Surviving a Tennessee State Tax Audit

November 2012 By James Anderson
Tennessee Corporate Newsletter

Benjamin Franklin, in a 1789 letter to French scientist Jean-Baptiste Leroy regarding the permanency of America’s new Constitution, wrote, “In this world nothing can be said to be certain except death and taxes.”  For a company that transacts a significant amount of business in Tennessee over an extended period of years, it is almost certain that sooner or later the Tennessee Department of Revenue (the “Department”) will conduct a state tax audit of that business.  This article discusses the governing rules and the various outcomes of these audits; it also provider suggestions for making a state tax audit a not-so-deathlike experience.

The focus of this article is on audits that the Department conducts regarding the kinds of taxes that it collects and administers.  In terms of the amount of revenue and the breadth of applicability, the  most important of the types of taxes collected by the Department are (i) state and local sales taxes on retail sales of tangible personal property and specified types of services; (ii) state franchise and excise taxes imposed on the net worth and net income, respectively, of corporations, limited liability companies, and specified other kinds of business entities; and (iii) business taxes that Tennessee counties and cities are authorized to impose on the gross receipts derived by companies from selling certain categories of tangible personal property and services.  Despite this focus on the Department’s audits, many of the procedural steps and suggestions for obtaining positive outcomes (e.g., maintaining complete and accurate business records, dealing with auditors in a professional and cordial manner, etc.) apply to a broad range of tax audits that regularly are performed by the taxing authorities of all states.

Pre-Audit Preparedness

A company’s managers and key personnel should operate on the assumption that an audit of its state taxes will occur at some time, and the company should strive to be prepared by maintaining accurate and easily available business records.  In addition to (and probably more important than) being able to respond adequately to an auditor’s questions and requests for documents, the maintenance of sound records enables a company’s managers to detect trends and potential obstacles to profitable operations.  It is also significant that deficiencies in record retention and management are often a major underlying cause in triggering an audit, as they lead to the filing of inaccurate or incomplete tax returns.

For virtually all categories of state taxes, important business records should be kept updated and easy to find.  These include: federal income and employment tax returns and supporting details, organizational charts, corporate minutes, financial statements and annual reports (if applicable).  For sales tax audits they include: sales and use tax returns, individual transaction records (such as invoices and receipts), and exemption certificates (for, e.g., non-taxable sales for resale or sales to government entities and tax-exempt organizations). 

In most instances, a tax auditor will legally be entitled to receive the kinds of records described above. It will be to the taxpayer’s advantage to have them prepared and set aside for easily providing them.  The auditor, in many cases, will have alternative sources for obtaining the information contained in such records.

To organize, file and store historical business records in an efficient way, it is helpful to know the applicable periods of limitation with respect to various categories of taxes.  For most kinds of taxes collected and administered by the Department, the time for making an assessment (in the absence of a fraudulent return) is three (3) years from December 31 of the year in which the return was filed.

Working and Dealing with the Auditor

For a business company, the onset of a state taxed audit comes in the form of a written document from the Department informing the company that it has been selected for audit.  From the beginning point and throughout the process, the company’s primary objectives should be to reach a conclusion of the audit with the minimum amount of disruption to business operations, costs and other economic outlays, as well as to learn the best way to be in compliance in the future and avoid becoming a serial tax audit target.

The first step in reaching a successful audit conclusion (based on the criteria mentioned above) is to have a thorough understanding of what issues and activities the audit will entail.  The process of ascertaining this key information usually includes a detailed review of the audit notification letter and an initial conference between the company (and its legal representative) and the auditor and his or her supervisor.  The most important information for the taxpayer to learn includes: (i) the category or categories of taxes involved; (ii) the audit period (i.e., the beginning and ending months of the time being examined); (iii) the issues to be examined (e.g., specific types of revenue, receipts, deductions, credits, etc., and/or whether the audit is based on new statutes, regulations or case law); (iv) the contact information of all Department personnel expected to be involved; (v) the records and documents expected to be requested; (vi) the dates and location requested for the production of records and documents; (vii) a list of witnesses (including expert witnesses, if applicable) to be questioned; and (viii) how much time is expected to be required to complete the audit.

Upon being notified of a state tax audit, one of the earliest crucial decisions to be made is whether an outside representative (an attorney or accountant) is to be engaged, and, if so, to what degree of control and conduct of the audit will be turned over to the outside advisor.  Under some circumstances, the making of this decision may be quite easy.  For example, if a large amount of money (compared to the company’s income and assets) and/or complex legal issues are involved, hiring an outside advisor will be mandatory; if the audit involves a relatively small amount of money and/or is “routine” (e.g., it involves the same issues with which company personnel have dealt in previous audits), it may be clear that little, if any, outside help will be required.  For the “in between” cases, the main disadvantage of hiring an outside advisor is the cost.  Conversely, the advantages of having an outside advisor generally will include familiarity with applicable laws and the Department’s methods and personnel; knowledge of how well other taxpayers dealing with similar audits have fared; reducing any sense of intimidation that the company may experience; and establishing to the Department that the company will have and use ample resources in dealing with any future audits that the Department may contemplate.

In the context of a tax audit, the services that an attorney or an accountant provide are similar.  However, the legal privilege of a client against disclosing information that it provides to its attorney in connection with obtaining legal advice and representation, and the ability to represent a company in judicial proceedings, are among the reasons why (if an outside advisor is to be employed) an attorney could be more advantageous than an accountant.

From a tax audit’s initial conference or other first communication between a company’s representatives and the Department’s audit officials, it is to the taxpayer’s advantage to establish and maintain a businesslike and cordial relationship.  From the taxpayer’s standpoint, this process includes being respectful in conversations with auditors, being punctual in responding to questions and attending planned meetings, and providing auditors who come to the taxpayer’s business facility with a comfortable place to work.  Each company representative who is involved in the audit should convey the message that the company desires a fair and reasonable outcome and will take every action reasonably necessary to achieve such a result on a prompt basis.  Avoiding the development of an adversarial or hostile relationship with the auditor generally will cause an audit to take less time, be less unpleasant and conclude with a satisfactory result.

Settling or Litigating

A business undergoing a state tax audit should determine early in the process which Department official has the authority required to negotiate a settlement between the taxpayer and the Department.  Usually, this is not the auditor who performs the detailed examination.  The company (without being disrespectful to the primary auditor) should try to assure that the official who has such settlement authority continually is informed of the audit’s developments, so that he or she can make prompt decisions regarding which issues can be resolved based on an agreement.

A tax audit often involves numerous factual and legal issues, and generally at least some of them can be dealt with by agreement.  To the extent that there are issues that cannot be settled by compromise and the Department determines that at least some amount of additional taxes should be accessed, the Department legally is required (pursuant to a statute, Tennessee Code Annotated § 67-1-110, known as the “Tennessee Taxpayer Bill of Rights”) to provide a written explanation of each item of proposed additional tax.  After reviewing this written explanation, the taxpayer has an opportunity to determine how sound (or unfounded) the Department’s legal and factual assertions are, to file a written response, and to have a timely hearing before “an impartial hearing officer from the Department.”  The hearing officer can make non-binding decisions on the correctness of the parties’ respective positions.

If there are issues that remain unresolved after the process described above is completed, the taxpayer must decide whether (i) it is willing to concede to the Department’s position and pay all of a proposed assessment of additional taxes, or (ii) it will litigate all or some portion of an assessment in court.  In making this decision, the key factors include the amount of money involved, whether the issues are likely to recur in subsequent tax years, and how strong the taxpayer perceives its legal position to be.

After a Tax Assessment

Once the Department makes a formal assessment of additional taxes, a taxpayer has a statutory period of 90 days in which to (i) pay the assessment (and then have three (3) years in which to file a refund claim), or (ii) file a lawsuit challenging the assessment, without paying the assessment but instead filing a bond or irrevocable letter of credit or otherwise meeting a statutory prescription for establishing its ability to pay the assessment if it does not prevail in litigation.  The appropriate court for either a suit challenging an assessment or disputing the Department’s denial of a timely refund claim is the Chancery Court of Davidson County or the Chancery Court of the county in which the taxpayer has it principal place of business.  (A refund suit in chancery court must be filed within one (1) year of the date that a refund claim is filed with the Department.)

If a taxpayer takes one of the two steps described above within 90 days after the Department makes a tax assessment, the Department’s ability to collect the assessed tax (but not the accrual of interest thereon) is stayed until the issue is resolved.  If the taxpayer takes neither of such actions within this 90-day period, it loses its ability legally to challenge the assessment, and the Department may begin collection action.  The running of the 90 days following the Department’s making of an assessment is tolled if the taxpayer (within 30 days of the notice of assessment) files a written request with the Department for an informal conference to discuss the assessment.  This tolling lasts until the Department, following an informal conference, notifies the taxpayer of its informal conference decision.

Upon the filing of a final judgment by the appropriate chancery court with respect to a refund suit or a suit challenging a tax assessment, the Department and the taxpayer each has 30 days in which to appeal to the Tennessee Court of Appeals by filing a notice of appeal in such chancery court.  Upon the timely filing of a notice of appeal, the right to appeal to the Court of Appeals becomes a matter of right.  Once a final judgment is issued by the Court of Appeals in such a case, the losing party has a period of 60 days in which to file an application for permission to appeal with the Tennessee Supreme Court.  In a tax case, as in other types of cases, the granting or denying of such a request is a matter of the Supreme Court’s discretion, and permission to appeal generally is denied unless the case involves “the need to secure uniformity of decision,” or “the need to secure settlement of important questions of law.”

In litigation involving issues of Tennessee state taxes, a final judgment of the Tennessee Supreme Court (or the final judgment of the Court of Appeals in cases in which the Supreme Court does not grant permission to appeal) is final and conclusive with respect to the taxpayer and the Department, except in rare instances in which a question of federal law is involved.

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