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Why State Tax Audits Are Increasing

When most people imagine a painful tax audit, it’s the Internal Revenue Service that comes to mind, but it’s now just as likely to be a state auditor at the door.

Hungry for revenue, some states are going after more current and former residents for omissions and errors, intentional or otherwise, on their tax filings. They also are conducting more audits of estate tax returns, even as the government does fewer because of an increase in the estate tax exemption.

Tax advisers say audits have increased in California, New York, New Jersey and Iowa. The Illinois Department of Revenue recently added 50 auditors, in part to help a group of 136 others work on individual and corporate income tax audits.

Connecticut increased its income tax and estate tax audits by 10% for fiscal year 2011 over the previous year, says Sarah Kaufman, a spokesperson for the Connecticut Department of Revenue Services. She attributed the rise to updated computer programs and better use of information sharing between federal and state agencies that let Connecticut target questionable returns more efficiently.

State audits tend to begin with red flags including a change of residence, out-of-state property holdings, real estate in general, and trusts or partnerships that hold different kinds of assets. Stock options also now get a lot of attention, according to AmyLynn Flood, partner, global human resource services at PriceWaterhouseCoopers.

Each state has its own set of taxes and its own pet issues. New York, for example, has gone after people who live in a neighboring state but spend time in a Manhattan pied-a-terre or upstate hideaway. Anything that suggests a contact or former contact with New York by someone who now claims to live out of state is a red flag, according to Stephen Breitstone, a partner at Meltzer Lippe, Goldstein & Breitstone, LLP in Mineola, N.Y.

While audits seem to be proliferating, “they aren’t necessarily prevailing,” according to John O. McManus, an estate lawyer based in New Jersey. Taxpayers may be able to prove their returns were accurate and their strategies valid.

New Jersey is looking closely at certain kinds of small business, including pizzerias, doctors’ and lawyers’ practices. Along with others, it also looks at people who move to states with lower tax rates such as, say, Pennsylvania. California pays close attention to New York- and New Jersey-based companies with business on the West Coast, according to McManus.

Grants of stock and stock options by an employer can prove tricky and often trigger audits, when, for instance, a taxpayer works in one state and resides in another. Issues can also occur for someone who has lived or worked in more than one state between the time they were granted and when they vest or are exercised. Most states tax part of an equity compensation award even if the person no longer lives there when taxes are due.

Data on audits is hard to come by, but Verenda Smith, interim executive director of the Federation of Tax Administrators, said some of the states’ new effectiveness may be the result of better use of data and of programs to analyze it. Tight budgets mean many states actually have less staff in their tax offices, but they are better able to identify those who are underpaying their taxes. In those states, fewer audit notices are going out, but anyone who gets one should prepare for the worst. Why, what should they do?

Readers, have you been audited? Any advise if you have?

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About The Tax Blog

  • The Tax Blog brings together a team of award-winning tax journalists from the Dow Jones network and around the web to examine the tax issues, changes and legislation that affect families, investors and small business owners. Our contributors include Tax Report columnist Laura Saunders (WSJ), Tax Guy columnist Bill Bischoff and senior reporter Jilian Mincer (SmartMoney.com), retirement-focused reporter Anne Tergesen (WSJ), wealth management writer Arden Dale (Dow Jones Newswires), TaxWatch columnist Eva Rosenberg and personal finance reporter Andrea Coombes (MarketWatch), and reporter Alyssa Abkowitz (SmartMoney). They’ll provide the latest news and insight, mine the tax code for tips and loopholes, and answer your questions about tricky tax situations. Contact the The Tax Blog with ideas, suggestions or tax questions at thetaxblog@dowjones.com.

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