Voluntary Disclosure Agreements: Getting Right With State Taxes

Richard Cram is the Director of the Multistate Tax Commission’s National Nexus Program in Washington, D.C. The National Nexus Program provides a Multistate Voluntary Disclosure Program that 38 states and the District of Columbia participate in. Cram has recently contributed articles to Tax Analysts State Tax Notes and has presented as a co-panelist at the Georgetown Law School Advanced State and Local Tax Institute and the Paul J. Hartman SALT Forum. Prior to his current position, Cram served for 15 years as the Director of Policy & Research in the Kansas Department of Revenue, and for 2 years as an attorney in the Legal Services Bureau of the Department, in Topeka, Kansas. He has worked as a research attorney for the Kansas Supreme Court, and practiced law as an associate in law firms in Chicago, Illinois and Goodland, Kansas. Cram graduated from the University of Kansas School of Law. He currently resides in Alexandria, Virginia.

Russ: First things First. In simple terms, what are voluntary disclosure agreements (VDAs) and what do they typically cover? And importantly, what are their most common limitations?

Richard: A voluntary disclosure agreement is a contract between the taxpayer and the state tax agency, whereby the taxpayer acknowledges nexus with that state for certain tax types, represents its activities in the state and that the taxpayer has not had prior contact with the state, and agrees to perform the following within the required time period: register, file returns, and pay past due taxes (including interest) accrued during the state’s “lookback period” (which generally ranges from 3 to 5 prior tax years, depending on the state). In return, the state waives penalties and back tax liability owed prior to the state’s lookback period.

Voluntary disclosure agreements are generally limited to sales/use taxes, income/franchise taxes, employer withholding taxes, or other excise taxes that the state tax agency administers, but not property taxes. Local taxes associated with these tax types are also included, unless the local tax is locally administered. In that case, the voluntary disclosure agreement would need to be entered into with that local administering authority, which is beyond the scope the MTC Multistate Voluntary Disclosure Program.

Voluntary disclosure agreements do not protect the taxpayer against audit by the state for the time periods included in the lookback period and going forward.

If the taxpayer has past due collected but unremitted sales tax or withholding tax, voluntary disclosure agreements generally do not include waiver of penalties or lookback period relief for those amounts.

Russ: How does a company most often find out that a VDA is something they may need to explore?

When the company selling in multiple states seeks competent state and local tax professional advice, the consultant should alert the company to potential tax liability exposure, including the need to seek voluntary disclosure relief. Also, if the company is large enough to have staff dedicated to state and local tax compliance, that staff should be aware of such tax liability exposure and alert the company. Otherwise, it falls upon company leadership to stay abreast of state and local tax developments that may affect the company’s multistate tax liability exposure (such as the 2018 Wayfair decision and states’ enactment of sales/use tax economic nexus laws). The company needs to constantly maintain awareness of its current and historic physical presence and economic presence in all of the states where it is making sales or conducting other business activity.

Merger and acquisition transactions often result in either the entity being acquired seeking voluntary disclosure relief prior to the transaction, or the acquiring entity seeking voluntary disclosure relief for the acquired entity after the transaction

Richard: With the Supreme Court Wayfair decision, widespread adoption of economic nexus thresholds, and other tax changes in recent years many companies are obligated to collect and/or pay taxes in many more states than previously.

Russ: Are you finding that many companies do not have sufficient awareness of their potential liabilities?

Richard:Yes. A surprisingly large portion of small-to-medium-size remote sellers apparently still remain unaware of the Wayfair decision and states’ enactment of sales/use tax economic nexus laws.

Russ: Because of these changes in the tax landscape, are you seeing an increase in use of VDAs?

Richard: Yes. MTC Multistate Voluntary Disclosure Program applications have more than doubled since the Wayfair decision. However, we know that multiples more of businesses out there should be applying but have not yet.

Russ: Can VDAs be used for both sales tax and income and franchise taxes?

Richard: Yes. The taxpayer chooses in the application which tax types to propose including in the agreement, and one or more tax types can be included. Certainly, if the taxpayer has liability exposure for sales, income and franchise tax and has not had prior contact with the state concerning any of those tax types, they should all be included in the agreement.

Russ: If so, must the taxpayer enter into an agreement on both?

Richard: As mentioned above, the taxpayer decides in the application which tax types to propose to include in the agreement. When the taxpayer’s application is sent to the state for review, the state may determine that based on the facts represented in the application, the taxpayer has nexus for tax types in addition to the one the taxpayer chose in the application. Then the state may respond that the agreement needs to include those additional tax types before the state is willing to sign the agreement. At that point, the taxpayer can decide to enter into an agreement including those additional tax types, or withdraw the application. Keep in mind the taxpayer can apply to the MTC Multistate Voluntary Disclosure Program anonymously and is not required to disclose identity to the state until the state first signs the agreement and it is sent to the taxpayer for execution.

Russ: Given that the taxpayer will be making their presence known, are there any reasons not to include both taxes?

Richard: I cannot think of any. The taxpayer certainly wants to avoid entering into a voluntary disclosure agreement for one tax type with the state; Then after the taxpayer has already disclosed its identity to the state in that agreement, the state discovers that the taxpayer has nexus for additional tax types not included in that agreement. The taxpayer could then face back tax liability that would not be eligible for inclusion in another voluntary disclosure agreement.

Russ: Once a taxpayer concludes that they have an obligation to collect sales tax, they presumably lower their exposure if they begin to do so as soon as possible. I understand that doing so can actually disqualify a taxpayer from entering into a VDA in many states. Is this true?

Richard: Yes. One of the qualifying criteria for voluntary disclosure relief with states participating in the MTC Multistate Voluntary Disclosure Program is that the taxpayer has not had prior contact with the state concerning that tax type. If the taxpayer has registered, filed returns, and remitted sales tax prior to applying for voluntary disclosure with that state for sales tax, then such prior contact would make the taxpayer ineligible for the MTC Program. The state already has the taxpayer’s identity. The purpose of voluntary disclosure relief is to provide an incentive for an undiscovered taxpayer to come forward to a state and become tax compliant, in return for the relief provided.

We also see taxpayers who have collected but not remitted sales tax and not registered with the state prior to submitting their application for voluntary disclosure. While this will not disqualify the taxpayer from eligibility for voluntary disclosure, most states will not waive the penalties for failure to timely remit that collected sales tax. Registration for sales tax is what gives the seller the legal authority to collect that sales tax. A business that collects the tax without being registered is breaking the law.

As long as the taxpayer waits to register and start collecting sales tax until after submitting an application for voluntary disclosure to the MTC Multistate Voluntary Disclosure Program, that activity would not be considered a disqualifying prior contact with the state. The taxpayer does need to disclose in the application the intent to register with the state after submitting the application. Otherwise, registration with the state may trigger notices from the state that otherwise would not be triggered if the state’s voluntary disclosure staff is aware that the applicant is registering with the state.

Registration after submitting the application but before the state has signed the agreement would provide the state the applicant’s identity prior to the applicant knowing for certain that the state will enter into the voluntary disclosure agreement, but it does allow the applicant to commence collecting the sales tax sooner, thus reducing liability exposure for uncollected tax.

When the taxpayer waits to register with the state until after the taxpayer receives the state-signed agreement, the taxpayer has assurance that the state is granting voluntary disclosure relief, assuming the taxpayer timely follows through with executing the agreement, registering, filing returns and paying back taxes for the lookback period.

Russ: This variation among states can be a real trap for an unsophisticated taxpayer. Do you have suggestions as to how to deal with this problem?

Richard: With a few exceptions, states that participate in the MTC Multistate Voluntary Disclosure Program use the same standard agreement form. When the taxpayer submits an application to the MTC Multistate Voluntary Disclosure Program, selecting the states being applied to, MTC staff will send the taxpayer the standard agreement form for review and approval. Once the taxpayer approves that form (this does not require the taxpayer to sign anything—just approval to move forward with the process) MTC will use that standard agreement form to prepare a draft agreement for the state and send the application along with that draft agreement to the state, which will include the tax types to be included and the proposed lookback periods. If the state finds the draft agreement acceptable, the state will sign the agreement and return it to MTC staff, who will forward it on to the taxpayer, along with instructions for executing the agreement, returning it directly to the state, registering with the state, filing returns and remitting back taxes owed. The state could instead send a counterproposal back to MTC staff (which will be forwarded to the taxpayer) that might change the lookback period, request that additional tax types be included, etc. At that point, the taxpayer can decide whether to continue proceeding forward with the application or withdraw it. Since the taxpayer’s identity has not been disclosed to the state at that point, the taxpayer will be no worse off, should the taxpayer decide to withdraw.

Even though states may vary on their lookback periods or other policies concerning voluntary disclosure, the taxpayer always has the option to withdraw from the process prior to executing the voluntary disclosure agreement that the state has signed, which is the final step in the process.

Russ: What are the other most significant variations among the states? (e.g. lookback periods, taxes covered, what constitutes inability to use a VDA).

Richard: State do vary on the length of their lookback periods, and those can also vary, depending on the tax type. Income or franchise tax periods are generally measured in prior past due tax years, and sales tax lookback periods are measured in months (but roughly equivalent to the income or franchise tax lookback period). We publish on our website a spreadsheet showing the lookback periods for participating states in the Program, which is attached.

Because the state tax agencies are the entities that participate in our Program, the tax must be administered by that tax agency in order for it to be included in a voluntary disclosure program. Thus, only local income or sales taxes that are centrally administered by the state tax agency can be included in the voluntary disclosure agreement. If the local taxes are locally administered, unfortunately, that means the taxpayer must seek voluntary disclosure directly with those local tax administration entities. For example, Colorado and Louisiana have locally administered local sales taxes, so to the extent those taxes are locally administered, they could not be included in a voluntary disclosure agreement with either of those states and would need to be the subject of separate voluntary disclosure agreements with those locally administered local jurisdictions. However, both states are working toward total central administration of their local sales taxes in the future.

There may be some variation between the states on what they consider to be a prior contact that would disqualify a taxpayer for voluntary disclosure relief.

Russ: When does it make sense to use the MTC VDA process and when might it make more sense to go through individual states?

Richard: Of course, we like to think that it always makes more sense for the taxpayer to use the MTC Program for applying for voluntary disclosure to states that participate in our program, rather than applying directly to those states. But taxpayers certainly have the option of applying directly to the any of the states—even those that participate in the MTC Program. The taxpayer can apply anonymously to the MTC Program. The taxpayer needs to fill out one online application and submit it to us, rather than complete each state’s separate application form. We have a standard agreement form that most of our participating states use, rather than each state having its own agreement form. MTC staff serves as a single point of contact on behalf of the states during the voluntary disclosure process up to the point where MTC staff sends the taxpayer the state-signed agreement.

Taxpayers can also apply only to one state, using the MTC Program. The application does not necessarily need to include multiple states. When the taxpayer has nexus and back tax liability exposure in multiple states, the taxpayer can choose which of those states it wants to apply to and does not need to apply to all of them at once. The taxpayer could later submit an application to those other states not initially applied to.

Russ: This is pretty complicated stuff. And the process assumes a need for anonymity and confidentiality. Is it correct that VDAs are almost always handled by a tax professional on behalf of a company?

Richard: The majority of applicants retain a state and local tax professional to handle the voluntary disclosure application process for them, but we do see some business owners who handle those responsibilities themselves. Determining the taxes that need to be included, the state and local rates in effect at the time of the transactions, and calculating the back tax liability exposure for current and prior years, as well as completing the state’s registration, return filing and tax payment processes can be significant tasks without professional help.

As you mentioned, the taxpayer’s application is considered confidential taxpayer information, and MTC staff will provide that only to the state to which the taxpayer has applied. Other states are not made aware that the taxpayer has applied to any particular state. Also, once the taxpayer has submitted the application to the MTC Program, the taxpayer is considered to be “protected” from “discovery” by the state during the processing of the application (assuming the taxpayer is timely and actively pursuing the process). If the taxpayer is discovered by the state during the application process and the taxpayer receives an inquiry from the state concerning the tax type that the taxpayer is seeking voluntary disclosure relief for, that discovery will not affect the taxpayer’s eligibility to follow through and complete the voluntary disclosure process. If the application becomes dormant at some point, then that protection from discovery will be lost.

Russ: Once a VDA is signed and the taxpayer’s identity is disclosed to the State, do the agreements remain confidential?

Richard: Yes. The agreement itself expressly provides that the state will keep the agreement confidential except in response to an inter-government exchange of information agreement or pursuant to a statutory requirement or lawful order.

Russ: How long can a taxpayer expect the VDA process to last?

Richard: The pandemic has definitely pressured state tax agencies, leaving fewer resources for processing voluntary disclosure agreements. We are telling applicants to expect that the process could take six months. Some states are faster than others in processing applications.

Russ: About a dozen states do not use the MTC process, and giants CA and NY are among them. Why do these states not use the MTC? Are there major differences in their programs?

Richard: I wish I knew the answer to that question. If I did, we would certainly take action to try to address those reasons and get those states on board with our Program. All states, even our participating states, have their own voluntary disclosure programs to which taxpayers can directly apply, if they choose. We feel that the MTC Program makes the process more efficient for taxpayers applying to multiple states, so the taxpayer can complete one application form, instead of each state’s individual application form, and one standard agreement form can be used for each state agreement, instead of each state developing their own agreement form. Also, MTC staff functions on behalf of the states as a single point of contact during the voluntary disclosure process, up to the point when MTC staff sends to the taxpayer the state-signed agreement with instructions for completing the execution of the agreement, registration, return filing and tax payment directly with that state.

All of the states’ voluntary disclosure programs are fairly similar: a nonfiler can come forward to the state, register, file returns and pay back taxes (plus interest) to the state for that state’s lookback period, and in return, the state will waive penalties and tax liability owed for periods prior to the lookback period.

Russ: It seems an important aspect in considering the use of VDAs is risk management. Not just whether to do one or more, but what the timing should be. What are some of the considerations and strategies companies may want to consider in making these decisions?

Richard: Proper risk management begins with staying abreast of state and local tax developments that affect multistate businesses. For example, prior to the 2018 Wayfair decision, the rule for sales tax nexus was physical presence: the only state a multistate seller had to worry about registering with and collecting sales tax was the state in which it was physically located. Since that decision, all states have implemented sales tax economic nexus with specific thresholds (sales volume or in some states transaction volume per year) that create economic nexus if exceeded. Thus, within a period of a year or two, a business making retail sales in several states in significant volumes can be exposed to enough back tax liability in multiple states sufficient to threaten that business’s continued existence. First and foremost, then, is staying informed of relevant state and local tax developments.

Second, the business needs to track its multistate sales and constantly monitor sales and transaction volume, so the business can determine when it may have exceeded a particular state’s economic nexus thresholds, necessitating registration and collection of that state’s sales tax going forward. Businesses must also track where and when they may have physical presence (employees, representatives, inventory or other tangible or real property leased or owned) in a state.

Ditto the above for income tax liability exposure in multiple states as well. Some states have also enacted economic nexus thresholds for income tax. P.L. 86-272 may offer protection against a state’s income tax for sellers of tangible personal property falling within the scope of protection of that law.

If a multistate business timely monitors state and local tax developments and tracks its state tax nexus exposure in the states where it is carrying on business activities or making sales, it can register and stay in tax compliance before any significant back tax liability accrues. That would do away with any need to seek voluntary disclosure relief. Depending on its size and resources, the business can accomplish these tasks either with internal staff or by seeking outside professionals.

Even when multistate nexus and back tax liability exposure has accrued for the business, the sooner it is discovered and acted upon the better, and the easier to resolve through a process such as voluntary disclosure with the states concerned. The MTC Program stands ready to assist, should that need arise.