Voluntary Disclosure: How to Come Clean and Limit Your State Tax Exposure
Daniel Gayer, Tax Senior Manager
State budgets have been especially tight in recent years as states struggle to recover from the ongoing effects of the Great Recession. In their search for new sources of tax revenue, states are constantly trying a wide range of techniques to expand enforcement and encourage taxpayers to comply with existing tax laws, finding it far easier to strictly enforce and broaden the interpretation of current law rather than to raise revenue through new legislation that inevitably would be vilified as yet another tax increase. Tax amnesty programs are an occasional and well publicized tool used by states to encourage compliance, typically offering taxpayers the opportunity to file late returns and pay back taxes and interest, but forgiving penalties that normally would be assessed. While many states offer such a program from time to time, they tend to last only for a short period of a few months and are often narrowly tailored to apply to a specific tax type or class of taxpayers identified by the state as a good source of potential revenue. For example, Massachusetts has recently authorized an amnesty program, but the program only runs from September through October of 2014, and, based on issued guidance, only applies to abate penalties for assessments that have already been issued as of July 1, 2014.
For the majority of taxpayers who know or suspect that they may have missed filing a state tax return and have not yet been contacted by a state department of revenue with an assessment or audit notice, no amnesty program will be currently available for which they can qualify. However, a less publicized but always available alternative will allow taxpayers to achieve the benefits offered by most tax amnesty programs at any time: voluntary disclosure.
Every state offers some form of voluntary disclosure program. Some programs are more formalized and involve specific voluntary disclosure forms and applications that must be filed, and some are simpler, allowing application by letter. The primary requirement of most programs is that the taxpayer has not yet been contacted by the state regarding the liability in question and is coming forward voluntarily. As long as you have not received a notice from the state, you will most likely qualify for voluntary disclosure for a wide range of taxes including personal and business income taxes, franchise taxes, sales and use taxes, and others. Most states allow taxpayers to apply anonymously by providing a general explanation of the situation, the taxpayer’s history in that state, and why returns were not filed on time. States will then give a preliminary approval based on the facts contained in the application, and only then must the taxpayer reveal its identity. If the state rejects the anonymous application, the taxpayer can simply walk away without fear of having tipped off the state and inviting trouble. Rejection is rare, however – in most cases anonymous applications are approved and assuming the actual facts revealed once the taxpayer’s identity is disclosed are consistent with those represented in the anonymous application, the taxpayer will be approved for voluntary disclosure and obtain several valuable benefits:
- Limited Look-back – Most states only require the most recent 3 or 4 years of returns and tax payments for taxpayers participating in voluntary disclosure. If the state finds the taxpayer first, they can go back much further, typically 6 years or more.
- Penalty Abatement – Although taxpayers must still pay interest, most penalties are abated. Many late filing and late payment penalties compound annually or even monthly, and can quickly add up to more that the tax that was initially due, so the penalty abatement can provide a significant savings opportunity.
- Protection from criminal penalties – depending on the specifics of your situation, failure to file returns and pay taxes may give rise to criminal penalties if the state finds you first. Voluntary disclosure can offer a way out of this situation.
In addition to the benefits and significant tax savings mentioned above, participating in voluntary disclosure will allow taxpayers to come into compliance at relatively low cost, allow larger companies to reduce reserves for outstanding tax liabilities, and generally give taxpayers peace of mind and reduce potential risks and liabilities.
Who should be most interested in voluntary disclosure? To start with, anyone with a suspicion that they may not be in compliance with state tax laws should investigate the possibility to avoid headaches down the road. Beyond that, businesses that have employees and file payroll tax returns and/or sales tax returns in states where they do not file business income or franchise tax returns should investigate voluntary disclosure. Filing one type of return but not another means that you are on the state’s radar and should carefully evaluate if you potentially are liable for other taxes before the state comes to you and demands that you either prove you are not liable or file late returns and pay taxes, interest, and penalties.
State tax compliance is particularly important for business owners seeking substantial bank financing or equity investment, or those interested in selling their business. Banks and prudent investors will want to know that a business is a compliant taxpayer before investing and may demand escrow amounts or a reduction in sale price, and may walk away entirely if they are not satisfied with the business’s tax compliance history.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.