BENEFIT OF AUDIT MANAGEMENT

Almost every state in the U.S. has some form of a balanced budget requirement compelling state legislatures to balance projected revenue with expenditures. This leaves state budgets subject to the fluctuations of economic volatility and can leave state legislatures scrambling to raise revenue during periods of economic decline. Changes to income and property tax can take a year or more to raise new revenue, whereas sales tax changes can raise new revenue shortly after they are enacted. As a result, legislators often rely upon sales and use tax changes to close budget gaps due to the immediate effect they can have, creating a compliance challenge for businesses that collect and pay sales taxes. State revenue agencies use audits to enforce tax compliance, regularly auditing large taxpayers and increasing frequency of audits on all businesses, causing companies to devote time and resources to manage these audits and look out for the company’s interests. Taxpayers facing an audit often engage with advisors specializing in sales tax to represent them and manage the audit with the taxpayer’s interest in mind.

The Audit Process – Initial Data Gathering

When selected for an audit, the state will contact the taxpayer to inform the taxpayer they are under audit. Once contact has been made and audit period established, the auditor will make a records request, which typically includes the following: company-wide sales and purchase data, trial balances, sales tax payable accounts, detailed general ledgers, fixed asset listing, depreciation schedule, tax workpapers and any use tax accrual worksheets. It is imperative that the data provided is complete and accurate. Missing records and incorrect data files can lead to significant liabilities levied against the taxpayer.

Below is a discussion of some commonly requested data during an audit:

• Company-wide sales and purchase data: Auditors will first determine whether the sales data ties to the trial balance, then compare the sales reported for the respective state to the state sales on the company-wide sales data to ensure sales are not underreported. Underreported sales are assessed against the taxpayer and tax collected but not remitted can lead to criminal penalties.
• Trial balance: Auditors will use sales per trial balance to compare company-wide sales data to ensure sales data provided is accurate. Auditors also use trial balances to select accounts of interest to review (assets, expenses, sales, etc.).
• Sales tax payable account: Auditors will perform a reconciliation and verify all sales tax collected for the respective state has been reported and remitted to the state.
• Detailed general ledger: Auditors will request detailed general ledger data, so they have a complete set of data for the audit period and have additional information when selecting accounts of interest.
• Fixed asset listing/Depreciation schedule: Auditors request the fixed asset listing and reconcile to the trial balances to identify assets located in the state and determine whether sales tax was paid on those asset purchases. Auditors will also compare any disposal of assets, as sales of fixed assets can be subject to sales and use tax that the taxpayer must collect and report.
• Sales tax workpapers: Auditors request sales tax workpapers to review how taxpayers determined gross sales, exempt sales, taxable sales, sales tax due, taxable purchases and tax due on purchases.
• Use tax accruals: Auditors request this listing of purchases in which the taxpayer self-reported tax on purchases that are taxable. Any taxable purchases where use tax was not reported and remitted to the state will be assessed against the taxpayer.

The Audit Process

Once all the requested records are provided to the auditor, the auditor will verify the taxpayer has provided complete and accurate data for the audit period. Once verified, they will start to review the records on the state level. They will first look to make sure all the sales were properly reported, and all the collected sales tax was remitted to the state. Next, they will select sales invoices, resale/exemption certificates and purchase invoices for review. A typical audit includes several thousand records, possibly millions for large taxpayers, so many states allow for a sample to be drawn and extrapolated to determine the audit result. Auditing and sampling procedures vary from state to state, and taxpayers are responsible for understanding the procedures employed in the states where they do business.

Common Audit Assessments – Sales

The most common audit assessments on the sales component of an audit are due to missing or incomplete resale/exemption certificates. Taxpayers should obtain a resale/exemption certificate at the time of sale to substantiate the exempt status of the sale. Having a properly completed resale/exemption certificate at the time of sale avoids unnecessary back and forth with customers to obtain a correct, complete certificate. The state can assess sales tax on any transaction in which sales tax was not collected and the certificate is either incomplete, incorrect or missing.

Another common assessment during a sales audit is due to incorrect local taxes. Many states authorize local government entities such as cities, counties and special purpose districts the ability to impose local sales taxes in addition to the statewide sales tax. A sometimes-confusing area for taxpayers is what local sales taxes to collect on an invoice. For sales made from a brick-and-mortar location, the sales tax is typically based on that location. However, some states have enacted rules that additional local taxes may be due on the ship-to address (for in-state sales). In addition, the local tax rates can change unexpectedly (usually on a quarterly basis) and can create a challenge for taxpayers to keep up with the correct sales tax rates. These frequent changes in local taxes are a compliance burden for tax departments and can result in unexpected underpayment of sales tax, leading to audit liability.

Common Audit Assessments – Purchases

Taxpayers are also responsible for self-reporting and paying use tax on purchases in which sales tax was not collected by the seller but should have been. This applies to all purchases but is more frequent on purchases shipped from an out-of-state vendor to the taxpayer’s in-state location. The tax rate to be paid to the state is based on the location of the purchaser, although in some instances is based off the place of business of the seller if the seller has an in-state location.

Another overlooked area is when a taxpayer makes an out-of-state purchase that includes sales tax, but the tax rate is less than at the taxpayer’s place of business. For example, a taxpayer purchases office furniture in a state with a 6.00 percent sales tax rate, and subsequently brings the furniture to their office for first use in a location with an 8.25 percent tax rate. In this scenario, the taxpayer would be responsible for paying 2.25 percent use tax on the office furniture on their next sales and use tax return (8.25 percent – 6.00 percent tax rate paid). Since the purchase is taxable in the state where the furniture was ultimately used, the taxpayer is required to pay the applicable use tax rate (with credit allowed for properly collected out-of-state sales taxes). Reviewing out-of-state purchases for potential use tax can help to catch these purchases sooner so the taxpayer can avoid assessments on this often-overlooked area.

Reductions to Audit Liability

State tax auditors focus their attention on transactions where tax was not collected or paid and move quickly past transactions where tax was paid; however, states offer exemptions from sales and use tax depending on the nature of the transaction. In general, exemptions are available based on the purchaser (e.g., governmental entities, religious organizations, educational institutions), the type of property sold (e.g., food, prescription medicine) or the use of the property (e.g., resale, manufacturing, agriculture). Overpayments of tax on exempt items is refundable to the taxpayer and can be used to offset audit assessments, penalties and interest, but the responsibility to identify and claim overpayments rests with the taxpayer.

Below is a discussion of some commonly overlooked exemptions that can be refunded during an audit:

• Property used in manufacturing: Materials purchased to be manufactured or processed into finished goods are generally exempt in most states. Additionally, many states allow an exemption for machinery and equipment, electricity and gas and consumables that are used in manufacturing.  Specific rules apply and vary from state-to-state.
• Digital products: Some states allow an exemption for property transferred digitally in certain situations. This can include software, information services and subscriptions. This has been an area of interest for many states lately due to the growing volume of transactions involving digital goods.
• Non-enumerated services: Sales and use taxes originated in most states only on sales of physical goods.  As states have needed to raise revenue, the tax base in most states has grown to include specified services as well. Examples include repairs to business property, business services (security service, credit reporting, real property services) and utility services (electricity, telephone).

The requirements to support an exemption from sales and use tax can be complex and the rules vary from state to state, but reviewing for overpayments should be done during every audit. Often taxpayers have paid sales tax in error that can be recovered or used to offset liabilities.

Alvarez & Marsal Tax Says

It is important to understand what data and records to maintain for an audit, and how to ensure they are complete and accurate before providing them to an auditor. Additionally, sales tax audit procedures, rules, rates and exemptions can be complex and vary from state to state. Managing an audit through each step of the process is critical to ensure the result is accurate and the taxpayer only pays the taxes they actually owe. A&M Tax can advocate for taxpayers before, during and after an audit. A&M Tax has a team of professionals with diverse backgrounds and experience to thoroughly support, manage and defend sales tax audits and represent the best interests of the taxpayer. A&M Tax can help ensure that no erroneous assessments are included in the audit, any overpayments are identified and captured, and that penalty and interest is minimized.

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