Few words in the English language evoke more fear than “you have been selected for a sales tax audit by the ‘State X’ Department of Revenue.” If this is the first sales tax audit your business has experienced, your first reaction may be to panic and wonder why you were chosen. If you have previous audit experience, you may be a bit more relaxed, but the inconvenience and disruption caused by an audit may have you looking for ways to delay the audit until a better time.
Regardless of your reaction, there are important steps to take in preparing for a sales tax audit. There are also critical things for you to avoid as you deal with the auditor. We will outline a few of the significant “dos” and “don’ts” when it comes to sales tax audit preparation and audit management. Because each business is different and because each state audit is different, these suggestions need to be evaluated in light of your specific situation and the types of transactions your business conducts.
Why Do States Audit Sales Tax?
State sales tax audits are conducted for a number of different reasons. First and foremost, the states will tell you that the audit is to make sure that the state sales tax laws are being followed by the businesses being audited. In reality, the audit is a significant and effective way to increase tax collections and state revenue. Although auditors are not generally evaluated or compensated on the amount of audit collections they generate, the unspoken expectation is that they will collect enough unpaid tax to cover a multiple of their salary. Audits facilitate increased state revenue directly through the assessments of tax, interest, and penalties paid by the taxpayer at the conclusion of the audit and by the future increased tax remittances of the business once the errors have been identified and corrected.
In addition to generating immediate tax revenue, sales tax audits also provide fertile and valuable information for future audit leads. As an auditor is gathering information on untaxed purchased made by from out-of-state companies, this information is gathered and evaluated. This often leads to nexus questionnaires being sent to these out-of-state businesses who may be audited if it can be proved that they have nexus with the state and should have been collecting tax on the sales they make.
Finally, audits provide a very clear picture as to what types of transactions are occurring in the market place. States laws and regulations lag significantly from realities of the market place. As auditors see new sales transactions and new types of products and services being sold that do not neatly fit into the existing tax framework, they often give this information to the tax policy folks who can change the regulations to better define the tax treatment of the transactions.
To sum it up, states audit in order to:
- Collect revenue for the state
- Make sure businesses within the state are collecting sales tax (and in the right amounts)
- Generate future revenue for the state as businesses become compliant
- Find out-of-state businesses that may potentially have nexus in-state
- Find out what types of transactions are occurring in the marketplace in order to make new tax laws
Now that we’ve talked about why states audit, we’ll get to the nitty gritty about what to do if you find yourself with an audit notice.
Dealing with the Auditor
For companies that have not been audited for sales tax previously, there is often a misconception about the role the auditor plays. I’ve encountered several companies that thought the auditor would act more like a consultant and help them identify errors and find ways to minimize the tax they paid. Shockingly, they were not really expecting the auditor to give them a six-figure assessment for the tax errors that were identified!
To put it bluntly, the auditor is not your friend! The auditor works for the Department of Revenue. They are not a consultant and they will use any information you give them (whether it’s correct or not) to their advantage. There are exceptions, but the auditor’s goal is generally to separate your business from as much money as they can by identifying as many mistakes (in their opinion) that you have made.
Dealing with auditors is a delicate task. You must realize their job and appreciate their situation. You must also treat them with some degree of professional respect and courtesy. Your goal is to be to provide them with the information that will allow them to complete their work as quickly as possible. Having a good professional relationship with auditors can go a long way when it comes to penalty abatement and the tax treatment of unclear transactions.
Over the years I’ve had clients that took pride in the way the treated auditors. They put them in a small office where it was either too hot or too cold, they spoon fed them information and made the auditor ask multiple times for the same information, and they delayed and stalled on every issue of the audit. It was not surprising, then, that their audits always resulted in large tax assessments, full imposition of penalty, and a very poor success rate on audit appeals.
Treat the auditor as a professional. Keep it polite but remember they are not your tax advocate. They work for the state. It is not their job to provide consulting services to you or to point out areas where you have overpaid tax. Their job is to collect revenue.
Preparing for the Sales Tax Audit
In theory, your business should always be preparing for a sales tax audit. Your company should periodically review the sales tax procedures and policies it has and make sure that these policies are still valid and that they are being followed. In most cases, though, this does not happen! As such, once the notice for audit arrives, people panic and start to scramble to assemble the information requested by the auditor. This is the worst thing that can happen. If you need more time to pull the information together, then request and extension as quickly as you can. If the sales tax audit is set for the same time as your financial audit or is occurring during some other significant event, then move the audit. Nothing good will come from trying to deal with an auditor when you are distracted by other business matters.
As you review the audit request, make sure you understand what the auditor is asking for. The requests are usually generic and may not apply to your business. If that’s the case, call the auditor and develop an alternative. Also, don’t provide the auditor with items that they have not asked for. Anything you give the auditor is fair game for review. More is not always better.
I recently had a company that prepared a detailed analysis on its sales transactions that was not requested by the auditor. Their rationale for this was to make sure the auditor understood their business and accounting process. Once I saw the report, I instructed them to shred it and not to mention it to the auditor. The auditor had not asked for the report and the report only opened a “can of worms” and raised more questions than it answered. If the auditor had asked specific questions, we would have answered them, but there is no requirement that we divulge this type of information.
Also, have the information available when the auditor arrives. I’ve been in too many meetings where the auditor and the taxpayer meet for the first time, and my client says “what type of information do you want?” This is not what the auditor wants to hear and it’s not what needs to happen. Not only should you have the information assembled prior to the auditor arriving, you should also have it reviewed to make sure it’s complete. Ideally, you would have someone conduct a ‘pre-audit’ of the information to identify issues in advance of the auditor arriving. Once the information is turned over to the auditor, it’s too late to correct any errors or fill in any missing pieces of information.
During the Audit
Once the audit begins, there is a delicate balance between letting the auditor do their work and keeping tabs on the progress they are making. I always suggest and opening conference with the auditor to make sure they understand the business, the type or products and services provided, how your invoices are prepared, how your exemption certificates are filed, and the basics of your sales and use procedures. The last thing you want is for the auditor to complete their audit without a good understanding of your business. This can prevent questions and wasted time on the part of the auditor. I also recommending checking in with the auditor at the end of each day for questions they may have and to see what they are finding. Some auditors are forthcoming about what they are seeing and others like to surprise you when they have completed their fieldwork. Don’t abandon the auditor and leave them to their own devices. On the other hand, don’t hover over them and monitor their every move.
It is also important to monitor who the auditor communicates with and how they communicate. It should be made very clear to the auditor who they are to talk to and how they are to present their requests. Without some instruction, the auditor may strike up conversations with company employees who don’t really know anything about the business and then take what was learned as being truthful and complete, and make some very egregious errors in their audit based on incorrect or incomplete information.
What the Auditor Will Look At
For most sales tax audits, the auditor is looking for two things: taxable sales that were not property taxed and taxable purchases that were not taxed. The variations on this basic rule vary by business and industry. Here are a few of the common issues found in sales tax audits:
- Missing exemption certificates for untaxed sales
- Sales made to non-profit organizations that seller believed to be exempt but are not
- Not charging tax on shipping charges are required
- Not charging tax on other services as required by law
- Failure to tax bundled transactions according to state law
- Failure to pay use tax on untaxed purchases used by your business and not resold
- Payment of additional local tax when purchases are consumed in multiple local jurisdictions
- Failure to have proper documentation to support non-taxable purchases such as downloaded software and other digital products
- Failure to have receipts to support charges made on credit cards to show where purchase occurred and that tax was charged
- Improper or unclear invoices that don’t accurately portray the sales transaction
- Operating and capital leases that are not taxed properly
- Intercompany transactions that are not properly taxed or documented
- Asset sales or business disposition that are not properly taxed.
The list can be expanded based on the business involved. Restaurants have different sales tax issues than contractors and manufacturers have different issues than software companies.
Be Careful What You Sign
Audits contain a lot of forms to be signed by the taxpayer. These include statute of limitation waivers, sample agreements, receipt of documents, and agreements to proposed assessments. These are legal documents and if you don’t know what you are signing, get help from someone who does. In most cases, once the document is signed, it can’t be rescinded. Signing a sample agreement without knowing what it means or what the outcome could produce may end up costing you thousands of dollars in tax. It is not the auditor’s job to explain the implications and ramifications of these documents. It’s your responsibility to get help if you don’t understand.
Protesting the Audit
Many auditors like to view themselves as the final arbiter of audit and push taxpayers to pay the tax assessment, interest, and penalties. In reality, the auditor is just the gatherer and processor of information. If you don’t believe that they have made an accurate tax determination, there are many levels of review and appeal that taxpayers can pursue. These vary by state. Don’t be afraid to offend the auditor if you don’t like what they did. It’s not personal, it’s just business! I once had an auditor tell a client that she had never had an audit protested and that it would make her look bad if they challenged the audit. I promptly protested the audit, requested an informal hearing, and had 90% of the auditor’s work thrown out because she relied on an administrative rule that was no longer valid.
Do not rely on what the auditor tells you about your protest rights. If the state law says you have 30 days and the auditor tells you that you have 45 days, you only have 30 days. The law determines your remedy not the auditor.
Many businesses may never have the pleasure of going through a sales tax audit. Only a small fraction of companies ever get audited. But, if your business is ever selected for an audit, you need to be ready. In fact, your need to build certain processes into your sales tax function that will prepared you for an audit even if one never occurs. Once you’ve been notified, the opportunity to make changes has passed and you will be judged on your activities as portrayed by your business records.
Most auditors have an appreciation for the position they are putting you in and do what they can to reduce the stress as much as they can. In most cases, you are at an automatic disadvantage. Even the most inexperienced auditor has more experience in auditing than you do. That’s all they do and they become pretty good at it. There is not an even playing field between you and the auditor. Get help as soon as you need to. Once the audit is complete is not the time to get help. By then it’s too late.
The IRS and State will not forget about you or your sales tax debt, it will only increase the pressure to collect!
If you owe state or local taxes, dont’ worry. Every tax case is different, but EVERY case has a solution and you don’t have to face these agencies alone. We are here to help. Call our office at 855-472-8294, and we can help you figure out the most appropriate solution to your tax problem.