Give Me Your Documents

by Tom Yamachika, President, Tax Foundation Hawaii

In this past year’s legislative session, there was a a lot of squabbling about a bill proposed by the Department of Taxation.  That bill would have penalized a taxpayer under audit who was requested to give documents to the auditor if the taxpayer couldn’t or didn’t produce those documents within a certain number of days after the auditor’s request.  The penalty proposed in that bill was a ban on the taxpayer using those documents in a tax appeal if they were found after the auditor’s deadline.  We expect that the bill will be reintroduced in the 2025 legislative session.

But what kind of documents are auditors after, anyway?

An auditor can ask for accounting records, for example.  The auditor could ask for a “trial balance,” which is what any business with an accounting system should be able to produce.  But not every business has an accounting system; instead, some of them have a checkbook.  If such a business gets asked to produce a trial balance and tells the auditor, truthfully, that they don’t have one, what happens then?  In theory, the auditor can reconstruct parts of a business’ trial balance from analyzing the checkbooks and bank records. That way the auditor can figure out how much money came in and went out, if all the business’ money went through the bank account. (If the taxpayer used their left pocket rather than a bank account, that presents another set of problems for which there are different audit techniques to verify.)  It seems fair enough for an auditor to ask a taxpayer for a trial balance, if one exists, or for checkbooks and bank records, if there is no trial balance.  But if the taxpayer is unwilling or unable to produce those records, for example if the audit is of activity 10 years ago and both the taxpayer and the bank have purged their records, can the auditor just make a number up (“Well, businesses of your size typically made $1 million in sales per year”) and force the taxpayer to disprove it?  If the bill passed, would the taxpayer be unable to reconstruct its own records to disprove the auditor’s number?

Another common request from auditors here in Hawaii is that the taxpayer produce a schedule reconciling income reported for General Excise Tax purposes to income reported on the taxpayer’s income tax return.  One problem with the request is that the vast majority of taxpayers have never made such a schedule and thus don’t have one that is lying around somewhere.  Actually, this kind of reconciliation is a work paper that the auditor is supposed to prepare and is trained to prepare.  Taxpayers who have never seen such a work paper before are at a disadvantage unless they are lucky enough to have an attorney or accountant who is familiar with this type of schedule.  So, let’s say the auditor asks for one and the taxpayer, having no idea how to prepare one, miserably fails.  What then?  Is the taxpayer’s schedule then used as the basis for a tax assessment?  (This has happened before.)  If the taxpayer isn’t able to comply with the auditor’s request to produce the schedule, can the auditor then make a number up and force the taxpayer to try disproving the number?  And if the bill passes, is the taxpayer then prohibited from using general excise tax records AND income tax records to disprove the auditor’s number?

As mentioned earlier, I expect the Department’s bill to resurface in the 2025 legislative session.  It’s obvious, perhaps only to me at this point, that such a bill needs to be thought through a LOT more before it can be allowed to become law.  At the very least, any penalty for non-production of requested records should depend on: (1) whether the records currently exist, (2) the burden on the taxpayer required to produce or create the items requested, and (3) whether the penalty for non-production is reasonable given the records the taxpayer does have.