to capture a share of those e-commerce revenues.

As if tougher enforcement and zealous tax collectors weren't trouble enough, small-business owners are drowning in paperwork from multiple tax jurisdictions--each one with its own idiosyncratic rules, deadlines, and definitions. "Over the last 10 years, the administrative burdens of making sure we're in compliance with the tax laws has easily doubled," says Michael Tincher, president of Buker Inc. in Gurnee, Ill. It's so bad, he says, "quite frankly, I would never start another business."

In 1991, the 10-person consultancy, based near the Wisconsin border, decided to set up satellite offices in three additional states to be closer to its clients. Suddenly, Buker's comptroller, Joan Bodenlos, was dealing with payroll, corporate income, sales, and use taxes in five different states--Illinois, Wisconsin, Utah, Kansas, and New Hampshire. On her bookshelf, she kept a stack of five different tomes on withholding rules alone. "It seemed so silly with just 10 people," she says. (The satellite offices closed in 1997, yet the hassles continued. Last year, Bodenlos still had to file income tax returns in two states where the company had signed long-term leases.) "Most businesses don't understand how tangled that web is," says Bodenlos. "Even after we closed the offices, the tax issues haunted us."

As a rule, the more sophisticated and aggressive the state tax department, the bigger the headache. In New York and California, two states infamous for inducing high anxiety, audit rates average 3% of business returns, says Ernie Dronenburg, regional tax partner at Deloitte & Touche in San Diego, and a former California tax official himself. By contrast, the audit rate for many midsize states is about half that. The easygoing feds audit roughly 1% of corporate income tax returns and even fewer sole proprietorships.

Perhaps most frustrating for entrepreneurs is that there's no one clear strategy for dealing with state tax collectors, as the particular sore points can vary widely from state to state. In New York, for instance, a particularly contentious issue is the levy on telecommuters, which opponents argue has been taken to extremes. Case in point: In December, a state tax court ruled that George A.P. Wallace, the chairman and co-founder of Wallace Eannace Associates Inc., an equipment marketing and distribution company in Plainview, N.Y., owed New York $53,587 in back taxes, even though Wallace lived in Maine and spent almost 90% of his working days outside New York. "It was the petitioner's choice to move to Maine," said the court, stating that the move did not pass the "necessity" test which might have made his income exempt. Wallace declined to comment, but company President Henry C. Kunkel Sr. says: "It certainly doesn't seem fair that New York wants to tax 100% of his income."

New York attorney Peter L. Faber, who represents a computer programmer in Nashville in a similar case, thinks the tax policy is unfair and has petitioned the state commissioner of taxation and finance to reconsider. This is "a real sleeper issue," says Faber, because corporate officers can be held personally responsible for failing to withhold taxes on their nonresident employees' income.

State officials aren't oblivious to the burden in cases like Chamberlin's dispute over the Navajo construction project. "We certainly empathize with how difficult an area of tax law this is," said Jeff Kros, public information officer at the Arizona Department of Revenue. But one reason it can be so hard is the sometimes-haphazard way that rules get applied. Kros contends the state issued two rulings in 1989 that spelled out its position: Work done for any government entity--federal or otherwise--was subject to state tax. While he admitted that the position was different from that taken by the department in issuing Chamberlin her refund on the previous job, he said, "having someone scribble a reason on a form" should not be relied upon as a department ruling.

Nor does Kros think the state revenue department should be held responsible for the possibility of Chamberlin having to declare bankruptcy. "Those business decisions are up to her," he said. "We've always worked with taxpayers to set up payment plans based on ability to pay."

Even states with reputations for mild manners--mostly in the South--are more than willing to go after businesses to get their due, but they do it with a lighter hand. Like California and all the other states with a sales tax, Florida collects a use tax on out-of-state purchases by businesses. But while Florida will assess back taxes and interest on companies that failed to pay the use tax, it will often waive penalties if there's no suspicion of fraud, says Jose E. Valiente, president of ValienteHernandez & Co., a CPA firm in Tampa.

As a rule, big business still gets audited by the states more than small companies, but you could be subjected to a so-called friendly audit. These reviews are aimed at relatively young companies--at least two years old--to make sure they're complying with the law, says Dronenburg, but tax authorities tend to be somewhat forgiving when mistakes are found. They don't have to look far: Small-business owners in general are more likely to make attention-getting errors, usually out of ignorance or carelessness. Chicago CPA Pier recalls a family-owned business with more than $1 million in revenues that didn't deposit withholding taxes within 15 days after the end of the month in which the money was withheld. The state immediately sent the company a penalty notice. While Pier tried to convince authorities her client shouldn't be punished for failing to know the ins and outs of withholding rules, the company ended up paying $3,000 in penalties. The problem, she notes, stemmed from ignorance by the family member put in charge of payroll. "You need to hire people who know what they're doing," she says.

What if your state does hit you with a big tax bill you don't think is fair? Get professional help fast, says Leo March, CEO of San Diego-based Integrated Sign Associates Inc., a sign maker. "Never have direct contact with these people unrepresented," cautions March, a veteran of six state audits. Why? Because if you say the wrong word or fail to correct information, the agency will pounce on the extra revenue. March once faced the prospect of coming up with $50,000 in cash in a sales tax dispute after auditors misclassified his company. The situation wasn't resolved until Dronenburg, who was on the state tax board, intervened. Michael Hoffman, a CPA in Princeton, N.J., tells of a firm in which the controller himself responded to a letter from the state tax agency asking for data on whether the firm had taxable sales in that state. The controller mistakenly indicated that it did, when in fact the sales were to tax-exempt schools and police departments. But "oops" doesn't cut it with state bureaucrats: It took $4,000 to straighten out the mess.

If you discover a problem with your state taxes, sometimes the best approach is to just fess up and negotiate with your state department voluntarily. States often are willing to limit the number of years for which back taxes are owed and will abate penalties and interest, says Ernst & Young's Starbuck. If negotiations fail, pay up first, then sue for a refund later, advises Jack E. Karns, a tax lawyer and professor at East Carolina University School of Business in Greenville, N.C. At least you won't be accruing any more interest and penalties.

In one respect, at least, dealing with state tax issues has gotten easier: The Net has made information readily available. Every state's Web site links to its tax department, and some have special sections for small business. You'll find frequently asked questions and answers, news about new taxes and rates, filing deadlines, and tax forms and publications. "Many states are trying to reach out and help people," says Dronenburg.

That's not to say your state tax department will become your new best bud. "They'll do everything they can to lighten your wallet," says Paul Gada, an analyst at CCH Inc., a tax and business publisher in Riverwoods, Ill. It's almost enough to make you cry uncle--for Uncle Sam, that is.

By Virginia Munger Kahn

Before it's here, it's on the Bloomberg Terminal.