Although not on the mind of most taxpayers, an audit by the City of Chicago Department of Finance (“Department”) is a risk for any taxpayer who may be operating in the City or who enters Chicago for any business purpose. With a variety of unusual taxes, such as the Chicago Amusement Tax, Personal Property Lease Transaction Tax, and Real Property Transfer Tax, compliance is no easy task and an audit can come as an unwelcome surprise.
Chicago’s Authority to Tax
The initial question taxpayers may contemplate is, does the City have the authority to impose tax? Generally yes. The Illinois Constitution grants a home rule unit, which includes a municipality with a population of more than 25,000, any power and authority to perform any function pertaining to its government and affairs, including, but not limited to, the power to tax. Ill. Const. Art. VII, § 6(a). As a result, because Chicago’s population clearly exceeds the minimum requirement to constitute a home rule unit, the City has the authority to tax. For taxes that are measured by income or earnings or that are imposed upon occupations, Chicago only has the power provided by the General Assembly, however. Ill. Const. Art. VII, § 6(e); 65 ILCS 5/8-11-6a. For example, the Illinois Municipal Code allows Chicago to impose taxes on persons engaged in the business of selling tangible personal property, other than an item titled or registered with an agency of the State’s government, persons engaged in the business of selling cigarettes at retail, on owners of motor vehicles or motor bicycles, on persons in the business of renting automobiles in the city, or on approval of the electors, each gallon of motor fuel sold at retail within the city. 65 ILCS 5/8-11-1; 65 ILCS 5/8-11-3; 65 ILCS 5/8-11-7; 65 ILCS 5/8-11-15.
Audit Selection and Process
A common concern among taxpayers is: how did they find me? Businesses can be referred for audit by another division of the Department, by a competitor, from another government agency under an information exchange agreement, or based on information in a filed return. Once selected, a business will receive an audit notice that includes the taxes subject to review, the periods under audit, and the time and location where the Department will undertake the audit. The audit notice may also include a list of the initial records or documents that the Department has requested to review as part of audit.
An audit generally initiates with an opening conference between the auditor and a representative of the taxpayer. If the taxpayer wishes to be represented at the conference by an unrelated accountant or attorney, a Chicago Power of Attorney form must be executed authorizing the auditor to disclose the details of the auditor to the representative. Following the opening conference, the auditor will determine the sampling method to be used in the audit, which may include judgmental or statistical sampling. Whereas judgmental sampling only requires the auditor to identify and review a test period and then extrapolate those results over the entire audit period, under the statistical sampling method, the auditor performs a detailed review of all periods. Accordingly, although statistical sampling is the more accurate approach, it requires more labor on behalf of the taxpayer and auditor, and is only available if the taxpayer has complete books and records for the entire audit period. If the sampling method is utilized, the taxpayer should be cognizant at the outset of the audit that an accurate and representative period is selected. As a result, whether the sampling or statistical approach is “better” for a taxpayer is largely reliant upon the accuracy of the business’s records and the sample period selected. Although the taxpayer has the option of weighing in on its preferred approach, the auditor supervisor has the ultimate authority for deciding the audit approach.
Often taxpayers will take the approach that if they stalemate or refuse to produce the requested documentation, the auditor will concede and close the audit. However, this is an imprudent strategy that may lead to several unfortunate consequences in Chicago. For example, if the taxpayer fails to make its books and records available to the Department for review, the Comptroller may issue a jeopardy tax determination and assessment, which is based on the best estimate of the person’s tax liability. This may result in a higher assessment amount than if the taxpayer had merely complied and presented its books and records. Additionally, the Comptroller has the authority to issue subpoenas duces tecum for the production of any relevant books, records, or documents. As a result, not only may failing to produce the requested books and records result in an inflated assessment, but the business may be forced to eventually produce the documentation and comply anyway.
At the close of the audit, the taxpayer and auditor will generally meet for a closing conference where the taxpayer is provided a copy of the audit file and a Report of Field Collection of Audit Determined Liabilities (“Report”). If the taxpayer accepts the auditor’s changes, the taxpayer can close the case by signing the Report, signing all returns that were due during the audit period, and by remitting the full amount of tax and interest due within twenty days of the closing conference. The advantage to complying at this stage is that all applicable penalties may be waived.
Protest to the Department of Administrative Hearings
Commonly, however, the taxpayer disagrees with the result of the audit and refuses to sign the Report. If the matter cannot be resolved at audit, the Department issues a Notice of Tax Determination and Assessment (“Assessment”), which includes the applicable penalties. The taxpayer then has 35 days from the date they receive the notice to file a formal written protest and petition for hearing. To file a protest, the taxpayer or its representative can file the Protest and Petition for Hearing Form provided at the end of the audit or available on the Department’s website. Unlike the Illinois Independent Tax Tribunal (“Tribunal”), which requires payment of $500 for Illinois matters involving tax liability of over $15,000, there is no associated fee to protest a Chicago Assessment. Further, the process is favorable for taxpayers because there is no requirement that the underlying tax be paid under protest.
Taxpayers pursuing a formal protest should be aware that the procedure differs from review by the Tribunal or Cook County Circuit Court. Specifically, proceedings at the City are governed by Chapter 2-14 of the Municipal Code of the City of Chicago, the Procedural Rules and Regulations of the Department of Administrative Hearings, and the Supplemental Rules of Procedure for Tax Cases. For example, although parties may make an objection to the constitutionality of a statute, ordinance, rule and regulation or other legislative or administrative action for the purpose of preserving the argument in the record for review by a higher court, administrative law judges do not have the authority to pass muster upon the constitutionality of a statute, ordinance, or rule and regulation. See Proced. Rules & Regs. Of Admin. Hearings, Ch. 8 Sec. 8.3; Hunt v. Daley, 286 Ill. Ap. 3d 766 (1st Dist. 1997); Yellow Cab Company v. City of Chicago, 938 F. Supp. 500 (1996). However, the Chicago administrative law judge can address the constitutionality of a statute, ordinance or rule, as applied. Also, mirroring Cook County, the Chicago administrative law officer is not bound by the technical rules of evidence. Supp. Rules of Proced. For Contested Hearings, Sec. 8. However, unlike the Cook County Department of Administrative Hearings, which does not allow for discovery, Chicago’s procedure is more akin to the Tribunal’s, because Chicago adopts and incorporates Illinois Supreme Court Rule 201(h), allowing for formal discovery. Proced. Rules & Regs. Of Admin. Hearings, Ch. 6, Sec. 6.3.
Within approximately 30 days of filing the protest, the taxpayer will generally receive a Notice of Hearing setting the initial Case Management Conference at the Department of Administrative Hearings. The Case Management Conference must occur within 60 days of the Notice of Hearing being mailed. The taxpayer may represent themselves or be represented by counsel. If represented by counsel, it is advantageous for counsel to attend the initial status conference.
The timing of matters depends upon the complexity of the factual and legal issues under review. Based on the input of the parties, the administrative review officer will set a discovery schedule. However, similar to the Tribunal, if the facts are not in contention, the parties can instead proceed on a joint stipulation of facts. After the discovery process is complete, the parties have an opportunity to settle the matter without the need for a formal hearing. Based on our experience, the Department is generally open to settlement but typically requires the taxpayer to open the discussion via a formal written offer. Because the Department often understands the risk of litigation or the strength of the case at hand, settlement can be a useful means to end a matter without the substantive expense of a hearing and appeal.
Nevertheless, if the parties cannot timely reach settlement, the administrative law officer sets a final pre-hearing conference to allow the parties to advise on the status of the case and to set a final hearing date. At the final pre-hearing conference, the parties must also identify their witnesses and exhibits to be produced at the hearing, which will be set no later than 30 days from the date of the pre-hearing conference. After the parties have concluded presenting the case, and within 30 days of the hearing, the administrative law judge is required to make a determination on the basis of the admissible evidence, testimony and arguments presented and enter a written order in the matter. Similar to decisions by the Cook County Department of Administrative Hearings, the final order can be appealed to the Circuit Court of Cook County within 35 days of receiving the final decision. Proced. Rules & Regs. Of Admin. Hearings, Ch. 11, Sec. 11.3; 735 ILCS 5/3-10, et seq.
Although a Chicago audit can be an arduous process, securing a representative or counsel familiar with the City’s unique set of taxes and procedure can reduce the taxpayer’s potential exposure, including the issuance of an Assessment of liability. Nevertheless, once an Assessment has been issued, taxpayers should act quickly to protest the liability and preserve their rights to a formal challenge. Although litigation may seem daunting for certain taxpayers, it is often worth engaging in the process to, at minimum, pursue settlement and request the abatement of penalties.