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New York State Tax Audits and Investigations - Civil and Criminal | Print

Preparing For and Protecting Yourself from a New York State Tax Audit
Audit Adjustments Consenting and Pitfalls
Civil Audit vs. Criminal Investigation
Civil Audit Notice - Statute of limitations
Criminal Tax Offense - Statute of Limitations
Effect of a Criminal Tax Plea on Civil Liability
Representation at the Audit
Conducting and Concluding the New York State Tax Audit
Audit Adjustments: Consenting and Pitfalls
When Negotiation is Not Enough


New York State Tax Department Audit Authority and Selection

Like the Federal System, New York relies upon self-assessment and self-reporting of income, franchise, sales, and other taxes which are imposed on the taxpayer. The system of self-assessment by its nature requires voluntary compliance, accurate calculation, and reporting of the tax due by the taxpayer. The Department of Taxation and Finance utilizes its authority to conduct the audit in order to verify that the taxpayer has properly reported his tax due. Along with the power placed in government to enforce the tax laws through audit and assessment, the system is balanced by the rights of the taxpayer to dispute the agency’s findings within the administrative system and courts.

New York State audits for a variety of different taxes including income, sales, corporate franchise, unincorporated business, and payroll. Each presents different problems and requirements. New York State tax inquiries and audits are performed by representatives of the New York State Department of Taxation and Finance, Division of Taxation. The Division of Taxation audit programs are carried out by personnel from the units responsible for the type of tax being determined. The unit conducting a sales tax audit would therefore be different from that which conducts an income tax audit. Income tax determinations made by the New York State Department of Taxation and Finance, Division of Taxation would also be used to adjust New York City income tax liability where appropriate. Criminal tax inquiries are conducted by the Office of Tax Enforcement.

Audits can be triggered in a variety of ways. Returns are often compared by the tax department's computers to statistical norms in order to determine the likelihood of error or under- reporting. Apparent anomalies on the return itself can also trigger an audit. For example, there is a very high likelihood that a significant difference in the gross sales reported by a New York business on its income tax return and the gross sales reported on its sales tax return will result in a sales tax audit. Similarly, deductions that vary significantly from the average at a given income level or type of business will also make an inquiry more likely.

There are various types of audits conducted for the different taxes. The two most common types of audits are the Desk Audit and the Field Audit. A desk audit reviews tax returns and third party information by correspondence, with the taxpayer being asked to provide information by mail or phone when necessary. Desk audits usually are reserved for the more routine and lower value type of audit issues, often focusing on specific items or issues on the return. Field audits generally involve more significant amounts and issues, and are the way most business tax audits are conducted. Field audits are initially scheduled at the taxpayer’s business location, although when a taxpayer is represented by a professional they will usually, and preferably, be conducted at the representative’s office. Either type of audit is commenced by an audit notice letter. Taxpayer’s should be aware that preparatory work is done by the auditors prior to the mailing of the audit notice. For example, prior to the mailing of a notice for a field audit of a taxpayer’s retail business the auditors will have often made an anonymous site visit to the premises, noting for example the nature and scope of operations, number of employees, number and type of cash registers or terminals and the like. At times they will even make a test purchase, expecting to see it on the records eventually produced in response to the audit notice. The audit must be conducted for a period that is not outside the statute of limitations at the time any eventual assessment can be made.

Preparing For and Protecting Yourself from a New York State Tax Audit | Back to TOP

The absolute best way to protect against any significant consequences from an audit is to maintain legally sufficient and adequate books and records. While legal issues are often present in any business audit (e.g., the taxability of particular income and transactions, or nexus for tax jurisdictional purposes), most audits typically rise or fall on the availability and quality of adequate records. The tax statutes require taxpayers to maintain adequate records. The burden of proof, other than regarding fraud, is typically on the taxpayer in any dispute as to the existence of a liability. For example, New York's sales and use tax law (§1135) states, in part: "Every person required to collect tax shall keep records of every sale or amusement charge or occupancy and of all amounts paid, charged or due thereon and of the tax payable thereon.... Such records shall include a true copy of each sales slip, invoice, receipt, statement or memorandum.... Such records shall be available for inspection and examination at any time upon demand by the tax commission or its duly authorized agent or employee and shall be preserved for a period of three years...."

When books and records are adequate, the calculation of sales or use tax due must be based upon those books and records. Original source documents are required to constitute adequate books and records. The consequences of failing to maintain adequate records can be severe, particularly under the sales and use tax laws. The New York State Department of Taxation and Finance (the "Department") may use an indirect audit methodology in a sales tax audit when the taxpayer's records are so insufficient that it is "virtually impossible to verify taxable sales receipts and conduct a complete audit." To determine the sufficiency of the taxpayer's records, the Department must thoroughly examine such records, because it is their inadequacy that justifies the use of an indirect audit methodology. In order to do so, the Department must make a clear and explicit request for books and records.

If books and records are not adequate, the Department can estimate the tax due based on "external indices." This is basically an assumption made based on other criteria, such as stock on hand, purchases, rent paid, number of employees, observations of business activity, or other factors. When external indices are applied, the Department is given enormous latitude to make a determination, with a strong presumption in favor of its calculations.

Even in the absence of adequate books and records, however, the method chosen to estimate taxes must be rational. If the Department is unable to describe the basis of its audit methodology at a hearing, the audit methodology is per se irrational. External indices must be reasonable. In order to overcome the presumption of accuracy for any external indices, the taxpayer must show "by clear and convincing evidence" that the audit method used was unreasonable. An auditor's methodology requires only a "rational basis." Nevertheless, a test period sample must be representative of general sales. Similarly, an audit may be upheld despite "deplorable" behavior by an auditor whose "competency was questionable." Recent amendments to New York's tax law have added to the severe consequences of failing to keep adequate books and records by imposing a civil penalty of up to $1,000 for the first quarter, and up to $5,000 for each additional quarter, for which a vendor fails to maintain adequate books and records. Recent changes have also added the requirement that the records be in “auditable” form, in addition to being adequate. If the records are not in auditable condition it may serve as an excuse for the tax department to use “external indices” in calculating an assessment in addition to imposing an additional penalty of up to $1,000 for each quarter for which the records are not in auditable form. Records will not be in “auditable” form when they “lack sufficient organization, such as by date, invoice number, sales receipts, or sequential numbering, or are otherwise inadequate (without reorganizing, reordering or otherwise rearranging the records into an auditable form) to permit direct reconciliation of the receipts, invoices or other source documents with the entries.” Finally, any records kept electronically must be turned over to the auditors on request, even if they have been given hard copies, and a failure to do so can result in a penalty of up to $5,000 per quarter.

Income Tax auditors are generally permitted to use indirect audit methodologies (as opposed to “external indices”) to make income tax adjustments in the absence of adequate records to determine and verify income amount, type and source. As to deductions the rule is even simpler: the taxpayer must substantiate all deductions or lose them. While some types of deductions require stricter substantiation than others, a taxpayer who does not keep adequate and reliable income and expense records is likely to suffer as a result of any deficiency. Taxpayers are not given the benefit of the doubt in the absence of records.

When only a few months remain on the statute of limitations, and the state has not completed its audit review, taxpayers will be asked to sign a consent extending the statute of limitations. A failure to execute a requested consent will often result in the issuance of a Notice of Deficiency or Determination based on available information. Such a notice, however, may not be issued without basis solely to hold the statute open.

Audit Adjustments Consenting and Pitfalls | Back to TOP

The burden of proof is on the taxpayer to prove that his return is correct, and there can be draconian consequence for a taxpayer’s failure to meet that burden. Thus, the key to avoiding difficulties in any audit of an individual or business is the maintenance and retention of adequate books and records to support the entries on the tax returns as filed.

Civil Audit vs. Criminal Investigation | Back to TOP

Whenever a taxpayer receives a notice of an audit, it is appropriate to confirm that the matter is civil rather than a criminal investigation. This is particularly important in New York State tax cases. In federal criminal investigations, IRS special agents (whose job title alone signifies that the matter is criminal) are required to give a voluntary equivalent of a Miranda warning. In marked contrast to the IRS procedures, New York State Department of Taxation and Finance agents engaged in a criminal investigation give no such warning. Tax agents if asked, however, must disclose the criminal nature of the investigation. Enforcement personnel in New York State and New York City tax investigations often have both civil and criminal enforcement roles, so their title is no indication as to the civil or criminal nature of the inquiry. It sometimes seems that the investigators intentionally give the inquiry the outward appearance of a civil matter, thereby lulling taxpayers and their representatives into making statements and disclosures. Therefore, the prudent thing to do before proceeding is to confirm that any audit is civil only. Once a taxpayer becomes aware that the matter is criminal, the taxpayer should, and most likely would, retain criminal counsel forrepres entation.

Unfortunately, government is often resistant to changes that provide greater protections to taxpayers against abuse. When Barry Leibowicz drafted legislation in 2002 to require Miranda warnings, just as IRS agents are already required to give, the bill was passed by both houses of the legislature. However, under intense lobbying from both the City and State agencies, then Governor Pataki vetoed the legislation. Barry Leibowicz continues to lobby for the warning, while recognizing that taxpayers must exercise a high degree of caution to defend against such misrepresentation by New York tax agents.

As in the case of any criminal investigation, the taxpayer should not speak to the agents or provide any records or assistance without first contacting counsel who will then make the necessary determinations as to how to proceed.

Civil Audit Notice - Statute of limitations | Back to TOP

If an audit is determined to be exclusively civil in nature, one must first determine whether the periods covered by the audit are within the statute of limitations for assessment. For a civil assessment to be valid, it must be made by a Notice of Deficiency or Determination that is mailed, within the statute of limitations, to the taxpayer's last-known address.

The ordinary statute of limitations applicable to personal income tax adjustments is three years after the later of the tax return's due date or date filed. If the return omitted gross income in an amount that exceeds 25% of the gross income reported on the return, the limitations period is extended to six years. Corporate franchise taxes are subject to similar three- and six-year limitations statutes. If an income or franchise tax return is fraudulent, there is no statute of limitations for a civil assessment. For sales and use taxes, a three-year limitations statute also begins on the later of the due date or filing date of each required return, which in turn depends upon the filing frequency (monthly, quarterly, or annually). Three years is the maximum limitations period applicable to sales and use taxes, except in the case of a failure to file or the filing of a fraudulent return, tax may be assessed at any time.

Statutes of Limitations for NY State income tax audits are similar to federal law. However, there is one major difference. When a New York State adjustment is required because of a corresponding timely federal change, the New York State statute of limitations is effectively extended, requiring a voluntary filing of an amended New York return incorporating the Federal adjustments.

None of these civil limitation periods begin to run until a return is filed. The statute is always open if the taxpayer has not—or cannot prove that he has—filed the return. Regardless of any records-retention policy for the source books and records, the return itself, with proof of filing, should be preserved forever to support a statute of limitations defense. If a taxpayer cannot prove a return has been filed, he can be audited and assessed at any time because the statute has not begun to run. Audit policy, as expressed in the state's audit manual, generally provides that an audit should not begin within 120 days of the expiration of the statute of limitations.

When a civil statute of limitations is likely to expire before an audit determination can be completed, the taxpayer will often be asked to sign a waiver of the statute of limitations prior to its expiration. Taxpayers often execute the waiver under a threat that a refusal to extend will result in an immediate issuance of a notice of deficiency or determination because no further audit examination will be possible in the time allotted. Generally, taxpayers and their counsel execute such waivers to avoid the assessment and allow time for negotiation. However, sometimes the advantage inherent in terminating any further audit review or inquiry offsets the risk and costs of dealing with an immediate assessment, and a refusal to waive is appropriate. These involve very complex and technical tactical and legal issues that are best resolved with the assistance of a professional tax advisor.

Criminal Tax Offense - Statute of Limitations | Back to TOP

If an audit is determined to be criminal in nature, one must first determine whether the periods covered by the audit are within the statute of limitations for assessment. For a criminal assessment to be valid, it must be made by a Notice of Deficiency or Determination that is mailed, within the statute of limitations, to the taxpayer's last-known address.

The statute of limitations on criminal liability begins to run from the date the offense was committed. Historically, most alleged New York State tax crimes were prosecuted under the larceny statutes with a five-year statute of limitations. The state apparently relied on the general larceny statutes because the specific defined tax crimes were relatively benign. The New York 2009-2010 budget legislation, however, revised the criminal provisions of the tax law by creating a new crime of "tax fraud acts," which applies to all types of New York taxes.

The category of felony in which a tax crime falls depends in part on the amount at issue. Thus, the offense level for a willful commission of an act of tax fraud runs from a Class A misdemeanor (tax fraud in the 5th degree) to a Class B felony for underpayments or excess refunds of more than $1 million (tax fraud in the 1st degree). It takes underpayments or excess refunds of only $3,000 to be guilty of a class E felony. In each instance, the underpayment or excess refund must have occurred as the result of intent to evade tax or to defraud the state. A similar five-year statute of limitations continues to apply for most felony tax evasions.

Effect of a Criminal Tax Plea on Civil Liability | Back to TOP

A major issue in resolving any criminal tax charge is the collateral estoppel effect of a guilty plea on corresponding civil liabilities. The "criminal numbers" typically are used in settling the criminal case and consist solely of the liabilities that the state can prove "beyond a reasonable doubt." "Collateral estoppel" is a doctrine "barring a party from relitigating an issue determined against that party in an earlier action, even if the second action differs significantly from the first one." This doctrine typically deprives the taxpayer of any defense to onerous civil fraud penalties and interest rates levied upon significantly higher civil assessments for which the taxpayer has the burden of proof. In the tax context, this means that once the taxpayer takes a criminal guilty plea and agrees to pay the tax criminal numbers, he is defenseless in a subsequent civil audit covering the same periods. Even in a criminal matter, the potential civil tax liabilities should always be considered and dealt with in a comprehensive, global manner.

These concerns are more important than ever given the escalation of civil penalties in New York's recent budget legislation. The legislation increased civil fraud penalties from 50% of the tax due to 200% of the tax due. It also added or increased penalties for submitting false or fraudulent documents or filing frivolous income tax documents, and penalties imposed on paid preparers who aid or assist in preparing fraudulent returns, reports, or other documents, or who supply false information to the authorities.

Representation at the Audit | Back to TOP

Taxpayers may deal directly with the taxing agency, or engage a representative to do so for them. Except in the very simplest audits with the very least amount at stake, it is always advisable to obtain expert advice and representation. Attorneys, Certified Public Accountants and Enrolled Agents are all authorized to represent taxpayers before the taxing authorities. Each brings a different set of skills and qualifications to the task of representing the taxpayer, with the particular skill, education and experience of the representative being the most important factor in determining the outcome. If there are any possible criminal tax repercussions from the audit, however, the only representative that one should choose is an attorney. That is because only attorneys possess the necessary Attorney-Client privilege to allow you to speak freely to them without the risk that they be compelled to testify to your confidences in a subsequent proceeding. Although recent legislation gives other types of representatives a privilege against forced disclosure in Civil tax proceedings, no such privilege attaches in Criminal tax cases to anyone accept a licensed attorney. Attorneys who specialize or concentrate in the area of taxes often have a graduate law degree in taxation known as an LLM (taxation) from an accredited Law School graduate tax program. Even if the matter is not criminal, in choosing a representative for a contested or potentially contested tax matter, it is important to understand that, at the end of the day, the tax dispute may ultimately be resolved by litigation in a judicial or administrative body. A representative who is to be effective in that environment requires litigation skills and experience before tax tribunals in addition to any substantive tax knowledge required to present the case. For tax controversies that generally requires an attorney with tax litigation experience and expertise.

Conducting and Concluding the New York State Tax Audit | Back to TOP

During the Audit be cooperative without giving away any substantive rights. It is not generally a good idea to volunteer anything. Let the auditor do his job and neither be obstructionist nor unnecessarily helpful. There is a certain rhythm to audits and they must run their course. Patience is a virtue in audit matters: attempts to speed things up are often counterproductive. If the audit is being conducted by New York State, remember that the Federal Statute of limitations continues to run during the audit. It therefore pays not to hurry if the federal statute is likely to run during the conduct of the State audit. However, dragging things out unreasonably is not only improper, but is likely to create more problems than it solves.

If there is a statute of limitations that will soon expire, the auditor will request a waiver of the statute of limitations as the price for continued discussions. This is something that should not be taken lightly. Although it is often executed by taxpayers and their representatives without much thought, the waiver surrenders a significant protection which should not be done without weighing all the facts and circumstances as well as tactical considerations. The statute is discussed in more detail at Civil Audit Notice- Statute of limitations.

Auditors prefer an “agreed” case and this is often the basis for getting the best possible result. Often items are discussed, pro and con, as they come up during the audit although all negotiation should be based on the final “bottom line” at the conclusion of the audit. The audit supervisor or group chief is often the invisible guest at negotiation sessions. An auditor cannot merely give away an issue; it is your job to present him with a rational and plausible explanation or legal theory for doing what you would like him to do.

In particular, understand that the most effective negotiating style is that known as “win-win”. There doesn’t have to be a loser in a negotiation if both sides properly state and support their positions and act reasonably. Becoming offensive or hostile is not beneficial to either side, and a mutually acceptable conclusion is often the best possible outcome.

CAVEAT: If you are not likely to reach an agreement, do nothing to improve the quality of a proposed adjustment. The second best thing to an agreed solution is one in which the agent takes a ridiculous or unsupported position that can easily be defeated on appeal. If you spend too much time instructing an uncooperative or unreasonable agent on the weaknesses in his proposed adjustment, it’s quite likely to lead to a stronger and more difficult adjustment, rather than a sudden revelation in the agent that you are right and should not be assessed. Often there are significant differences in approach required for Federal vs. State and Local audits and negotiations. It is OK to avoid unnecessary disclosure where possible, but not to perpetrate a fraud. Try not to be spontaneous. Get all questions in as formal a manner as possible and consider the possibilities.

At the conclusion of the audit, the auditor will generally invite an informal discussion either before or after issuing an auditor’s report in the form of a thirty day letter proposing adjustments. The process of negotiation will often result in an informal agreement before any formal documents are issued at the conclusion of the audit. Therefore, the issuance of the documents becomes a mere formality, reflecting the deal the parties have already reached.

Audit Adjustments: Consenting and Pitfalls | Back to TOP

At the conclusion of an audit, the auditors typically produce a statement of proposed audit changes and solicit the taxpayer to execute a consent to their findings. The amount and character of these proposals will often incorporate the results of negotiations and agreements between the taxpayer and the auditors. The matter is then resolved by the execution of the consent and payment of the tax and associated interest. Still, a taxpayer must be fully aware of the consequences of executing even an agreed-to consent if the taxpayer is to avoid simply substituting one problem for another.

In recent years, consensual sales tax adjustments that include increases in gross sales have been used by the Department as the basis for a corresponding income tax adjustment. For example, a sales tax auditor might propose to settle an audit by the assertion of an additional $25,000 of sales tax based on a finding of approximately $300,000 of unreported sales derived from "external indices," with the promise of simple interest and no penalties. The taxpayer and his representative, after considering the cost of protesting the assessment—or the even higher tax, penalties, and interest threatened by the auditors if no agreement is reached—decide that paying the $25,000 makes economic sense. They then sign the consent "to get it over with." Months later they very well may be presented with a bill for income tax on the $300,000 of "additional sales" to which they agreed. The state also will take the position that the taxpayer is "collaterally estopped" from denying the additional income, since the taxpayer has already agreed to it in the sales tax audit. Because the taxpayer's consent finally and irrevocably fixes the tax as having a rational basis, the audit method and audit computation cease being issues. Finally, to add significant insult to injury, once the state income tax is sustained upon this "additional" $300,000 of sales income, the determination becomes binding for federal income tax purposes as a matter of law. The end result is that the taxpayer, who settled simply "to get it over with," made things much more complicated and expensive for himself than if he had continued to protest the original sales tax assessments.

When Negotiation is Not Enough | Back to TOP

As is the case for Federal Tax audits, negotiation is generally the preferable approach to conclude all but the most difficult of audits. However, when a negotiated agreement cannot be reached, the procedures for protesting a deficiency are entirely different but equally full of traps for the unwary.

If you do not agree with the auditor a notice of deficiency will issue to your last known address giving you 90 (sometimes only 30) days to protest. The 90 or 30 day period is strictly enforced and if you fail to protest within 90 (sometimes only 30) days the assessment will have to be paid.

This protest period gives you two options. The first is to file a request for conciliation with the Bureau of Conciliation and Mediation services. Generally a partially filled in request for conciliation is sent to you along with the notice of deficiency. The second option is to file a petition with the Division of Tax Appeals, of the New York State Tax tribunal in Troy, New York. A blank form petition may be found here for your convenience. In each case the request or petition should be sent certified mail from the protest to firmly establish that you filed within the 90 (sometimes only 30) day protest period. Any doubt as to timeliness of filing will generally be resolved against you and result in you losing your rights to obtain conciliation or obtain pre-assessment review of your protest by the DTA.

Generally, it would be preferable to request conciliation rather than to immediately file a petition with the Division of Tax Appeals. You obtain a chance to resolve your case at BCMS with a Conciliation Conferee who serves much the same function as an appeals officer at the Internal Revenue Service Appeals Office. There is nothing to lose since a failure to reach agreement still leaves you with the right to petition the Division of Tax Appeals within 90 (sometimes only 30) days of the issuance of the Conferee’s Conciliation Order. At that point you can file your petition. Again certified mail from the post office with a postal stamped receipt within the protest period is good practice.

A detailed discussion of the procedure for protesting assessments can be found here PROTESTING A NEW YORK STATE ASSESSMENT.

It is strongly recommended that you be represented throughout this process by a person with the education and credentials appropriate to the issues presented. The further you go in the process the more difficult it is for someone without legal tax litigation training and experience to properly plead your cause. Further, as opportunities for resolving the problem are lost through lack of expertise, it becomes more and more difficult for even a professional to resolve the problem the further in the process you go unrepresented.


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