Common Errors Identified in Tax Audits

• February 2010 - Taxable Items for Illinois Income Tax

When repairs are made to real property, the taxpayer converting tangible personal property to real property is subject to use tax and must not be billing their customer tax on the invoice.  If the taxpayer collects tax from the customer on these transactions; this is deemed to be Excess Tax Collections and must be remitted to the Illinois Department of Revenue.  The taxpayer can separately bill the customer 'reimbursement of use tax' but the entry on the invoice must clearly show that it is a reimbursement for use taxes paid by the taxpayer (contractor).

A retailer of Other Tobacco Products must register with the Department and remit Other Tobacco Products Tax on the cost of the products purchased if they fail to remit this tax to their Other Tobacco Products supplier.  The Other Tobacco Products Tax must be separately listed on the invoice from the supplier.  This tax is due in addition to the Retailers' Occupation Tax due on the retail sale of the Other Tobacco Products.

Taxpayers claiming deductions either on the return or by elimination need to maintain the documentation to support the deductions and have available during the audit process.  Examples of documentation for the deductions are the following:

• Sales for Resale - Completed CRT-61 (Certificate of Resale) with valid information
• Sales to Exempt Organizations - Copy of Tax Exempt Identification Letter issued by the Illinois Department of Revenue
• Sales in Interstate Commerce - Bills of Lading, UPS or comparable business shipment log books, Delivery log books for own vehicles

If the lease is a true lease (no nominal dollar purchase option available at end of lease), the lessor is responsible for Use Tax at the time that the tangible personal property is placed into service.  The leasing company can bill the lessee for 'reimbursement of use tax paid'; however the leasing company cannot collect tax from the lessee on the rental receipts received monthly.  If the lease is a conditional sales contract (nominal dollar purchase option available at end of lease) the leasing company should treat the lease in the same manner as a retail sale.

If a retailer is accepting Manufacturer's Purchase Credits on sales qualifying for the credit the retailers needs to report the sales on Line 1 of the ST-1 and report the amount of MPC credit on Line 16a of the ST-1.  Failing to report the sales on Line 1 could result in local governments not receiving their non-state taxes because MPC is only the state portion of the taxes collected.  An earner and user of MPC must file the appropriate forms (ST-16's and ST-17's) by June 30th of the following year.

All taxpayers need to voluntarily comply with the Illinois Use Tax laws and remit use tax to the Illinois Department of Revenue when the purchaser of tangible personal property for use or consumption fails to remit Illinois Use Tax to the supplier or vendor.

We have noted instances where taxpayers have not included in their sales factor numerator receipts from the sale of tangible personal property shipped from Illinois to states that they are not taxable. Per Regulation 100.3370(c)(1)(A)(ii), such sales should be included in the sales factor numerator.

For years ending after 12/30/08, receipts generated from the sales of service are apportioned to Illinois on a market basis. As such, receipts are apportioned to Illinois if the services are received in Illinois.  Auditors are noting instances where the old cost of performance rules are being applied to apportion receipts from services.

To support why they are not subject to the add-back, and are instead subject to a net income tax in the foreign locale, taxpayers are presenting to our auditors foreign returns with the expectation that our auditors work to translate them. Per Regulation 100.9530, all books and records used to substantiate entry shown on any return covered under the Illinois Income Tax Act (Act) should be kept in English.  We will return foreign returns to the taxpayer with the expectation that they present the return version that is translated to English.

Auditors are discovering instances where the apportionment denominator includes items of income (foreign dividends, tax exempt interest, etc.) that are being subtracted during the computation of base income. Per Continental v. Lenckos, (1984) any gross receipt excluded from base income or subtracted in the computation of base income must be excluded from the apportionment numerator & denominator.

An election by a partner, beneficiary or shareholder to treat all income as business income shall cause all nonbusiness income received by that partner, beneficiary or shareholder from the pass-through entity to be treated as business income received directly by the partner, beneficiary or shareholder.

Certain interest and other income is exempt from Illinois Income Tax by virtue of Illinois or US law, Illinois or US Constitution, or US treaties. In order to take the exemption, taxpayers must claim it as a subtraction modification on their Illinois return. The amount subtracted is net of any bond premium amortization that's deducted Federally. The subtraction is allowed only to the extent that it's included in Federal income.  For a quick guide of the type of interest and other income that is exempt from Illinois taxation, please review Publication 101, which is available on our website. Regulation 100.2470 is the Department's formal authority on the subject.  If the item is not identified in Publication 101, it does not qualify for the exemption cited by Regulation 100.2470.

Illinois filers cannot deduct some interest, 'intangible expenses' (such as royalties, and losses on sales of intangible assets), or insurance premium expenses from transactions with a taxpayer who would be a member of your unitary business group except that 80 percent or more of its business is conducted outside the United States, or conducted with an affiliated company that would have been a member of the unitary group except that they use a different apportionment method (noncombination rule company).   Interest, intangible expenses, and insurance premium expenses deducted Federally in excess of taxable dividends received from 80/20 company or noncombination rule companies must be added back, unless an exception applies.  Please see the instructions to Schedule 80/20 (Related Party Transactions) and Regulation 100.2430 for further guidance. Taxpayers must have clear & complete documentation on file to support any exception claimed.

We have noted that some companies are not using the proper criteria in making 80/20 determinations. Illinois law requires companies to be excluded from a unitary group only if 80% or more of it's activities are conducted outside of the US. The US is defined as the 50 states & the District of Columbia. It does not include US territories, possessions, etc. Also, the 80/20 test must be developed based on the industry that the taxpayer is involved in. The property and payroll factors are only used for companies that apportion income via the single sales factor. Special apportioning companies must include in their 80/20 test numbers that pertain to their industry (insurance companies use premiums, transportation companies use mileage, etc.) For further guidance, please review Section 1501(a)(27) of the Illinois Income Tax Act.

For transactions occurring on or after July 30, 2004, "business income' is defined as all income that may be treated as apportionable business income under the Constitution of the United States. The Department has found that many taxpayers are still applying the former definition of business income which was based on the functional test and transactional test.  Please see Regulation 100.3010 for further guidance.

If in prior years income from an asset or business was classed as business income, and in a later year is shown to be non-business, taxpayers must add back and recapture all expenses from that asset or business that was deducted in the later year and 2 immediately preceding taxable years. This recapture should be added back as business income in the year that the asset or business was disposed of.  For further guidance, please see Regulation 100.2405(d).