Get ready for a sales/use tax audit
The target: Buyers from other states who fail to pay a use tax on purchases made online or by phone. Vendors in these states are not responsible for collecting sales taxes unless they have a physical presence in the buyer’s state, so their state sales tax will not appear on the invoice. But the buyer is still responsible for reporting the purchase and paying the use tax to his/her local tax authority. Failure to do so can add interest and penalties to taxes owed.
Biggest mistake: assuming that not reporting such purchases eliminates the problem. States now monitor large out-of-state sales and may notify the buyer’s state, which can then track down the buyer. Also: Customs transmits declaration statement data to state tax agencies, enabling them to track overseas purchases.
Best bet: Pay the use tax on inter-state purchases. Amounts are not usually large—unless failure to pay results in interest and penalties.
But your state revenue department will be going after even the most honest, tax-paying businesses for more revenue by selecting you for a state sales and use tax audit.
Here’s what you should do:
“Your company has been selected . . . .”
You will receive a phone call or letter announcing the audit and, generally, the period being audited and which books and records to have available (you may be asked for more later on). Check the period being audited against your state’s statute of limitations on how far back an audit can go.
Before your company chooses an audit date, make sure a knowledgeable accounting professional can be present to explain exactly how the returns were prepared and the source of reported amounts. Agencies prefer to have the audit at your office so they can see your operation. If an outside CPA prepared the sales tax returns under audit, arrange to have the audit at the CPA’s office at the same time that you choose the audit date. After choosing the date and place, ask for a letter verifying both. Request that you be called if anything is changed.
Why would they want that?
Most firms are shocked at the number of books, records and support documents requested in an audit. Excluding variations by tax jurisdiction, the most commonly required items are:
- The general ledger, all journals (especially the sales journal) and pertinent schedules—i.e., the books. These are used to determine total sales and how your business works.
- Prior year income tax returns—federal and/or state. The auditor compares sales reported on the income tax returns with sales reported on the sales tax returns. Your company may not want to share its income tax returns with outsiders, but these can save a lot of time verifying reported data.
- Original documents that support amounts on the books for the audit. These include:
— sales invoices and/or contracts;
— customer purchase orders;
— vendor invoices;
— purchase requisitions and/or orders; and
— any other items used to compile amounts.
If any of these records are hard to produce—e.g., lost, destroyed or stored off-site—you must tell the auditor when first contacted. Auditors usually try to work with a firm to the extent the law allows.
If other items are requested, ask why they are needed and how they relate to a particular tax problem. Most auditors willingly explain.
Although not all items will be reviewed, have them available. Purchase data are usually needed for use taxes (these discourage customers from buying out of state to avoid sales tax), which most states have. Use taxes generally apply to fixed assets and other items not physically incorporated into products resold.
Sales claimed exempt as resales
Most states require documents to support sales claimed exempt as resales, such as a resale card or exemption certificate from the customer. Find out which documents your particular state requires, and have them ready. The auditor will probably sample these documents with block tests (selected quarters, weeks, days, etc.), statistical sampling or spot tests of items throughout the audit period.
Even one missing document can multiply your firm’s liability if an auditor projects it into a percentage.
Example: SellCo has 100 exempt sales in the audit period and has documents for all but one. A random sample of 10 exempt sales picks up the one missing certificate. The auditor projects this sample to “10% of exempt sales are undocumented and therefore disallowed.”
Result: SellCo’s tax liability (plus interest and penalties) is many times higher than its actual liability.
The audit
Have the auditor met by someone who knows all aspects of the business. Ask about audit procedures, time involved, sales tax law and agency policies.
If your facility is large, start with a tour. Describe operations, accounting methods and procedures and where records are kept. Introduce key accounting and management personnel. After the tour, ask for an audit plan: What areas will be verified? Are all items included or only random samples?
Sampling procedures
If random samples will be used, ask:
- From what base are samples drawn—all sales invoices for the audit period? one quarter of the audit period? one month of the audit period?
- What is the sample size?
- How will sample items be selected?
Many post-audit disagreements are about sampling procedures, so ask why a particular method is being used. Feel free to suggest a method and why you think it is best. One firm saved time by explaining to the auditor that support for exempt sales was in its contracts rather than invoices. The auditor sampled contracts instead of wasting time on invoices and then asking for support.
Most state agencies inform you of their findings as the audit progresses. But just in case it is not your state’s policy to do this, ask to be updated, and to be alerted to any problems that arise. Many problems can be explained on the spot.
The audit findings
If your firm owes additional tax, you will usually receive copies of the auditor’s workpapers, a summary of amounts owed and an explanation of the auditor’s findings. If you do not receive workpapers, ask for them.
If you disagree with the audit findings, ask for a copy of the appropriate section of the law.
If you cannot settle the disagreement, you can often reduce an assessment substantially if you take the time. Ask how the liability might be reduced, such as obtaining exemption certificates from customers who did not provide them. Set a defined time period for action with the auditor. Unclear deadlines create problems.
Appeals
Most agencies have pamphlets that explain the appeals procedure. Follow these procedures to the letter. If a step is unclear, ask the agency for a detailed explanation.
An appeal is usually time consuming, and interest may accrue in the meantime. You can pay any or all of the liability to avoid interest, but of course your firm then loses interest it would have earned on the amount paid. Such payment is not an admission of guilt, but simply a way to avoid paying interest if the appeal is lost. If the firm pays and then wins, it applies for a refund.
