State Audits Getting More Aggressive

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State tax audits are getting more aggressive. Unlike the IRS, there is no Congressional oversight to hold the auditors in check either. Some state revenue divisions, most notably California’s Franchise Tax Board, have a mandate to go find money and they often get very aggressive.

Two days ago, April 2, 2009, I blogged about the staggering number of people that might be looking at your federal tax return right now. Top of the list are states. In fact, each return is requested almost 10 times by various states.

Recently a friend of mine, also a CPA, got caught up in one of these state audits. She doesn’t practice as a CPA anymore. She has put her accounting knowledge to good use in her family investments and businesses. One of the investments that she and her husband made was in a land development project that lost money. They didn’t lose a fortune, but it was still a loss. She filed her 2004 tax returns showing the loss. In 2006, she discovered that there was a mistake so they went back and amended the 2004 return.

Time went on and suddenly she got an audit notice on her 2004 return. When she called me to tell me, I reminded her of the 3 year statute and said something like, “They can’t open that year. It’s closed.” The 3 year statute of limitation starts running when you file your return. Figuring she probably filed her return on extension, like I do, I calculated a 10-15-05 filing date and that meant the statute had run by 10-15-08.

I didn’t realize she’d filed an extension, so the state was right. The extension opens up the 3 year statute again. So, filing an amendment in November 2006 meant that the new statute was up November 2009.

She didn’t think there would be any issue and was kind of surprised that a state would audit her when the IRS did not. Here’s what had happened. The state had requested a copy of her return and all supporting documents (1099s, 1098s, W-2s, K-1s) from the IRS, just like we talked about a few days ago on the TaxLoopholes blog.

But somehow, there was a hiccup in the system. Instead of showing a small loss on the land development company, it showed a $3 BILLION gain! I couldn’t help laughing when she told me that. But it wasn’t funny. That’s because the state was now involved. They wanted to see the partnership return for the company. But the company didn’t want to show it. Why? If they did, it could mean that THEY were then open for audit again. They didn’t want to take that chance.

Finally she was able to prove that she didn’t have $3 billion squirreled away in her mattress. But the state auditors now had to justify the audit request. They tore apart her return and it became the audit that just wouldn’t end.

How do you protect against this?

(1) Request copies of the entire returns for all investments that you receive K-1s for. Normally partnership agreements give you the right to get access to these records.

(2) Think twice before you do amendments. Remember it opens up the statute again.

Other than that, just be ready. It’s not just the IRS who is looking at your returns.

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