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Sales and Use Tax Audits
If your business is located in any one of the 45 states in the United
States that has some form of a sales tax, you are all too well aware of
the challenges that it places on you and your business. Identifying
what products and services that you provide are taxable and what is
the appropriate rate is for each is only the beginning. If your business
conducts commerce in multiple states, you must duplicate that effort in
each of the other states. Then you must collect the tax and reserve
those collections for remittance.
When it comes to remittances, each state has its own requirements.
Each state sets thresholds that determine how often remittances must
be filed and paid. There are different due dates too. But most
probematic is that each state has its own reporting requirements.
Each remittance must be accompanied by a form that breaks down
revenues and the corresponding taxes collected. Moreover, where
there are local taxes involved, revenues and taxes will need to be
broken down by jurisdiction so the state can then forward those
remittances on to the proper authority.
After all that, you stop and think. You do all the work and the state
gets all the money. And how do they thank you? They send out an
auditor to make sure you are not somehow missing something that could
mean a loss of revenue for them! Worse yet, if they do find that
you are somehow remiss in your efforts on their behalf, they have the
ability to make you pay any shortfall and fine you for your inexcusable
neglegence. And if you make sales in states in which you do not
currently collect sales tax, you could now become a target of an audit
by those states as they seek to enforce previously unenforceable tax
laws. So, if you are contemplating the possibility of becoming the
subject of a sales tax audit, or if you have been notified of a forth
coming audit, you might wonder...
What happens in an audit?
Why as I selected for an audit?
What hidden dangers are there in an audit?
How can iPgmr.com help with an audit?
If you are looking for answers to these or any other questions about
sales tax audits, please read on.
In the simplest of terms, an audit involves a team of two or more
auditors who will spend about one week on site to gather the necessary
information for the audit. There is usually an audit worksheet that
has been prepared for the audit that will direct the auditor's
search. Although each audit will be unique, there is usually a
general game plan for the audit cycle. So if you know of someone
recently audited, they may be able to let you know what to prepare
for.
Generally the auditor will typically look to reconcile revenues
reported on the federal tax return to gross sales, sales reported on
the sales tax return, and sales as recorded in the company ledger.
Vendor purchases will also be looked at for unpaid use taxes. Audits
often review one to three years of activity. However, if any
irregularities are found, you can expect the audit to be expanded
beyond that. Before leaving, the auditors will meet with you to let
you know what comes next.
Back at the auditor's office, the team will compile their findings and
plan a return visit to present their report. If the audit finds no
fraudulent activity or pattern of irregularities, the final report
should be pretty simple. There will likely be a bill for any unpaid
taxes found, suggestions for keeping better records in the future,
and a token thank you for your cooperation. If anything significant
is found in the audit, you will want to arrange to be represented
in any further discussions with the audit team. You can be sure
that anything that you say after such a notification can and will
be used in any legal actions that follow.
In preparing for an audit, it can be helpful to know why you may have
been selected in the first place. Audit selection is often presented
as a random occurrence, but that is rarely the case. The cost to
conduct an audit is substantial, so the expectation is that the audit
will produce more than enough revenue to offset that cost. Therefore,
it can be reasonably assumed that there was a reason that you were
selected. Here are a number of common triggers that may be at the
root of your being selected for an audit.
- Nexus But No Registration
Nexus is a term used with sales tax to indicate a connection of a
business with a state. Most small businesses are registered in their
home state and that is where it ends. However, if the business has an
office, a distribution center, or employs individuals in another state,
a nexus or connection is established and the business will need to
register as a business operating in the outlying state. A simple rule
of thumb is, if you are paying employment taxes, real estate taxes, or
any other taxes in the state, you have a nexus. And even if you do not
fit the definition of a nexus with the state, if you have any dealings
with the state at all, you are more likely to be identifed for an audit.
- Reporting Exempt Sales
In most states, sales made for resale and sales made to non-profits
and government agencies are exempt from sales tax. However, such
sales require the seller have an exemption certificate on file for
each purchasing entity. Reporting exempt sales puts you on the audit
radar and they will focus on the availability of exemption certificates
for those sales. If such documentation cannot be provided, or if the
documentation on file is out of date for the sales, those exempted
sales will be disallowed. Knowing that maintaining these record is a
challenge, auditors will focus on businesses that are likely to cater
to such consumers.
- Mergers and Acquisitions
It would not be too hard to understand that mergers and acquisitions
create an opportunity for auditors. There are numerous ways in which
little things can be overlooked and mistakes made as two independent
operations are combined into one. And there is the issue of previous
liability. Failure to properly notify authorities of the changes can
leave the new entity open to previously existing tax liabilities.
Auditors know how to take advantage of this period of transition to
encourage quick settlements for real or implied discrepancies.
- Directory Listing, Advertisements, Internet Postings
You may not have any physical presence in another state, but have you
listed your company with any out of state directories or purchased any
advertising in any widely distributed publications? Do you have a
presence on the internet; a web-site, a Facebook listing, or connections
on social networks? All of these can easily result in a phone call or
letter to verify your status for conducting business in the state.
Regardless of your answers to such inquiries, if there is a suspicion,
an audit may follow.
- Whistle Blower Report
Competetors and disgruntled employees can easily put your company on
the radar of the revenue department. States often operate hotlines
where anonymous messages can be left. Even a false report could spell
trouble.
- Casual Contact
You take and deliver orders every day. What if an out of state order
was placed by an auditor or someone in a position to have contact with
the auditor's office? Would they take note if you omitted sales tax on
the order? Even a conversation about an untaxed purchase overheard by an
over zealous auditor could be reason enough for a preliminary investigation.
- Good News
We all love good news. And growing sales volumes are certainly good news
for any business. Management, employees, investors, suppliers and many
others can rightfully boast about their contributions to such success.
News outlets might even highlight the successes of local businesses in
their reports. Auditors can easily take note of such good news too.
- Public Information Outlets
Sales and employment statistics are often provided to business registries,
real estate agencies, and news organization who then publish this data
for the benefit of their particular audiences. Business surveys almost
always include questions about gross sales, number of employees, number
of outlets, etc. to help quantify their analyses. Auditors can look to
these types of information outlets for outliers that could become the
target of an audit.
- Private Information Outlets
Businesses may subscribe to private information outlets for data that
can help with their marketing efforts. Unfortunately even private
information can become available to governmental agencies when legally
requested.
- Shared Governmental Information
Governments have the ability to compell businesses to provide private
information as a condition for conducting normal business operations.
Revenue data, labor statistics, environmental information, etc. may be
given in confidence, but such information is often shared by
intergovernmental agencies. Tax auditors can use such information
to identify potential audit candidates.
- Use Tax Audits
Several things can trigger a use tax audit; a building permit, the
purchase of industrial equipment, the audit of a supplier, etc.
Though the focus of a use tax audit is purchases, any questiontionable
findings will likely bring up the possibility of a follow up audit of
sales taxes.
- Another Sales Tax Audit
If it becomes known that you are being audited by another state, the
assumption can be that there must be a reason for it. Other states
may respond accordingly and the audit floodgate is opened.
You do your best. You collect the taxes, you make your scheduled
remittances, you fill out all the paperwork, and now you are getting
audited. As far as you are concerned, there is nothing there. And
even if that is true, every auditor wants to justify their existence.
And how do they do that? They need to find something that will
justify the audit or at least something that can be put in the
final report. So, what are some of the hidden dangers that can
come up in an audit?
- Use Tax Violations
When Preparing for a home state sales tax audit, it would be normal
to think the audit will focus on the proper collection and remittance
of taxes on sales made. However, auditors will and
without fail look for use taxes not paid. So, what
are use taxes?
Use taxes are the equivalent of a sales tax on untaxed purchases.
For example, you purchase office supplies from an out of state vendor
who does not charge you sales tax on your orders. Use tax laws
require you, the buyer, to report and pay the unpaid tax that was not
collected by the seller. And even if you had paid out of state sales
tax, you would still be liable for the use tax in your home state.
The rationale being that you should be able to apply for a refund for
any taxes paid that you were not obligated to pay.
To look for use tax violations, auditors will want to examine paid
invoices. They may also want to look at AP ledgers to look for
unusually large expenditures that could point to a capital purchase.
Use tax on a vehicle purchase will be paid when registering the
vehicle, but other capital purchases, especially if purchased out of
state, may be subject to unpaid use tax. If a building permit has
been taken out for a capital project, the auditor may request invoices
on all purchases made in conjunction with the permitted
project to look for unpaid use taxes.*
*Whether or not an auditor has the right to demand access to such
documents or information must be addressed in state law and in any
agreements included in registering to conduct business in the state.
It is important to be properly represented during any
interaction with an auditor and throughout the entire audit process.
See also, "Unlawful Information Requests", also in this section.
- Improper Rates
Charging the right rate for every sale is a daunting task. There
are different rates for each state. In most states there are
additional taxes for cities and counties. And in some states there
are special rates in areas for public transportation, economic
development, police and fire protection, and other such services.
Then there is often different rates for different product categories
such as food, clothing, health and personal care items, vehicles,
and industrial equipment. Add to this list rate changes, which in
some states can occur on a monthly basis, and it is easy to be
charging an improper rate somewhere. Most audits will include a
random sampling of billed orders to verify applied rates.
- Unique Rules and Regulations
At the time of this report, in New York clothing is exempt from
sales tax. That is, except for the purchase of any single item in
excess of $110.00. In Tennessee there is a single item surtax that
applies to any taxable purchase between $1,600.00 and $3,200.00.
Of the 45 states that have a sales or use tax, only 18 specifically
exempt mail and cargo delivery charges.* These and many other unique
sales tax statutes complicates the proper application of rates and
greatly complicates the documenting of rates as applied. Auditors
know well how to exploit the unique challenges that their own
statutes provide.
*Sales tax on delivery charges is usually exempt because it
brings up several issues. First is, what portion of the charge
applies to the delivery state? It could be argued that only the
last few miles of a long transit apply to the delivery state and
therefore only that portion would be subject to the sales tax.
Second, license fees, fuel taxes and highway tolls are included
in the cost of transportation. Paying sales tax on these "taxes"
can be argued as wrong too. Third, there may be handling charges
paid to dock workers for loading or unloading burried into the
delivery charge. Requiring sales tax on labor costs are not valid
in any state. Complicated enough? Throw in questions that could
come up if using air cargo, rail freight, the US Postal Service,
and this could go on and on.
- Implied or Pattern Based Fines
A real danger in any tax audit is when an auditor looks for or
determines that there has been a pattern of evasion, fraud, or just
improper application of tax law. When such a pattern is found, it
opens the door for what could be a very large fine or even worse.
That is because statues of limitations do not always apply in tax
law when a pattern is found. In such cases, the auditor can request
documentation for past years, well beyond the two or three years
normally looked at in the preliminary audit. If such documentation
cannot be provided, a formulated tax assessment and fine can be
applied that assumes the understatement of taxes existed in those
past years too.
- Unlawful Informtaion Requests
In any audit, there are limits on what information is legally
within the scope of the audit. Any information requiested by
the auditor outside those limits would not have to be provided.
For example, they might have the authority to request a specific
sampling of hard copy invoices, but they may not have the authority
to request access to electronic invoice data. You could always
comply the request, but make sure you know your rights before
you say yes.*
*Having proper representation before, during, and after any audit
is highly recommended.
- South Dakota v Wayfair
On June 21, 2018, the Supreme Court of The United States handed
down its ruling in the case of South Dakota v Wayfair. That
ruling determined that the State of South Dakota was justified in
its pursuing sales tax collections by the internet retailer,
Wayfair, on its sales delivered to customers in South Dakota.
Before SD v Wayfair, the Supreme Court had decided that states
did not have the right to compel an out of state seller to comply
with sales tax laws unless they had a physical presence, or nexus,
in the state. Though the ruling does come with restrictions, it
does open the door for states to conduct audits of out of state
sellers on their sales into the state. For a detailed analysis
of SD v Wayfair, please see
2018-06-21 SCOTUS - SD v. Wayfair.
The iPgmr.com Sales Tax Calculator
(STX) was designed to provide the greatest level of granularity possible.
Rather than computing a single rate, each rate is an aggregate of individual
tax rates. For example, the tax rate for Alta, UT is 8.75% as of 4/1/2019.
That rate includes 4.85% for the state, 1% for the Salt Lake County local
option tax, an additional .25% county tax, a .25% county transit tax, a .1%
county zoo tax, a .25% additional county transit tax, a .3% Alta transit tax,
a .25% Alta additional transit tax, a 1% Alta resort tax, and a .5% Alta
additional resort tax.
Moreover, STX uses the United Nations Standard Product and Services Codes
(UNSPSC) to identify taxable and non-taxable sales, and to identify
differnt rates for differnt items such as clothing, food, vehicles, etc.
UNSPSC codes are broad enough to accomodate such challenges as the
difference between athletic wear and uniforms, uniforms and medical
apparel, medical apparel and safety apparel, safety apparel and common
clothing items, common clothing items and accessories, accessories and
footwear, and so on.
The system also has the ability to record every sales tax computed.
Each transaction is tracked from the time it is recorded until it is paid.
Transactions can be tagged with a reference number such as an invoice
number, an order number, a POS date and time, or any other transactional
reference appropriate to your operation. The available transaction
inquiry allows you to find transactions by date and time, by state and
city, by UNSPSC code, or by the assigned reference number.
The STX inquiry program can be called from your billing systems too giving
you a direct line into the sales tax system from your sales systems. And
if your ledger system has drill-down capabilities like the
iPgmr.com Integrated Accounting System
(IAS), you can walk back sales tax liability accounts from the ledger to
the journal entries, from journal entries to invoices, from invoices to
items sold, and from items sold to the sales tax or sales taxes applied.
STX also has a transaction report writer that is available to produce
hardcopy reports of sales tax transactions. Reports can be based on user
specified selection criteria similar to the inquiry program. Such reports
can be created to comply with an autoror's request without the need for
them to have access to your electronic systems.
Altogether, STX gives you the infomational tools you need to answer
pretty much any question posed by an auditor. That is good, but caution
must still be exercised. Tax laws do vary from state to state, and all
do put limitations on what an auditor can legally request during an audit.
Offering too much information early on in an audit can open the door to
more and more requests. And each request should be viewed as a search
for some vulnerability in your tax processing from the standpoint of the
state. So it is always good to use caution and to be well represented in
all interactions with a state sponsored tax auditor.
Please be aware that iPgmr.com is a software company and does not
provide any legal counsel or direction. However, our intimate
knowledge of sales taxes across the U.S. gives us a unique perspective
that may be helpful. Let us know if we can be of any assistance to
you or to help you with other questions you might have. Our contact
information can be found at
www.iPgmr.com/contact.htm.
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