Settlements of tax audits are typically memorialized in closing agreements between the department of revenue and the taxpayer. Negotiating these agreements can be an important part of any settlement.
The department of revenue may have standard printed form closing agreements, and the taxpayer should determine the extent, if any, to which the standard form can and should be changed. If department representatives are reluctant to change the printed form, one possibility would be to add an appendix that elaborates on—and even contradicts—the provisions of the form.
The agreement should indicate whether it is effective with respect to similar issues in future years. Part of the settlement may be an agreement as to how certain items will be treated in future years; if so, this should be explicitly stated. On the other hand, if the intent is that the agreement will not govern the treatment of settled items in future years, this too should be explicitly stated. We have had cases in which this was not made clear, and, when the taxpayer in future years departed from the agreed treatment of certain items, the auditors said that the taxpayer was reneging on a deal. When the taxpayer pointed out that the agreement specifically said that the settlement was not to apply to future years and did not necessarily reflect the opinions of the parties as to the proper tax treatment of any item, the auditors backed down, but they were still somewhat resentful. The best approach is to pin down precisely the effect, if any, of the agreement on future years.
The department of revenue may want to provide that it can reopen the audit years if it discovers tax avoidance transactions. While the auditors are thinking about abusive tax shelters, their suggested language is often broad and can apply to routine business transactions where tax considerations have been taken into account. One government draft closing agreement that recently crossed our desks would have allowed the department to reopen the audit in the case of any “scheme, product, or transaction structured with the intent of evading or avoiding federal or state taxes.” This language could apply to the most routine business transactions where taxes were taken into account, such as a decision to sell a business in a tax-free reorganization as permitted by section 368 of the Internal Revenue Code (the Code) rather than in a taxable sale. Taxpayers should try to limit any such provisions to objectively determinable tax shelters such as “listed transactions” within the meaning of the Code or comparable state law. While the desire of state tax officials to be able to challenge abusive transactions is understandable, the typical closing agreement occurs only after an audit has gone on for some time and the taxpayer’s books have been carefully checked, so there is no reason why any significant transaction should not have come to light. The department should not be allowed to reopen an audit or address routine business transactions just because they [...]