Introduction
Even in the best economic times, businesses need to be vigilant against unnecessary costs and risks. In challenging times such as these, it is more important to avoid missteps, protect cash flow, and derive maximum value from people and processes. But it is not just businesses that need to maximize cash flow these days: States and other tax authorities are feeling the same economic pinch. State budget deficits are mounting into the tens of billions, income taxes are shrinking, and federal help is drying up, leading states to become more creative in targeting additional products and services to tax, and more aggressive in collecting that tax. The result is a flurry of new laws and rate changes, intensifying collaboration to catch the non-compliant, and an explosion of new tax auditors on the streets, each charged with bringing home revenue.
This is not welcome news for businesses already reeling from the pains of the recession. Not only do companies have to navigate through the recession recovery, but they also have to stay on top of new tax laws and trends, preserve cash in the face of proliferating audits, and figure out how to reduce operational costs while covering their audit risks. Tax audits require weeks of effort and distraction, and come with the potential for tens of thousands of dollars in penalties and fees biting into your company’s bottom line, all at a time when you can least afford it.
This article outlines a survival guide to sales and use tax audits, based on knowledge collected from real-life past and present auditors who were asked about what they look for in an audit. It provides information to help you understand your company’s exposure to audits and how to avoid them right from the start, coupled with proven strategies for minimizing their effect on your bottom line. At the end of the day, the best defense against being audited is a good offense. Each new tax law change, newly taxable item or service, launch of a new product, etc., increases your odds of being audited. Passive acceptance or turning a blind eye will get you nowhere. This article concludes with techniques, tips, and tools that will enable you effectively manage your sales and use tax compliance, cost-effectively scale your ability to survive audits, and help you emerge successfully from the present downturn.
The Top Ten Issues that Trigger Audits
To cash-hungry tax authorities, your business represents a revenue stream, plain and simple. Their job is to maximize that stream, and a sales and use tax audit is one of their primary tools. In a sales and use tax audit, an auditor reviews your business records over a period of days, weeks, months to determine whether you are underreporting or underpaying taxes that are legally due. In addition to the time, effort, and diversion of resources this takes on your part, the resulting penalties can be substantial. In a recent survey of 514 companies, the estimated annual cost of penalties owing to sales and use tax mistakes was $34,000 over and above the recovered taxes. To you, that is an unexpected hit to your profits; to the State, it is “found money.”
Given this kind of return, it is no surprise that when states need more funds, as they increasingly do today, they send out more auditors. Case in point: In October 2010, the California Board of Equalization began hiring 98 new staff members to address the growth in the number of sales tax audit leads and to enhance tax collection efforts. The state expects the effort to bring in an additional $13.6 million to the State General Fund. The accelerated and new General Fund revenues are expected to be $62.2 million in 2011-2012 and $81.2 million in 2012-2013.
A third quarter 2010 survey of more than 200 indirect tax leaders at a Thomson Reuters Web seminar found that:
- 87% have experienced an increased number of audits due to state and local revenue shortfalls.
- 69% have made sales and use tax, and VAT a more strategic focus of their company due to the economy.
- 64% have implemented new programs and processes to remain compliant.
Also in California, auditors are literally going door to door to seek out businesses that are not properly paying sales taxes. In short, they are out there looking closer, more aggressively, and with greater frequency than ever before, and the more tax jurisdictions you do business in, the greater the likelihood that you will be audited.
How States Determine Whom to Audit
Most states use systematic methods and electronic data to evaluate and determine those taxpayers who are at potential risk for underreporting or underpaying sales, use, corporate, or withholding taxes. If you know what they are looking for, you can take steps to avoid being audited. But what are the triggers? According to current and former auditors, here are the top 10 issues that, when uncovered, will prompt an audit:
1. Nexus but no registration. Nexus is a confluence of factors that make a business liable for sales and use tax payment and reporting. It is likely that you have nexus with a state if you are paying payroll or other taxes. If you are not registered for sales tax, but do pay another kind of tax in that state, it is very probable that you will be contacted for an audit. All a state has to do is perform a little cross-checking.
2. In the phone book or on the web. If you cannot be found in the state system, a simple check of the phone book or of websites can lead an auditor to call you an inquire about your registration status and number.
3. Issued resale certificates. Resale certificates can be a major red flag. Using them to purchase items that will be used rather than resold can result in enormous penalties. If you have issued a resale certificate and are not registered for sales and use tax, you are an audit candidate.
4. Use tax auditing. If one of your vendors has not charged proper use tax. and that vendor gets audited, then you will likely get audited in turn. Current audits provide the best sources and leads for future audits.
5. Visual inspections. Auditors will often visit large construction projects and take note of the contractors on site. Audits can quickly follow.
6. Whistle-blowers. Auditors are happy to take hotline calls. Disgruntled employees, upset customers, aggressive competitors, and even neighboring businesses upset that you have not paid taxes when they have they can all dish out the dirt.
7. Casual observation. Auditors are people too, and are out there buying items and living normal lives. But that does not mean they turn off their professional antennae when purchasing from you.
8. Non-remission of use tax. Companies that file sales tax without filing use tax paint themselves with a large target.
9. High net sales. High sales volumes can harbor high volumes of errors and omissions. Hence, a successful and growing business can be fertile ground for an audit.
10. Exempt items. Companies that purchase or sell a lot of exempt items are another happy hunting ground for auditors as there is ample room for misinterpretation, error, and fraud around what is exempt and what is not.
Thus, there are many ways to position yourself as an audit target, and lots of ways to become a target even when you’re handling tax reporting and payment correctly and taking care to be compliant. Often, auditors do not even need a particular trigger to launch an audit; you can be statistically selected. A revenue department might receive a quota to generate x dollars of revenue, so they either hit it big or scramble to audit a lot of businesses. Some local jurisdictions even pay a commission. In any event, there are multiple pitfalls ahead, starting when the auditor makes initial contact with you, the taxpayer.
What Auditors Look For
Just because you have been selected for a sales and use tax audit does not mean you are automatically going to have to pay through the nose. Conversely, just because you have done everything right regarding these taxes does not mean you’re not going to have to spend considerable time and money proving it.
Audit procedures vary somewhat state by state, but are relatively uniform. For example, the Department of Revenue for the State of Missouri states:
On average, an auditor spends one week examining records for a sales and use tax audit of a medium-sized company. After examining the records, the auditor will allow you time to gather additional information, if necessary. Follow-up meetings will be scheduled to discuss the overall progress and preliminary conclusions of the audit.
A sales tax auditor will examine your federal income tax return to reconcile the gross sales between the federal return, the sales tax return, and the sales recorded in your accounting records. The depreciation schedule is also examined to determine if there were sales and purchases of fixed assets during the audit period.
The State of Nevada says:
If the business is registered for Sales and Use Tax with the department the audit will usually cover the previous 3 years. If not registered, the audit can go back as far as 8 years.
For a Sales and Use Tax audit, depending on the type of business, you will need some or all of the following business records:
- Copies of previously filed sales/use tax returns with any related reports or work papers used to fill them out.
- Detailed general ledgers and a chart of accounts.
- Monthly sales journals or registers.
- Sales invoices.
- Resale certificates and exemption letters collected.
- Federal Income Tax returns for the years under audit.
- All purchase invoices.
- Cash disbursement journals or check registers.
- Asset depreciation schedule or fixed asset schedule.
- Bank statements and cancelled checks.
- Cash register “Z” tapes.
- Other records the auditor may identify as the audit is performed.
The Most Common Pitfalls
If these procedures seem straightforward — aside from the burdensome requirement to produce all that documentation — remember that much falls between the cup and the lip. As an audit proceeds, there are numerous items and conditions that an auditor will commonly look for in order to catch you. Here are the top 10 pitfalls that are most likely to trip you up, and what you need to do to avoid them:
1. Use tax. This is an easy and substantial “hit” for an auditor. Use tax applies to the routine purchase of such items as consumables and office supply, as well as to the purchase of large fixed assets. Thus there is the potential for the state to assess a very large fee. Unfortunately, most people do not know this until it is too late — that is to say, when the auditor has come in, looked at a certain period of time, and then assessed back taxes and penalties retroactively. The only way to fight this is to maintain domain expertise in determining use tax applicability. But that is traditionally an expensive proposition for businesses of all sizes.
2. Exemption and resale certificates. If you do not possess proper exemption certificates, some auditors will let you go back and try to get them retroactively, but that is not something you want to count on. As for resale certificates, if they are not on file, the auditor will typically determine an error rate and project backwards to assess tax and penalties. If it is proven that a resale certificate has been used improperly, the penalties can be substantial. In California, for example, it is a 10-percent penalty of the tax due for each purchase or a 25-percent penalty for intent to evade tax (or both). To avoid these situations, companies should consider an automated process to ensure exemption and resale certificate compliance for each tax jurisdiction in which they do business.
3. Unreported sales. Mistakes happen and certain sales can go unreported. Sometimes even entire divisions get left out in error. The remedy is to rely on systems, not people — that is to say, let automated systems determine and calculate tax.
4. Charging wrong rates. In 2010, there were more than 750 tax rate changes across the United States. Staying on top of these changes and instituting new rates at the right time is extremely difficult, especially when districts get realigned. The only good answer is to have real-time rates applied automatically from the day they are effective.
5. History of audits and assessments. Bureaucracies have the memory of an elephant. Once flagged, you are under the microscope for life and can expect repeated audits. Most auditors will cite an error, and you might not have the time, energy or resources to address it going forward. Then, upon the return audit, auditors can easily find the exact same infraction and assess penalties on it. The defense here is to have iron-clad processes and procedures and good documentation. Adequate documentation makes an audit go much more smoothly, while poor record keeping will prolong an audit and ultimately sink you. Lacking documentation, an auditor will try to get a visual sample — which for a retailer just might end up being the day after Thanksgiving or the week before school starts — and then extrapolate that sample across your business year, potentially to your disadvantage.
6. Unique rules and regulations. Each state has its own special twists to its sales and use taxes. Auditors are highly tuned into these, particularly when the rules are new, and are quick to spot non-compliance. Tax authorities often have special taxes that apply to specific goods. There are many food/beverage, gambling, cigarette/tobacco, soft drink, timber, and fuel taxes that can be uncovered during an audit. Tax authorities will also audit specifically for these types of taxes from time to time, which can open you up to a full-blown sales tax audit if it appears there is weak recordkeeping. As with the issues above, adequate documentation and automated processes are necessary to keep you out of trouble. Specialized domain expertise in determining taxability for specific items is also requisite.
7. Sales tax accruals. Many companies do not properly remit the sales taxes they have collected. An auditor will look at federal tax returns, the general ledgers, invoice register, actual invoices, sales journals and summaries of sales by state to identify and reconcile disparities, and will then use the number that provides the best assessment. The best advice here, obviously, is to do the same thing yourself — exhaustively and comprehensively — before you report and remit.
8. Acquisitions. A business acquisition can really muddy the waters when it comes to sales and use tax compliance. For one thing, if an acquisition takes you into new markets, you can be creating nexus and thus opening the door to new tax liabilities and an increased number of audits. Then there is the issue of previous liability: When you acquire a company, you must immediately notify all states where the new combined company is doing business; if you do not do this, you automatically assume all previous tax liabilities. Specialized expertise is required to ensure that you are properly reporting pre- and post-acquisition taxes. After all, you are dealing with the potential for new nexus as well as material changes to your business.
9. Internet sales. Yes, federal protection is still in place regarding out-of-state sales tax on e-commerce purchases. But that is not stopping some states from eyeing this potentially huge revenue source. New York and Colorado, for example, are claiming affiliate nexus in regards to e-commerce. Thus, while XYZ Corp and its e-commerce XYZ.com affiliate can currently be set up as separate entities to avoid tax, states are now working to close that planning strategy.
10. Business Activity Questionnaires. These questionnaires are issued by Tax Discovery Auditors. The audit world’s version of the Marines, they are much tougher than your normal tax auditors as they are tasked with uncovering unregistered businesses and businesses engaged in fraudulent activities. As with other Informational Document Requests (IDRs), it is easy to check the “yes” box next to the general questions on these questionnaires, but doing so may well create nexus. Hence, be sure to seek counsel before filling out these or other IDRs.
A Cure Worse than the Disease?
The recommendations for avoiding these pitfalls are commonsensical: Deep domain expertise; automated processes; relying on systems, not people; real-time tax rate and rules tracking; thorough documentation; and specialized expertise and counsel will all ensure you get sales and use tax compliance correct up front. But for companies operating in a challenging economy, following through on these recommendations is not always economically feasible. For example, building and maintaining domain expertise in house may once have been an option, at least for large companies, but how many businesses can justify that today? Similarly, a huge percentage of companies still rely on manual tax processes, which are intrinsically expensive and error-prone. And while they may be attracted to the traditional enterprise software solutions, these solutions are prohibitively costly for most companies to install and maintain.
Despite these economic realities, businesses do not have to simply roll over and let the auditors eat them alive. It is possible to protect your business from non-compliance and audits without breaking the bank.
Outsourcing: A Possible Approach to Sales and Use Tax Management
Even when you are doing everything right, you have to pay to prove it. Yet there are ways for companies to reduce the risk of being audited, minimize the economic impact of audits, and cut the costs of compliance and defending themselves. As always, the best defense is a good offense. There are hundreds of tax law changes each year, even when tax authorities are operating in a strong economy, and researching these changes enables you to apply the latest rules and rates the moment they become effective. Preparing and simplifying your documentation in advance simplifies and streamlines the audit process, and helps you avoid audit sampling methods that may be to your disadvantage. Understanding the ins and outs of use tax applicability, exemptions and resale certificate usage can shrink the target on your back and keep you out of trouble. Replacing manual processes with automation minimizes the potential for human error and omission and ultimately reduces operating costs. And having expert counsel on hand, and on demand, reduces a myriad of potential risks. The question is, how does a company construct this type of active defense, cost-effectively and quickly?
Outsourcing key business processes, especially those requiring specialized domain expertise, has become an accepted and highly effective way for companies to achieve back-office efficiencies while avoiding large capital expenditures. The selling points of business process outsourcing are reduced costs (both upfront and ongoing), lower risk, and rapid implementation — plus the benefit of enabling companies to focus on their core business and not specialized functions such as payroll processing, HR, and tax.
Given the mounting pressures and substantial penalties for noncompliance, sales and use tax compliance is a logical candidate for outsourcing. An outsourced service can enable you to operate with a complete, expert and on-demand tax compliance resource base, without the expense and resource consumption of having to “care for and feed it” in house. The outsource provider makes all the investments in tax infrastructure, technology and people, while you focus on company growth. And as you grow, enter new markets, add new products, etc., your entire tax resource base is able to scale cost-effectively with your company’s needs.
Carla Yrjanson is the Vice President of Tax Research & Content for Indirect Tax for Thomson Reuters. She leads the Tax Research & Content Team, which is responsible for delivering Sales/Use Tax and Value Added Tax rates and rules within Sabrix and OneSource. Ms. Yrhanson has more than 15 years of experience specializing in indirect taxes. Before joining Sabrix in 2002, she was a tax auditor for the State of Washington for seven years and a state and local tax manager with PricewaterhouseCoopers LLP. Ms. Yrjanson received her B.A. degree in Accounting from Western Washington University, and her M.B.A. degree from Washington State University. She is a certified public accountant and is a member of the AICPA. She may be contacted at carla.yrjanson@thomsonreuters.com.