Tax Analysts Blog

Philadelphia’s Use of Contingent Fee Auditors

Posted on Aug 28, 2013

States’ use of third-party auditors is nothing new. While frequently used to conduct unclaimed property audits, states have also used third-party auditors for a variety of compliance enforcement tasks including determining nexus, performing audits, assessing tax, and of course, collecting tax, interest, and penalties. Third-party auditors can be compensated on a fixed-price basis or on a contingent fee basis.

The use of contingent fee auditors has been met with scorn by many in the tax community, and rightly so. With a contingent fee arrangement, the fee an auditor is paid is a percentage of the taxes, fees, or other amounts the auditor collects. The AICPA, the Tax Executives Institute (TEI), the Council on State Taxation (COST), and others have taken stands against contingent fee auditors. The reason for that is quite simple. Contingent fee arrangements encourage abuse. An article published by COST said, “Contingent-fee arrangements encourage auditors to be overly aggressive, to interpret State laws to their own advantage rather than in society’s best interest, to ‘cherry pick’ audit targets, and to ignore holder errors that would result in lower assessments.”

In a recent position paper, the AICPA raised numerous concerns about the use of contingent fee auditors, including that such arrangements create an incentive for auditors to assess the highest amount of tax, to interpret statutes and regulations more aggressively in favor of the state, and to close audits to the detriment of the taxpayer. Another consideration is that the use of third-party auditors increases the potential that confidential taxpayer information will be released to unauthorized persons.

But despite the fact that contingent fee arrangements are frowned upon by taxpayers and professional organizations, that doesn’t mean such arrangements will no longer be implemented. In fact, taxpayers doing business in the city of Philadelphia should be on the lookout for debt collection companies hired on a contingent fee basis to not only collect tax owed to the city, but also “to represent the City in the investigation, assessment and collection of taxes, interest, penalties, and fines.”

According to Michael Fleming of Peisner Johnson & Co. LLP, the debt collection companies are examining a variety of documents, including Forms 1099, and then are sending out letters suggesting potential non-compliance. The letters come with nexus questionnaires and other worksheets and request data back to 2007. Failure to provide the information requested, the letters say, “may result in a code enforcement action being filed against you in Philadelphia’s Municipal Court.” Fleming noted that a number of companies have contacted his firm in the last few months for guidance navigating this system.

Unfortunately, Philadelphia is far from alone in using contingent fee auditors. It’s almost too convenient for localities to resist. They can hire the auditors to search for unpaid taxes or fees and not have to pay the auditors until the revenue is collected. If nothing is collected, the locality isn’t out anything – except for potentially the trust of the taxpayers subjected to audit.

The most frequently cited argument against contingent fee auditors is the inherent conflict of interest in paying an auditor based on how much tax revenue he or she collects. While that is certainly an issue, a related issue is that contingent fee arrangements permit private auditors to interpret state or local statutes and regulations at times seemingly without guidance from revenue officials. In Philadelphia, Fleming says the revenue department refers taxpayers back to the collection agencies for answers to questions on underlying tax issues.

That simply should not happen. Revenue officials are responsible for providing guidance to taxpayers on tax issues. If localities (or states) abdicate that authority to private auditors, the whole system of obtaining guidance and the transparency that comes from an agency providing guidance falls apart. The private auditor has no incentive to ensure that similarly situated taxpayers are treated in a similar fashion. In fact, if disparate treatment will result in more tax revenue being collected, a contingent fee auditor has an incentive to treat similarly situated taxpayers differently.

It’s a bad system. Taxpayers deserve better.

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