Your business received that initial audit notice. Whether your company believes it has been properly reporting properly and has no issues or if you know of lingering issues, you probably have countless questions flying around in your head. Regardless, it is probably worthwhile to speak with someone that has experience with your situation and has helped handle sales tax audits. Even a short discussion with an experienced sales and use tax professional could reveal things that you could plan for during the audit.
On a daily basis, our company hears stories about a state sales tax audit started and the business had no concerns. Often times, businesses welcome state auditors through their doors with open arms. While auditors can be very friendly, turning over unnecessary documentation can result in large state sales tax liabilities.
The purpose of this article is to give you a big picture overview of the sales and use tax audit process and invite you to contact one of our state sales tax professionals for a free initial consultation if you have any questions.
The Audit Notice
This is a standardized form given to every business undergoing a tax audit. It is usually accompanied by a questionnaire that has been somewhat tailored to your specific business and often includes a request to provide responses to the questionnaire within a short time frame. While the auditor may push for a specific timeline, the state provides specific deadlines that often differ to the auditor. Upon receiving the initial notice, there is usually an opportunity to politely say no to the auditor and get yourself and business records organized and reviewed before the audit starts. Use that time to your advantage.
How Far Back Can the Audit Period Go?
The statute of limitations in a state is generally 3 years. If your business filed a sales and use tax return, the clock starts from that date, or when the payment due was made, whichever accrued later. The issuance of the audit notice tolls pauses that clock, so the state has time to finish the audit.
What Records Do I Have to Provide?
The initial notice is often WAY overboard in its record requests. The agency often asks for any document that is of a financial nature for the audit period, sounds easy enough. While you may feel pressure because it is the state that’s asking for it, you do not have to provide everything requested. Whether you decide to provide the auditor extensive documentation or not, the most common problem we see is not knowing the result of providing certain documentation. You should know the outcome of the documents provided before your business provides them to the auditor. You need to have a gameplan as to how to provide explanations for discrepancies for the following:
- Federal income tax returns
- Sales and use tax returns
- Sales records
- Exempt Sales
- Fixed asset purchase records
- Purchases account with taxable descriptions
While the auditor would prefer electronic records, the statute generally speaks to books and records, which can be subject to interpretation. Bottom line – be selective and know the results as to what you provide.
It rarely makes sense to provide the auditor access to or a copy of the accounting system, such as QuickBooks. We generally recommend that you DO NOT provide it. While QuickBooks and other accounting systems can be a tool, it is rare that the accounting software is used 100% properly. Some companies use QuickBooks just to write checks or generate invoices. A state auditor makes take an unreasonable approach that every invoice, even the draft ones, are real invoices. Small errors can result in large tax assessments. If you do not control the sales tax audit and know what certain documentation submissions should produce, you should not be handling the audit yourself.
Do I Have to Provide Any Records?
Conversely, providing nothing is usually not a good gameplan. It will likely not paint your business in the best light be telling the state auditor that you do not have any records. Further, the state will estimate and estimate high. And, by estimate, we mean tax all of your purchases, disallow your exempt sales, and base gross sales on whatever the largest number they can get their hands on. Fighting an audit is already an uphill battle and providing nothing often creates a guilty until proven innocent relationship.
What is Sampling?
Most companies are fairly predictable and follow a relatively systematic pattern. Generally, businesses have fairly predictable sales as to amount and volume. While a company might have thousands of transactions in 3 years, it typically has the same type of transactions to the same group or individual customers. As a result, the errors made during one period are often repeated throughout the audit.
Instead of looking at each and every record, the auditor will often look at a sample period. Depending on the volume of transactions, the sample or test period can be a year, months or even a single month in some cases. Once an error rate is calculated the auditor will use that percentage to apply over the course of the entire audit. It is important to understand and calculate whether that particular sample is represented or if you are better or worse off depending on the sample chosen.
As part of the process, the auditor will likely ask you to sign a sampling agreement. It almost never makes sense to sign it. Whether you agree or not, the state is likely going to do a sample if they so chose. Signing the agreement usually just eliminates some rights to you and does not change the approach of the auditor. In other words, the agreement is only for the state’s benefit on not yours, so DO NOT sign it.
4 Major Areas of Focus for the Audit
Almost every state sales and use tax audit will focus on 4 major areas as follows:
- SALES: This part of the audit will focus on whether you properly collected and remitted sales tax on the taxable transactions and whether you can prove that you were justified in not taxing any transaction that escaped tax.
- EXEMPT SALES: Once the auditor is comfortable that your total sales are captured, the next step is to verify the ones you reported as exempt are accurate. This is often where the sampling method comes in. The auditor will check to see if your sales were not taxable because of their nature or you have a piece of paper (resale or exemption certificate) to show the transaction should not have been taxed.
- Fixed Asset Purchases: Every business that buys equipment, autos, furniture, computers, etc. wants to take a federal income tax deduction for these large purchases. The problem is that all these types of purchases are usually also subject to state sales or use tax. So the auditor will want to see your federal income tax return depreciation schedule to easily identify these types of large purchases. You will need to provide invoices for each of the fixed assets purchased during the audit period and they hopefully reflect sales tax paid.
- Other Expenses: It surprises companies going through a sales and use tax audit for the first time when they find out that sales tax is imposed not only on the company’s sales but also on potentially all the company’s expenses as well. Does your company buy office supplies online? Do you pay sales tax to the vendor or remit use tax to the state on these purchases? The “other expenses” category can be a mind field for businesses because it may time the company does not retain the records to prove that sales tax was paid on the purchase. A simple claim that you never used your resale certificate does not work. The auditor has the full authority to presume you are guilty – and they do regularly.
Did Not Remit All The Sales Tax Collected
Some companies commit the cardinal sin of state sales and use tax. They collect taxes and do not turn it over to the state. Many of our clients are quite concerned if they know about it, while others are more concerned when it is done accidentally. Unfortunately, collecting and not remitting a very small amount of tax often can result in hefty criminal penalties. Having a professional intermediary is a good opportunity to catch tax collected but not remitted before giving it to the state on a silver platter. Equally important, it can usually be presented as an accident and dealt with before the issue is escalated.
If you received a sales tax audit notice and have known to underreport, then I highly suggest you talk to a qualified tax professional with experience in sales tax fraud.
If you have never been through a sales and use tax audit before, then it can be a very expensive learning experience. Very few companies escape a sales tax audit without owing some money. A few-thousand-dollar assessment is considered a good result by the end of most audits. However, we’ve seen many with assessments in the hundreds of thousands of dollars, even for small businesses. This is not something to be taken lightly.
Hopefully, I have provided you some useful information that will help you navigate the audit process. If you have any questions or need state sales tax audit help, then please use the phone number or contact information at the top of this page to contact one of our professionals today for a free initial consultation.