Lending a helping hand: two governments can work together.

Given the basic level of conformity between state and federal income tax bases (see earlier discussion), this information is often used to assess additional state tax directly. For example, one of the most effective information exchanges is an IRS program that matches third-party reports of income to entries on taxpayer returns. The IRS assesses additional federal tax where income has been omitted and provides information on the adjustment to the state tax authority in which the taxpayer resides. The state customarily issues an automated assessment of additional state tax, unless the income is exempted by the state. States also compare the exchanged data with state files to insure consistency in amounts reported to federal and state tax authorities and to identify potentially non-filing taxpayers. With the massive amounts of information involved, all information is exchanged on computer-readable or electronic media instead of paper. States and the IRS are now in the process of migrating the means of delivering the information from a physical transportation to secure electronic delivery.

Federal data and federal audit reports are the predominant means of independently auditing state individual income tax returns in many states. The rates of state individual income taxes (generally five to eight percent of taxable income) are such that it is not cost-effective (particularly compared to the yield on audits of state corporate income taxes and retail sales taxes) to maintain a substantial cadre of state revenue agents to conduct on-site audits of individual income tax returns.

States also use the results of federal corporate tax audits for enforcement. Since the computation of state tax generally begins with federal taxable income, states rely extensively on federal examination activities for verification of the tax base and the proper treatment of various transactions, particularly those involving international operations. State agencies devote their audit activities primarily to verifying the apportionment of income across states, examining the taxpayer's treatment of certain types of transactions, and determining the membership of the unitary group if the state employs combined reporting. The sharing of information on multistate corporations is not as seamless as many believe it should be. Current interpretations of federal law require that states must make a special request for information on a corporation that is not headquartered in the state. The information is available to the requesting state, presuming it can provide a valid tax administration reason as to why it needs the information.

States have recently gained access to data from other federal agencies to aid in tax enforcement activities. They receive regular reports from the U.S. Customs Service on imported goods, which they use to identify goods to which the retail sales and use tax may apply or to identify potential taxpayers who may not be registered.

Historically, the flow of information was largely from the federal government to the states. In recent years, however, states have begun providing more information to federal tax administrators, and the IRS has begun more systematically using the information it receives. In particular, federal administrators use state lists of registered sales taxpayers to identify potential non-fliers of federal employment and corporation taxes and to cross-check reported receipts. They also periodically use files maintained by other state agencies that license individuals engaged in various trades and professions as a source of leads (e.g., on non-fliers). Finally, state driver license files provide a good source of address information and potential assets in a seizure situation. Here again, the data are exchanged under legal agreements regarding the use and safeguarding of the data, and most information is exchanged in computer-useable form.

Two relatively nascent efforts that are primarily of benefit to the IRS are also worthy of mention because they indicate how the IRS is beginning to make more systematic use of the state data. The first is a program called the State Reverse File Match Initiative (SRFMI--pronounced Surf Me), where states will be extracting various items of return information from their individual income tax files and providing them to the IRS who will match them against the IRS Master File. The effort is two-fold: (1) Identify people who may have filed at the state level but not at the federal level; and (2) Compare certain items of income and expense that are reported on the state return to those entries on the federal return. Once institutionalized at the IRS and state levels, this can be a cost-effective match program. IRS has identified the information they want and the format they want it in. It will take some work by states to participate, but all have expressed a willingness to do so as long as they can fold implementation into their regular work plans.

The second "new" effort is the "State RAR (Revenue Agent Report) Program." Here, the states are doing what the IRS has done for some time, i.e., sending information on adjustments made during a state audit to the IRS so it can follow up with any appropriate federal adjustments. Once again, the IRS is finalizing the information it wants and the format in which it wants it. The program is being piloted and an implementation plan is being developed.

The tax shelter area is an excellent example of where exchanging information between the IRS and states can and has improved compliance at both levels. Through some extraordinary efforts at the state and federal levels, a regular, two-way flow of information between states and the IRS was developed on who was participating in shelters, the types of shelters, who was coming forward in the Voluntary Compliance Inititatives (VCIs), who the promoters were, and the like. This enabled both the IRS and the states to leverage their resources and achieve better coverage than they could have individually. Forty-eight states, the City of New York, and the District of Columbia entered into a Memorandum of Understanding (MoU) with the IRS to exchange information on shelter participants and promoters, and states and the IRS regularly exchanged information on adjustments made during tax shelter audits. According to the IRS, the Abusive Tax Avoidance Transaction (ATAT) partnership resulted in the sharing of over 28,000 leads between the states and the federal government, leading to the discovery of tens of millions of dollars in previously unknown fraudulent tax avoidance schemes. In one "infamous" case, one state was able to provide IRS with information necessary to make a $6 million assessment just hours before the federal statute of limitations would have run out because of the active program of information exchange.

About 40 states also signed MoUs among themselves to share information on tax shelter promoters and participants. States have developed a data base of information on promoters and participants in various tax shelters. The data base contains identifying information on the participants and promoters so that users of the data base can then examine their files for information on the taxpayer and the returns that have been filed. The IRS is considering participation in the data base, but there are some disclosure issues that need to be addressed.

Another initiative in the data exchange area is that states and the IRS are now exploring the possibility of establishing a "relationships data base" that would enable users to identify the ownership/ income relationships among various levels of pass-through entities. The intent would be to enable an auditor or agent to inquire against the data base and identify the various types and levels of pass-through entities in which an individual or corporation or other pass-through entity may be involved. The data base would be built using information already gathered by the IRS, maintained by the IRS, and governed by IRS disclosure and safeguard standards.

There are relatively few instances in which the states and federal government conduct joint audits of individual taxpayers. An exception is in the motor fuel excise tax area in cases where earlier investigative work by either the federal or state tax authority has revealed evidence of criminal tax evasion.

There is little in the way of cooperative efforts between state and federal agencies in the administration of excise taxes on alcoholic beverages or tobacco products, except for occasional working arrangements between individual agencies at the local level. (13) Federal law, however, does require that manufacturers of tobacco products and alcoholic beverages provide reports to state tax authorities on all products shipped to wholesalers in the state. This is a great aid in insuring that tax is paid on all products entering the distribution chain in a particular state.

There has been increasing cooperation between the federal government and states in the collection of delinquent tax obligations. Delinquent taxpayers may often owe money to both state and federal authorities. In fact, this is often a source of friction between tax authorities, with one level attempting to assert priority over the other where there are insufficient resources to satisfy both obligations. (14) However, the two sides have agreed to cooperate when the taxpayer is due a refund from one jurisdiction but has unpaid obligations to another.