Audit Division Reorganization Targets Flow-Through Entities

New York State Tax Department Makes Big Changes¹

By Paul R. Comeau and Andrew B. Sabol²

Many state tax departments have had a hard time keeping up with increasingly sophisticated taxpayers. While an asset or business may have been owned or operated by one individual or entity in the past, today, ownership may be scattered across a wide array of S corporations, partnerships, limited liability companies and other flow-through entities for various tax planning or business reasons. This poses a dilemma to auditors, who may suddenly find their personal income tax audits focusing on S corporation or partnership issues, which they may be ill-equipped to handle. New York has adapted a novel approach to solving this problem, and other states are likely to soon follow suit.

On June 19, 2002, representatives from the New York State Department of Taxation and Finance spoke at the Business Council Tax Meeting in Saratoga on the recent reorganization of the Tax Department’s Audit Division. Up until recently, the Tax Department’s Audit Division was comprised of four separate bureaus, namely: the Corporation Tax, Income Tax, Sales Tax and the Transaction & Transfer Tax audit bureaus. Each of these bureaus included both field audit and desk audit operations, for a total of eight operational units. While this system was in place for many years, by early 2000, there was a perception in the Tax Department that things were not running as efficiently as they could be. Certain taxpayers – mainly, flow-through entities – were not appearing on the audit radar screen. In other instances, auditors were ill-equipped to handle situations where the lines blurred between individual and entity audits. With this in mind, the Tax Department sat down to study the problem.

First, the Tax Department set out to determine the type and number of New York State taxpayers. In the corporate arena, it determined the following:

With regard to individual taxpayers, it found the following:

When the Tax Department compared this "universe of taxpayers" with the focus areas covered by the Corporation Tax and Income Tax audit bureaus, it found something interesting: taxpayers were falling through the cracks. The Corporation Tax audit bureau concentrated on C corporations (Article 9A), banks (Article 32), insurance companies (Article 33), stockbrokers (Article 9A), and transportation and transmission companies (Article 9). Meanwhile, the Income Tax audit bureau focused mainly on residency audits and withholding tax audits, both under Article 22. Comparing these two bureaus’ audit coverage with the universe of taxpayers, the Tax Department discovered that neither bureau was focusing on flowthrough entities such as S corporations, partnerships, limited liability companies, limited liability partnerships, trusts, or their related shareholders, partners or members. On top of that, the existing organizational structure was not flexible enough to allow one auditor to address crossover issues, namely, issues involving both corporation and income tax issues.

In April of 2000, the Audit Division set up the Flow Through Entity Audit program under the direction of Regina Jaffe, Director of Field Audit Operations. The Audit Division dedicated five field audit teams comprised of corporation and income tax field auditors and team leaders to audit flow-through entities. Pursuant to the new program, the five field audit teams adopted what they called a "TEAM" or "Total Entity Audit Method" approach to performing audits. This included increasing the knowledge base of all auditors, developing new audit programs and ensuring consistency in audits. The TEAM methodology was also designed to give each field audit team a better understanding of how entities were operating by reviewing all of the shareholders, partners, or members and any other entities in which they were involved. The flow-through entity teams focused on:

• Unreported gains at the entity and individual/partner levels;

• Tax shelter losses being used to offset capital gains at every entity level;

• Insufficient shareholder basis to claim losses; and

• Lack of a bona-fide business purpose in related-party transactions.

Audit selection was also revamped, using an entity-down approach rather than looking upward from the shareholder/partner. For example, an audit of an S corporation or partnership would include a review of the corporation or partnership tax return, all the shareholder or partner returns, as well as any other related entities. Audit issues were also more readily identified, and taxpayers found it easier to deal with the same auditor or team of auditors on all issues. In addition to being more efficient, taxpayers found the new TEAM approach to be less intrusive and time consuming.

Given the nature of the new audit methodology, one audit might involve auditing several flow-through entities, individuals, trusts and/or withholding tax issues. By April of 2001, five additional teams were dedicated to performing flow-through entity audits using the same TEAM approach. It soon became apparent that in order to respond to the way businesses were organizing, it was no longer feasible to classify audits as either "corporation" or "income" tax. Thus, in April of 2002, the Audit Division reorganized by merging the Corporation Tax Audit Bureau and the Income Tax Audit Bureau into a newly created Income/Franchise Field Audit Bureau and Income/Franchise Desk Audit Bureau. The new organization also introduced efficiency and cost-cutting measures by creating a Shared Services Bureau responsible for audit selection and research for both Field Audit and Desk Audit operations.

Specialty entities such as banks and insurance companies will not be handled by the new Income/Franchise Unit. Instead, they will continue to receive the same specialized attention as in the past.

Auditors now use the TEAM approach whenever a flow-through entity is involved. In addition to maximizing efficiency, this new approach should help ensure consistent treatment of all audit issues, as well as make audits less burdensome for taxpayers.

However, some might question the capacity of income tax auditors to properly address federal and state corporate tax issues, or vice versa. Each area is very complex, and it seems likely that personnel will struggle with their new responsibilities. Many taxpayers and practitioners find that audits are less difficult when the auditor is well-versed and experienced. Others wonder whether audits will extend indefinitely. For example, one individual may be audited, but might own 10% of an LLC, which is a 15% partner in a limited partnership. Will the individual audit trigger an audit of the LLC and its other members? Will the partnership partially owned by the LLC also face an audit? Will all other LLC members and partners face audits? What about other unrelated entities (S or C corporations, partnerships or LLCs) they own? Where will these audits end?

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