• State tax authorities are escalating audits of intercompany transactions, as transfer pricing crackdowns in several states are generating millions in tax revenue. 
• These state initiatives indicate growing regulatory emphasis on transfer pricing, which may encourage more aggressive audits (especially if budgets tighten). 
• Companies operating across state borders should take proactive steps, like conducting transfer pricing studies to validate policies and strengthen defenses before audits strike.

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A recent Bloomberg article affirms state tax authorities are ramping up audits of intercompany transactions at multistate corporations. The report points to an increase in audits in three “separate-reporting” states following transfer pricing settlement initiatives as a beacon of audit activity to come across other states that take this approach. 

While not ideal for multistate operators, this development may not come as a surprise to companies with international operations who have dealt with a myriad of cross-border tax issues in recent years. Close observers of state and local tax (SALT) developments have been predicting for many years the potential that states will be adopting similar positions with respect to transfer pricing. In a 2022 article focused on SALT transfer pricing enforcement, we highlighted several key indicators that more state transfer pricing audits could be on the horizon – including state budget deficits, a surge in auditor and consultant hirings, and renewed interest among states in collaborating on multistate audits. 

With confirmation that state-driven transfer pricing audits are on the rise, it is imperative for corporations operating across state borders to assess your transfer pricing risks and fortify your documentation and audit defense strategies. 

Surge of Transfer Pricing Audits in Separate-Reporting States 

According to the Bloomberg Tax report, the recent spike in transfer pricing audit activity has predominantly affected Southeastern states categorized as separate-reporting states. Currently, there are 17 separate-reporting states in the United States. With the exception of a handful of states like Indiana, Pennsylvania, Iowa, and Delaware, most separate-reporting states are located in the Southeast region. 

How separate-reporting states differ from other states in their taxation approach to corporations: 

• In separate-reporting states, each corporation within an affiliated group is required to file its individual tax return. This treatment considers them as separate entities with independent income, recognizing intercompany transactions, and allowing for varying tax liabilities.  
• In contrast, combined-reporting states require or allow affiliated corporations within a corporate group to file a single tax return, treating them as a unitary business with shared income, often eliminating intercompany transactions. 

Notably, two Southeastern states, Louisiana and North Carolina, have recently concluded audit resolution programs that significantly boosted their state revenues. Louisiana’s program generated nearly $38 million, while North Carolina’s efforts resulted in more than $124 million. Meanwhile, New Jersey, a Mid-Atlantic state that abandoned separate reporting in favor of combined reporting in 2019, is in the midst of a transfer pricing resolution program that has already collected almost $30 million. The success of these programs in collecting tax revenue is likely to motivate other states to explore similar initiatives. 

The success and subsequent expansion of these programs signify a growing emphasis on transfer pricing at the state tax authority level. State tax agencies are enhancing their knowledge and enforcement activities in this domain, giving auditors more confidence to adjust returns in transfer pricing disputes. This increasing competency may be viewed as a valuable tool by states – both those requiring separate and combined reporting – that are seeking ways to augment revenue streams. 

Strengthen Your Transfer Pricing Defenses Before State Audits Strike 

To preemptively safeguard your business from a state transfer pricing audit, a proactive approach to validating pricing policies is essential – and a comprehensive transfer pricing study is your primary defense. 

Here are three key advantages of conducting a transfer pricing study: 

1. Document Your Transfer Pricing Policy: A transfer pricing study provides robust documentation that can counter inflated tax assessments by identifying key intercompany transactions, referencing benchmark data, and highlighting any deviations that necessitate policy adjustments. Even if your company has undertaken prior studies, annual updates are indispensable to align with evolving business landscapes and provide tax penalty protection. 

2. Mitigate Your Risk: Beyond reducing audit risks and potential liabilities, these studies also play a pivotal role in supporting major corporate events like mergers and acquisitions (M&A). By demonstrating pricing compliance, they ensure that domestic affiliates have robust documentation and effective cost allocation analysis, thus preventing over-taxation or under-taxation. 

3. Ensure Consistency: Minimize uncertainty by achieving uniform entity-specific compensation across state agencies and affiliated entities. Swift collaboration with advisors when audits arise enhances dispute resolution capabilities. 

As states continue to gain confidence in challenging transfer pricing, multistate corporations must take proactive measures to ensure the resilience of their intercompany transactions under intensified scrutiny. 

Get Ahead of the Game with a Transfer Pricing Study  

If your company engages in substantial intercompany transactions across state lines, initiating a review of your current pricing policies, preparing your transfer pricing policies, and ensuring compliance with U.S. transfer pricing rules should be a top priority. Proactive measures can help you stay ahead of potential issues before state auditors come knocking. We have a robust transfer pricing team that works closely with our State and Local (SALT) Tax and Tax Controversy practices. Through a combined effort we can support you through every stage of managing a transfer pricing audit. Talk to our transfer pricing professionals today to find out how we can help you minimize your exposure to transfer pricing audits.  

• The Internal Revenue Service (IRS) instituted a moratorium on the processing of new Employee Retention Tax Credit (ERTC) claims due to an influx of fraudulent and exaggerated claims — primarily stemming from unscrupulous ERTC mills. 
• As of July 31, 2023, the IRS Criminal Investigation division had initiated 252 investigations involving more than $2.8 billion in potentially fraudulent ERTC claims. Fifteen investigations have resulted in federal charges, with six of those resulting in convictions with an average sentence of 21 months. 
• Taxpayers who are not certain of their eligibility should consult with a trusted tax professional for a second review and may want to avail themselves of the IRS’s new settlement and/or withdrawal programs.

The IRS recently took a drastic step to impede a wave of ineligible ERTC claims by halting the processing of new refund requests through at least December 31, 2023.  

Ineligible ERTC claims have plagued the IRS since Congress enacted the credit in 2020. In fact, the IRS opened its 2023 “Dirty Dozen” list with warnings about common ERTC scams that taxpayers should be wary of. This prominently placed notice — as well as subsequent announcements from the IRS — alerted taxpayers to unscrupulous actors who have been advising employers to claim credits in excess of what they could legitimately qualify for while charging those employers hefty upfront fees or fees contingent on ERTC refunds.  

In the wake of a flurry of IRS investigations that identified more than $2.8 billion potentially fraudulent claims, the halt on processing ERTC claims will allow the IRS to further focus their efforts on investigating and ultimately prosecuting fraudulent claims. In the following we’ll detail the impact of the IRS moratorium and provide guidance if you suspect you’ve been exposed to inaccurate or fraudulent ERTC claims.  

Background on the ERTC

First established in 2020 by the Coronavirus Aid, Relief, and Economic Security (CARES) Act, the employee retention tax credit was critical — along with Paycheck Protection Program (PPP) — in giving businesses that struggled to navigate the pandemic’s challenges much needed resources to pay employees while the businesses were shut down or facing declining sales.  

For most taxpayers, the ERTC was claimed on quarterly payroll tax returns encompassing the period March 13, 2020, through September 30, 2021 (i.e., first quarter of 2020 through the third quarter of 2021). For a small subset of businesses classified as “recovery startup businesses” (as defined below), the ERTC could also be claimed for the fourth quarter of 2021.  

Despite the halt in processing by the IRS, eligible taxpayers are still able to claim the credit by filing amended quarterly payroll tax returns. Amended payroll tax returns for 2020 quarters are able to be processed by the IRS as long as they are filed on or before April 15, 2024, while amended payroll tax returns for 2021 quarters are able to be processed as long as they are filed on or before April 15, 2025. 

The credit is calculated based on the “qualified wages” of employees. The maximum amount of payroll tax credit that an employer can claim per employee is $26,000. 

Qualification Tests 

To be eligible for the ERTC, businesses must generally satisfy one of the following criteria for each of the quarters for which they are claiming the credit: 

• Government Mandate Test — They experienced a full or partial suspension of operations that resulted from government orders that limited commerce, travel, or meetings. 
• Decline in Gross Receipts Test — They experienced a significant decline in gross receipts resulting in more than a 50% decline during each claimed 2020 quarter or more than a 20% decline during each claimed 2021 quarter. 
• Recovery Startup Business — They qualified as a “recovery startup business” — a business that began operations after February 15, 2020, and whose average annual gross receipts were $1 million or less. (Note that this last qualification only applies for the third and fourth quarters of 2021.) 

The IRS Processing Moratorium 

On September 14, 2023, the IRS announced that it would halt the processing of new ERTC claims through at least December 31, 2023. The IRS also stated that it plans to subject its queue of more than 600,000 existing ERTC claims to stricter compliance reviews, increasing the standard processing goal for those claims from 90 days to 180 days — with a potential for a much longer processing time for claims that require further review or audit. 

This processing moratorium comes on the heels of a significant influx of claims – many of which the IRS believes are ineligible. The IRS stated that it has received more than 3.6 million ERTC claims over the life of the ERTC program, with about 15% of those claims being received in the 90-day period preceding the processing freeze. This amounts to roughly 50,000 claims still being received a week. To put this in perspective: the IRS has paid out about triple the amount that Congress had originally estimated for the program. 

Additionally, as of July 31, 2023, the IRS Criminal Investigation division had initiated 252 investigations involving more than $2.8 billion in potentially fraudulent ERTC claims. Fifteen of the 252 investigations had resulted in federal charges, with six of those resulting in convictions. Four of the six convictions had reached the sentencing phase with an average sentence being 21 months. 

The IRS intends on utilizing the moratorium to add more safeguards to the processing of ERTC claims, to protect businesses by decreasing the momentum of the pop-up ERTC mill industry, and to provide several solutions for taxpayers who submitted invalid claims. Those solutions include: 

• A claim withdrawal program will be rolled out in Fall 2023 allowing businesses to withdraw ERTC claims that have not been processed or paid, even if those claims are under audit or awaiting audit. 
• A claim settlement program rolling out in Fall 2023 that will allow businesses to repay ERTC claims, while also avoiding penalties and future compliance actions. (Note that fraudulent claims may still be subject to criminal referral.) 

How to respond to IRS scrutiny of ERTC claims 

Given the expected extra scrutiny that businesses can expect to face on their claims, businesses should review ERTC claims that they have made and/or intend to make where there are any doubts regarding the eligibility of those claims: 

• If you have already submitted the ERTC claim and received a refund: If you have any doubts regarding your eligibility, we recommend reaching out to a trusted tax professional to obtain a fresh, objective assessment of your qualifications for the credit. If you determine that you were ineligible, you can participate in the IRS’s settlement program so that you can repay the claim, avoiding both penalties and audit-related fees. 

• If you have already submitted the ERTC claim, but the claim has not been processed or paid: The claim will take longer to process than during the summer — increasing from a three-month turnaround time to a likely six-month turnaround time. If you have any doubts regarding the claim during this period, we recommend reaching out to a trusted tax professional to have a second review of the claim. If you determine that you were ineligible, you can withdraw the claim under the IRS’s withdrawal program without penalties, even if an audit has commenced. 
• If you have not yet submitted the ERTC claim: Any claim submitted between September 14 and the date that the IRS lifts the moratorium – currently after December 31, 2023 – will not be processed. This should provide an opportunity for you to re-evaluate whether the claim has merits and to bolster the claim if needed. We recommend working with a trusted tax professional to have the best possible substantiation for your claim so that it is more likely that the claim will be sustained if challenged by the IRS. 

How MGO can help 

MGO’s ERTC Second Look program is geared towards the types of objective, trustworthy reviews that would benefit you during this time of heightened ERTC claim scrutiny. Our experienced Credits & Incentives team can identify audit red flags, areas that need more substantiation, miscalculations, and incomplete filings. In addition, our Tax Controversy team — in tandem with our Credits & Incentives team — can defend you if any of your ERTC claims are challenged by the IRS, with the ability to represent you during audit, appeals, and tax court. Contact us to learn more. 

• The Inflation Reduction Act of 2022 includes $80B in funding for the Internal Revenue Service.
• Over half of the funding will be set aside for IRS enforcement so the agency can hire more staff to conduct more audits, hoping to target those who do not pay their taxes.
• This will most likely subject those taxpayers with complex filings to additional scrutiny.

The Inflation Reduction Act of 2022 was recently signed into law with an eye-opening provision: the inclusion of nearly $80 billion in additional funding for the Internal Revenue Service (IRS). $45.6 billion of that is earmarked for IRS enforcement, which will be used to help the underfunded agency hire additional staff and conduct future audits in the hopes of collecting unpaid taxes.

Many publications cite the IRS plans to hire up to 87,000 new employees, though the actual number will be released in the coming months. These new hires will fill positions ranging from auditors to customer service representatives to IT specialists. The IRS has been plagued by more than a decade of budget cuts, which has limited its ability to modernize its old technology and staff appropriately. Since 2010, the agency’s enforcement staff has declined by 30%. The funding appropriate in the Inflation Reduction Act hopes to reverse this trend and bring in an estimated $203 billion in increased revenue.

The MGO Tax Controversy team breaks down what you need to know about this big change that could increase your risk of an audit.

How will the increase in IRS staff affect taxpayers?

Critics of the increase in IRS funding have claimed that the new resources will be used to target low to middle-income Americans and small businesses, burdening them with more audits and examinations. The Treasury Department refutes these claims reiterating they plan to focus primarily on large corporations and the wealthy — those more likely to evade paying their taxes — to close the tax gap, or the difference between what taxpayers pay in taxes and what they actually owe – an estimated to be $600 billion per year.

The IRS hopes the investment in funding will bring in around $203.7 billion in revenue because between 2015 and 2019, IRS audits declined significantly — 75% for Americans making $1 million or more and 33% for filers with low to moderate incomes. Lower-income Americans are mostly wage earners, so their audits are less complex and can be automated. However, more complex filers, notably large corporations and high-net-worth individuals and families – require the hands-on engagement of IRS agents and are most likely to experience increased levels of scrutiny from the new hires.

Ultimately, the average taxpayer should have an improved tax filing experience. New staff will be on hand to answer questions by phone, technology systems will be improved and modernized, and the backlog of unprocessed returns should diminish.

What is the timeline for implementing these changes?

While there is no set timeline, it is likely the way IRS audits work will change with the increase in funding. Currently, software is used to rank each tax return with a numeric score, and higher scores trigger an audit. Other mechanisms the IRS uses to determine candidates for audits include enforcement initiatives referred to as “campaigns” based on various criteria. The new funding will take time to phase in, and so will the hiring and training of new workers. It is expected new auditors will complete a six-month training program, starting small with cases involving a few hundred thousand dollars instead of tens of millions. Forbes performed some creative math to conclude while the funding will increase IRS audits, it is not likely to occur for the next few years.

How can I avoid future audits?

The best way to avoid an audit remains simple: pay your taxes on time and in compliance with tax laws. Simple accounting and documentation best practices are your best friend. If you feel you are at risk for a potential audit, you’ll want to get a head start now by ensuring your records are accurate and have been updated and maintained. Save your receipts and include every detail you can in your bookkeeping logs. If you do get audited in the coming wave, you’ll be glad you have all of this information organized and on-hand.

Our perspective on the increase in IRS staffing

The IRS has long been criticized because of their inability to provide taxpayers with the level and quality of service they deserve. The increase in funding as part of the Inflation Reduction Act should help. On the other hand, the number of tax audits is likely to increase, and you will want to be ready.

MGO’s dedicated Tax Controversy team can help by providing a holistic look at your tax filings as well as provide guidance for conflict resolution. From prevention to resolution, we guide you every step of the way.

If you’re an operator or investor in the cannabis industry, our Tax Practice recently published the Cannabis IRS Audit Survival Guide, which details everything you need to do to prepare for and navigate a tax audit. You can download the Guide for free here.

About the author

T. Renee Parker is a tax partner and the National Tax Controversy Practice Leader at MGO. With more than 15 years of tax controversy experience, she is a member of the IRS Tax Advocacy Panel and is well-versed in all areas of tax controversy. These include but are not limited to U.S. federal, state, and local tax audits; sales and use/payroll tax audits; international tax compliance related audits; negotiation and settlements with tax authorities; and corresponding and negotiation with tax authorities. Contact Renee at RParker@MGOCPA.com.