Anyway you look at it -- the number of audits conducted, the amount collected, or the anecdotal tales of tax lawyers and accountants -- the New Hampshire Department of Revenue Administration is putting the squeeze on businesses, as both businesses and state government face their own budget squeeze. The DRA audited some 8,751 returns in fiscal year 2009 (which ended last June 30) nearly all of them business-related, according to figures released Feb. 19 to NHBR.And at the rate being set this fiscal year, the agency should be getting into some 10,000 returns by this June 30. That would be a 55 percent increase from 2007, when a total of 6,867 audits were conducted.According to the DRA's annual reports, 6,000 taxpayers (who are sometimes audited on multiple returns) were audited in 2009 -- a 20 percent increase from 2008. There were 5,000 taxpayers audited in 2007 -- more than double the number of 2006, and in 2006 more than double the revenue was collected through audits than in 2004.The amount of revenue collected through DRA audits fell last year in 2009, from $55 million to $43.5 million. That's thanks to the recession and the unwillingness or inability of businesses to pay up, said DRA Assistant Commissioner Margaret Fulton.But the annual reports also show that the amount of money DRA is seeking in its audits has increased dramatically, from $57.4 million in 2008 to $79.1 million in 2009, a 38 percent increase.Fulton said that could be because of the arbitrary up and down nature of what auditors find, but it could also be the result of increased audit activity."It's a way to raise money without raising new taxes," said David Juvet, senior vice president of the Business and Industry Association of New Hampshire.DRA Commissioner Kevin A. Clougherty puts it another way. In the past, when there weren't many audits conducted, some taxpayers abused the system and didn't pay their taxes. The Legislature asked the state to close loopholes and make sure everybody pays a fair share of taxes."We are just doing what the Legislature has asked us to do, what we are supposed to do -- bring in more revenue," Clougherty told NHBR. "Has the pendulum swung too far in that direction? That's a fair question. And we think it's good that they are asking it."What is the nature of the audits? The DRA says it can't say for sure, since its outdated computer system can't track audits by the matter involved. It can only break them down by type of tax return being audited, with the business profits tax and business enterprise tax accounting for more than half of all audits conducted, and rooms and meals tax audits accounting for about a fifth, over a four-year period.One of the sharpest increases has been in the number of interest and dividends tax audits. They have so far tripled from last fiscal year, ever since the Legislature voted to extend the interest and dividends tax to owners of limited liability companies.But tax accountants and lawyers said that the biggest issue they have seen in the last few years has been over "reasonable compensation" -- an issue that has become a hot potato in the debate over expansion of the I&D tax to LLC distributions.One of the reasons the LLC tax is so controversial is the concern that business can no longer reduce their profits, and therefore their "dividends," by classifying a distribution as compensation. That means that in addition to an 8.5 percent BPT tax, a business might have to pay a 5 percent interest and dividends tax, instead of a 0.75 percent BET tax.
'Low-hanging fruit'Businesses have already known all too well that the DRA had already been cracking down on "unreasonable compensation" on BPT returns. That, they say, is the reason there has been such an increase in audits.
Some 5,000 BPT or BET returns were audited last year, nearly 4 percent of the 131,000 returns that were filed, according to data supplied by DRA to NHBR. Compare that audit percentage to that of the Internal Revenue Service, which audits small businesses with less than $10 million at a rate of less than 1 percent.What is going on here? Is the DRA audit department "running amok," as CPA Steve Feinberg of Appletree Business Services LLC in Londonderry puts it?Feinberg was referring to another controversial audit strategy: the sudden interest in commercial real estate transactions known as 1031 exchanges. Under such exchanges, a business can avoid paying capital gains on the sale of real property if it uses the money to invest in another.Under IRS rules, such capital gains are "disregarded," even if the investor in the deal forms different LLCs for each transaction, as required by some lending institutions. But the DRA doesn?t disregard them and has been seeking to tax them retroactively over the last few years, assessing investors with bills for hundreds of thousands of dollars."This practice without announcing they are doing this is really law by audit," said George Foss, whose Littleton-based firm Edmund & Wheeler has been leading the charge for 1031 reform. "The art of taxation is plucking a chicken without making it squawk. In New Hampshire, they are fishing around looking for money. The easiest way is to grab this low-hanging fruit."Such 1031 audits affect very few investors, though those who are involved are affected a great deal. Reasonable compensation audits are much more far-reaching, especially if they spill over to the new interest and dividends tax.Reasonable compensation audits aren't new. There is some case law going back to the 1970s. The conventional wisdom is that the department's attention was drawn to the issue starting in 2004, when the DRA's audit budget was increased during the administration of Gov. Craig Benson.But Phil Blastos, the revenue commissioner at the time, disputes the conventional wisdom. Blastos, now a consultant and an ardent opponent of the extension of the interest and dividends tax to LLCs, is proud of the fact that audits increased under his watch, but, he maintains, they were mainly conducted against large companies over "big tax shelter issues" -- giant transactions that had no economic substance -- and were being counted as expenses, said Blastos.One reason that such audits may have increased so dramatically is that the number of LLCs has increased dramatically, said Steve Burke, chair of the Tax Department at the law firm of McLane, Graf, Raulerson & Middleton.The returns of LLCs -- which only came into being in New Hampshire in 1993 -- are different than corporations, including the S corporation, which mirror federal returns. In a corporation, all you have to do is move your federal tax bottom line to the state form. The reasonable compensation expense is included in that figure, even though it is invisible on the state form.However, on an LLC that expense "sits right in the middle of the page. You turn a page, and there's the number. It makes it much easier to audit," Burke said.While LLC compensation may be easier for an auditor to detect, disputing it doesn?t go down easy for the taxpayer.First, most small-businesses owners -- unless they are a lawyer who needs to note time spent for billing purposes -- don't keep track of their time, especially for management functions."People don't live their lives that way," Burke said. "They find that request just impossible."Second, many business owners find this "almost an insulting exercise. Their worth is being challenged right in front of their eyes," Burke said.Yet a taxpayer is unlikely to challenge that challenge because, unlike the IRS, appeals of DRA rulings "look like a trial" and are an expensive and intimidating process, Burke said. Therefore, cases get settled, and there is very little case law or guidance over the issue.According to the DRA, about 50 cases were appealed from fiscal years 2006 to 2009, and almost all were settled.When businesses don't respond fully for requests for documentation about reasonable compensation, the DRA proposes an assessment in a letter, and then the negotiation begins.The letter, as characterized by Manchester CPA Karl Heafield, reads, "If you agree (with the assessment), please pay. If you don't, you have to justify your compensation. In my opinion you are back on your heels before you have a chance to give them information."Bob Sanders can be reached at firstname.lastname@example.org.
This article appears in the February 26 2010 issue of New Hampshire Business Review