Businesses often inadvertently overpay their state and local tax liabilities. Because of the complex nature of state and local tax management and the lack of management resources dedicated to a business’ tax situation, businesses often turn a blind eye toward their state and local taxes, other than for required compliance functions. This article encourages those involved with financially distressed businesses to be aware of the hefty state and local tax burdens borne by these businesses to avoid overpaying such obligations.

In many instances, a business’ state and local tax burden is hidden in the components of its financial statements, within sections such as assets, liabilities, equity and other operating income and expenses. Furthermore, due to the myriad of state and local taxes, which range from unemployment compensation tax to franchise tax to various types of excise and ad valorem taxes, a business is usually unaware that these taxes, when totaled, constitute a substantial amount of its overall tax liabilities. This causes a business to overlook its true state and local tax liabilities, and consequently, to overpay them.

To exacerbate the problem, personnel who have little or no tax experience, such as accounts payable clerks, often manage matters that significantly affect a business’ state and local tax liabilities, and available exemptions are thereby frequently over-looked. These problems are inherent in even the largest corporations with sophisticated tax departments due to the heavy time commitment required for the business’s compliance functions. Therefore, it is always advisable for a thriving business, and even more so for a financially distressed business, to seek out a multi-state and local tax specialist to identify its state and local tax overpayment exposure for which a refund/credit may be garnered and future overpayment may be prevented.

Sales Taxes

A discussion at this point of all the possible tax overpayment scenarios would be too lengthy for this article, although a brief discussion of one of the major state and local taxes—sales tax—would be an appropriate example of a possible overpayment scenario and why it arises.

State Taxing Scheme: Forty-six states (excluding Alaska, Montana, New Hampshire and Oregon), the District of Columbia and many local jurisdictions around the country impose some form of sales or gross receipts tax upon the purchase or sale of tangible personal property. These state and local sales taxes, when totalled, could amount to a heavy tax burden to any business. For example, Rhode Island imposes a hefty 7 percent state sales tax, while local taxes may accumulate as high as the 4.5 percent that New York City imposes upon the gross receipts derived from the sales of property within its borders.

State Exemptions: Along with this complex multi-jurisdictional taxing scheme are equally complex jurisdiction-specific exemptions that purchasers may take advantage of. To needlessly advance the complexity of the sales taxing scheme, every jurisdiction has its own specific list of exemptions that do not necessarily mirror the exemptions allowed by the neighboring state. Therefore, an exemption for the purchase of certain equipment may be available in California but may not be available in neighboring New Mexico.

Internal Inefficiency: Ideally, every business should have a full-time, multi-state sales tax expert on staff to review the sales tax laws of every state and locality in which it does business. However, the fact is that very few businesses even consider the possibility because most do not realize that there is a problem. Even internal or external accounting services generally fulfill only the required compliance function of the business and do not investigate whether sales tax is legally owed. Rather, in most businesses the common practice is payment of a bill is authorized by an accounts payable clerk who has little or no sales tax experience, and no further inquiries are made into the proper imposition of the sales tax. This lack of a proper internal and external control system for sales tax payments is one of the reasons for a business’s inability to identify often substantial overpayments of sales taxes.

This situation is even more likely in a financially distressed business, which typically has been mismanaged. The main concerns of the owners or managers are whether and when the bills are getting paid. Generally, they are not concerned with the tax experience of the clerk paying the bills or whether the tax is calculated properly. Therefore, it is clear that those who most desperately need not to overpay their tax are usually the ones that do.

Timing: For many businesses, sales tax returns are filed on a monthly basis. The various statutes of limitations for filing sales tax refund claims typically begin on the filing due date or the date the return is actually filed. As a result, the time limitations for filing sales tax refund claims generally expire on a monthly basis. Thus, if an overpayment has been made, the estate or business will forego potential sales tax refunds and thereby lose cash funds for each month that passes before the refund claims are filed. For this reason, any sales tax refund claims should be filed as expeditiously as possible.

State and Local Government Audit

Tax Fallacy: There is a tax world fallacy to which most business managers and CFOs subscribe: "If I have survived a government audit, then my tax position is solid now." The only truth in this statement is that from the government’s point of view, your tax position is solid for those years which were under audit because they did not find any underpayment for which you were not assessed. However, the extent of the fallacy is quite evident when you ask yourself, "Was the government auditor looking for overpayment of tax?"

Audit Focus: The focus of a government audit is to find underpayments of tax and then hit the business with a deficiency assessment, with interest and penalties tacked on. During these audits, managers and business owners will lose sleep over worrying about whether the business has paid its proper share of tax. However, have any of these managers even considered the possibility that they have overpaid their proper share of tax? Have they given thought to the fact that they, like many other businesses, have overpaid their state and local tax liabilities, and the government entity that has sought or is seeking money from them actually owes them a refund of taxes plus interest? One thing is for certain: The government auditor is not approaching an audit with the purpose of finding the taxpayer refund opportunities!

Possible Solution

A detailed analysis of a business’ state and local tax exposure is highly suggested for any financially distressed business. Such an analysis could, in many cir-cumstances, locate refund opportunities to provide greater funds for liquidating payments to creditors in a chapter 7 case. The same type of analysis also could prove extremely valuable to a reorganizing business and its creditors by producing an influx of cash from refund opportunities that were uncovered during the analysis. This would improve the business’s chance at a successful reorganization through a reduction of its tax burden, increased cash flows, an improved financial position and enhanced shareholder/owner value. At the same time, this service should not needlessly drain the bankruptcy estate with professional fees but should be provided on a contingency basis. If properly performed, this service could further the goal of the Bankruptcy Code in providing a true financial "fresh start" for a business being drained by overpayment of state and local taxes.