New Jersey Tax Audits — What to Expect
The New Jersey Division of Taxation conducts its fair share of tax audits. Its approaches to auditing businesses and individuals are quite different.
Businesses often face a simultaneous audit of the “big three” taxes: corporation business tax (CBT), gross income tax withholding (GITW) and sales and use tax (SUT). This article will not address any of the many other taxes administered by the Division of Taxation, such as cigarette tax, inheritance tax, litter control fee and motor fuels tax, to name a few.
Typically, one auditor will conduct an audit of all three of the big three taxes (other states have separate audit functions for corporate tax versus sales and use tax). After the taxpayer — or their outside CPA representative(s) that has executed Form M-5008-R, Appointment of Taxpayer Representative — has responded to the examination letter announcing the selection of the taxpayer for audit, a pre-audit conference is usually scheduled to kick off the audit.
At the pre-audit conference, the auditor first announces which taxes and tax periods are going to be examined. For CBT, it is typically the past four tax years, for GITW the past three years and for SUT the past 16 quarters (four years) if filing, which grows to 28 quarters (seven years) if a non-filer, all coinciding with the applicable statutes of limitations. The auditor will look to complete a multipage questionnaire, gaining knowledge of the business operations while completing it. A tour of the facility often takes place. An initial Information Document Request is presented, and the auditor will seek to schedule the official start of the audit within a few weeks.
GITW usually results in few issues, especially if the taxpayer is current with its GIT remittances and filings. CBT issues can be varied. For smaller taxpayers that receive some of their revenue in cash, an auditor will often search for unreported income by totaling bank account deposits and comparing the sum to the gross revenue reported on the CBT return, as well as cross-checking the total revenue reported on the SUT returns. Support for the allocation factor, which is now single-factor receipts, might be sought if significant. And modifications from federal taxable income may be questioned, including the addback of state and local income taxes and decoupling from federal depreciation.
SUT is frequently where the auditor focuses much of their time. For use tax, a sample period, often the most recent calendar year, is chosen for review of expense invoices. In addition, all fixed-asset invoices for the audit period are looked at since fixed-asset purchases do not lend themselves to extrapolation as is the case with recurring expense items. If one can convince the auditor that an expense invoice is truly non-recurring — for example, the taxpayer’s area code changed or the taxpayer moved, requiring a large order of new business cards, envelopes, labels, stationery, etc. — if sales tax was not charged, the auditor will likely not extrapolate that item in calculating a use tax assessment. Credit card statements with no supporting invoices often are a problem as there is no proof that the vendors charged sales tax.
For sales tax in a situation where the business is required to charge sales tax, the auditor is going to need to be provided with exemption certificates where sales tax was not charged, aside from shipments out of state, which are automatically exempt from New Jersey sales tax. When the taxpayer becomes aware of being selected for audit, it is prudent to review their records pertaining to exemption certificates and to seek any missing certificates before the audit commences. Depending on the volume of sales invoices, the sample period looked at could be as small as one month or one quarter. An error rate will be calculated and extrapolated on the total sales for the audit period.
The auditor will generate a preliminary assessment that will be provided to taxpayer personnel/CPA representatives handling the audit for review and rebuttal. If a mutually agreeable settlement cannot be reached, the auditor will generate a Notice of Assessment for which a protest can be filed with the Conference and Appeals Branch within 90 days.
When it comes to auditing individuals, the Division of Taxation devotes much of its resources to desk audits. A taxpayer will routinely receive a letter requesting that they provide certain information to allow the Division to complete its review of their gross income tax return. The requested information typically includes a copy of the federal income tax return, copies of nonresident state income tax returns, copies of Schedules K-1 and documentation pertaining to the reporting of tax-exempt investment income.
Once the assigned desk auditor has reviewed the submission, it frequently leads to a tax assessment being made. Commercial tax software rarely calculates a resident credit correctly if it involves pass-through income from partnerships and/or S corporations. Since the gross income tax law does not piggyback the Internal Revenue Code and other states handle various items differently than New Jersey does (i.e., New York allows full Section 179 expense), the resident credit is often reduced on a desk audit. There are several landmark cases to be cognizant of when it comes to calculation of the resident credit, including the Beljakovic, Berliner, Bonanno and Mannino decisions.
Whereas the level of IRS audit activity has been steadily decreasing in recent years due to constant budget cuts combined with not replacing retiring auditors with any regularity, the New Jersey Division of Taxation has not shown any decline in its audit activity and, in fact, has hired additional auditors where possible. During the COVID-19 pandemic, state auditors were not visiting taxpayer locations and new audits were not being launched, one of the few things that taxpayers were likely happy about as far as the disruptions caused to everyday life.
This article appeared in the January/February 2021 issue of New Jersey CPA magazine. Read the full issue.