Sales Tax and Use Audits
Handling a Sales and Use Tax Audit
You didn’t ask for it, but you have been selected for and notified of a sales tax audit! What should I do?Most companies are not regularly audited by the state for sales and use tax purposes, so it is unlikely you have previously handled an audit. While the requested lists of records and documents that will be reviewed appear straightforward, there is much more to handling a sales tax audit. Warning, there are a lot of potential pitfalls during the interaction with auditors that may occur as you address the questions they typically ask.
What You Don’t Know May Hurt You
Importance of getting the facts correct. Addressing the facts seems like a pretty easy task to handle. However, some auditors are good at asking leading questions which support their position. Some state auditors look only for underpayments. Their directive is to get in and out of the field as quickly as possible, and their priority is looking for under-reported sales and use taxes. Therefore, few auditors will inform taxpayers about potential over-payments since they assume you determined internally that tax was due on a transaction. For example, for issues like IT services, some vendors may be conservative and charge sales tax because they are unsure of the proper taxation.
Benefits of Hiring a Tax Professional
Experience with auditor or industry issues. External representatives or sales tax experts are typically involved in many sales tax audits and might have already worked with your assigned auditor. In addition, from an industry perspective, ‘gray’ issues with respect to certain areas or unpublished rulings by the state may exist. An experienced external representative or sales tax expert will be aware of these.
Understanding the transactions in question.
Sometimes auditors will ask taxpayers to gather unnecessary exemption certificates or other documentation. This may cause the company to invest internal resources to secure the information, which might have been avoided based on an external representatives experience and knowledge. Other times, the state might have already audited the other party to the transaction (the customer on the sales side or the vendor on the purchases side). A company may not know internally what should be pursued and how to secure correct documentation.
Settlement authority.
A company may not be aware of internal policies establishing the amount of tax that can be conceded by the auditor or the supervisor to secure a fully agreed case.
Handling Proposed Adjustments
- If the actual audit results in significant proposed liabilities, you may be compelled to now engage an external professional representative.
- The auditor believes the audit is complete and may be reluctant to invest more time to address the issues.
- The auditor might have made concessions during the discussions about the questioned transactions that may not be documented in the report detail. The external representative may not be aware of those discussions.
- The external representative may identify new or additional facts that were not presented to the auditor or were not entirely accurate explanations.
- The auditor may not want or be allowed to include offsets at this stage in the audit.
- The auditor may want to refer those refunds to an office auditor for review. This can take more time, and there may be an interest rate differential between assessment interest and refund issues in some states.
Tips to Manage Your Sales and Use Tax Audit
Following are some best practices to consider:
1. Communicate with your CPA, a sales tax expert, or other external representative when you are identified for audit. They can discuss the audit process with you, provide some background on various sampling methods, and provide insights on specific industry issues targeted by the state.
2. Even if you are handling the initial audit preparation internally, communicate with the external representative as schedules are shared so he or she is aware of the initial schedules vs. revised schedules.
3. Evaluate whether it is appropriate to perform a refund study/ reverse audit at the same time to identify potential opportunities for refunds.
4. If you opt to use a third party for the preparation and actual audit, make sure you understand the scope of their work and how they will be compensated.
5. Do not engage in contingent fee arrangements on questioned items by the auditor unless you have already made the first pass. Otherwise, you may be paying them on reductions for errors made by the auditor or obvious exempt transactions.
6. If they are doing a refund study/reverse audit, their fee should not be based on savings in periods outside the audit period.
7. Their fee should always be based on offsets actually granted by the state. Payment should be made at the end of the audit, or a provision should be included to reverse any offsets not allowed.
8. Understand whether their services are included only at the audit level or whether services related to appeals or tax court are included.
9. Understand their specific experience with your specific state and your industry.
Ask for references.
A sales tax audit is not an ordinary occurrence. Therefore, you need to invest the proper efforts internally or with external assistance. While you most likely work with an accounting firm that handles your financial audit or tax compliance, they may not have dedicated professionals who specialize in state and local tax matters. Inquire about their experience with sales tax and audit defense issues for your industry in your state being audited. If they do not have the experience, then actively seek out experts through your business contacts at other companies, trade associations, and/or Internet research.