Cash-Short Cities Culling Data to Enforce Obscure Tax Rules

Los Angeles officials scoured 324,000 electronic files in the process of hunting down Don Mann, an admitted business-tax violator.

But in his case, at least, their prize looks pretty paltry: If Mann’s accountant is correct, all that searching will lead the Van Nuys resident to cough up about $100 in delinquent business license taxes.

Mann, a freelance movie consultant, concedes that he didn’t pay the tax. He didn’t know about it, he says. City officials acknowledge that’s likely, given the obscure nature of the levy.

Yet in this age of stressed state and local budgets -- with declining revenues and mounting expenses -- every little bit counts. And stories like Mann’s are bound to become far more common.

Cities, counties and states across the country increasingly are turning to a practice known as data mining to squeeze more money out of taxpayers, often through the collection of little-known levies such as business taxes and so-called use taxes.

“It amounts to combing through files that can tell you something about taxpayers, or people who should be taxpayers, and matching those results to your files,” explained Harley Duncan, executive director of the Federation of Tax Administrators in Washington.

For taxpayers such as Mann, that sometimes results in unpleasant surprises.

“It’s outrageous,” Mann said. “I’ve never heard of this tax, and I’m getting billed for the past three years.”

Mann’s saga is a classic example of data mining in action. Los Angeles’ business license tax isn’t new, and the city has long believed that all businesses, including small firms and sole proprietors, should pay it. But few freelancers and home-based workers have complied -- in some cases because they didn’t think of themselves as subject to corporate taxation -- and the city had no way of knowing who was not paying.

That changed in 2001, when a state law was passed allowing the Franchise Tax Board to share information gleaned from Californians’ income tax returns with cities and counties. That gave city finance departments a way to check on taxpayer compliance, and Los Angeles asked for files on anyone living in the city who reported income from self-employment or owning a business.

The city received 324,695 files. About half of those taxpayers were dismissed as duplicates and bigger businesses that already paid tax under a corporate name.

The rest -- about 151,000 Angelenos -- were sole proprietors, self-employed individuals or people who worked at home or had some outside freelance income. Late last year, Los Angeles sent notices demanding three years’ worth of tax payments on their gross revenues and threatened penalties of up to 40% if the taxes weren’t paid.

Officials say they weren’t surprised when confused and sometimes furious taxpayers flooded city phone lines.

“We have never done an enforcement program with sole proprietors and home-based businesses before,” said Antoinette Christovale, the city’s director of finance. “Those people are going to be shocked to find they are subject to the tax.”

More than 80 other California municipalities -- from big cities such as Anaheim, Sacramento and San Francisco to smaller towns including Tulare, Clearlake and Larkspur -- requested similar information last year, according to the tax board. In all, state tax officials sent out 759,159 files on taxpayers with business income.

Mining computer files to trap recalcitrant or oblivious taxpayers isn’t confined to business taxes or the Golden State. A far bigger area of increased national scrutiny is the use tax, which essentially is a sales tax that kicks in on purchases for which no sales tax was imposed.

For instance, if you bought a $10,000 piano from a retailer in Oregon, where there is no sales tax, and had it shipped to Los Angeles, where there is an 8.25% sales tax, you avoided paying $825 in taxes at the point of purchase. But the obligation to pay the tax never went away -- it simply shifted from the retailer to the consumer.

The consumer using that new piano in Los Angeles owes a use tax equal to what would have been paid in Los Angeles as sales tax. Technically, this piano buyer must file a form with the state Board of Equalization and send a check for using his piano at home.

Use taxes are not new, said John Logan, a state tax expert at CCH Inc., a tax publishing house in Riverwoods, Ill. About 45 states impose use taxes, but few of the consumers liable to pay them are aware of the levy’s existence. California’s use tax law has been on the books since 1935.

“The biggest problem is that the average person doesn’t fully understand how the use tax applies,” said Vic Anderson, supervisor in the state Board of Equalization’s sales and use tax division. “There is even some misunderstanding with the businesses that register with us. Use tax continues to be our No. 1 area of noncompliance.”

Translation: People don’t pay it, usually because they don’t know about it.

But thanks to data mining, that’s slowly changing. California is addressing the noncompliance problem in three ways, Anderson said.

The first is the low-tech option. In an attempt to heighten awareness and encourage voluntary compliance, the state has started putting use tax forms and instructions in income tax booklets that are sent to the public. Seventeen other states have added a line to their income tax forms for much the same reason, Logan said.

Other efforts boil down to more data mining. California has been getting electronic tapes from the Customs Service, which are then employed to find information about California residents who declared overseas purchases when they returned to the U.S.

In addition, the state participates in a “border states caucus” that involves reciprocal tattling about major purchases. If Oregon tax officials notice a lot of out-of-state customers when they audit the piano dealer, for example, they’re likely to tip off officials in the buyers’ states.

That process is still a bit hit-and-miss, experts say. Not all companies are audited and not all information-sharing agreements are effective. Still, the chance of getting caught is slowly rising.

Once tipped off, California officials would call the piano owner to determine whether a use tax is owed. It isn’t always, Anderson points out. If a consumer bought a piano for use in an Oregon vacation home, for example, California couldn’t reach up and tax that sale. But if the piano is used in California, it’s taxed in California, no matter where it was sold.

Cross-border information sharing arrangements extend well beyond California, of course. All across the country, officials are “taking a closer look at purchases of big-ticket items brought into their states,” said Duncan of the Federation of Tax Administrators.

It was just such a pact that tripped up former Tyco Chairman L. Dennis Kozlowski.

Although New Hampshire doesn’t have a sales or use tax, it has an information-sharing agreement with New York, which does. After Kozlowski bought millions of dollars of artwork and shipped it from New Hampshire to New York, Kozlowski got hit with charges of evading more than $1 million in New York taxes.

Not every case is pursued with such vigor. When cross-border transactions involve relatively small amounts -- as they often do when consumers buy books, records or clothing over the Internet -- state officials haven’t bothered to badger residents into compliance, Logan said, adding that it’s simply too time consuming and costly to chase what’s owed.

“In the big picture, it’s a lot of money, but on the individual consumer basis, it’s nickels and dimes,” Logan said. “With smaller transactions, the only way the states can effectively get this revenue is to get the seller to collect it.”

States want sellers to collect taxes, even on Internet sales, but retailers aren’t always cooperative. And the U.S. Supreme Court has been on the retailers’ side. A 1992 decision from the high court said that states couldn’t force national retailers to collect sales taxes until the states came up with a consistent set of tax rules.

Until recently, Logan said, states were reluctant to meet the standard imposed by the court. But the growth of Internet commerce has provided a huge incentive for them to do so. Now, more than 30 states have joined a consortium to create consistent rules for sales taxes. If their coalition succeeds in getting a preponderance of state legislatures to go along, Logan said, it will be the first step to imposing taxes in cyberspace.

For its part, California loses about $147 million annually in sales taxes to online purchases, officials say.

Still, implementation of Internet taxes probably is a long way off. At best, Logan estimates, the consortium might be able to swing something by 2005. In the interim, cities and states are stuck with mining their taxpayers to shake loose whatever revenue they can.

“Data mining isn’t enough, in and of itself, to bring states through this particular crisis,” Duncan said. “But if you’re in Iowa and you’re looking for $25 million to augment a program, and you can pick it up by better mining your tax base, that’s significant.”

Or, as Whittier accountant Thomas Theisen put it: “If you are in a situation where you have a shortfall in revenue like the city of Los Angeles does, you have to shake the trees.”