the ultimate guide for
The Ultimate Guide to Fighting Your Sales Tax Audit is for business owners and professional tax advisors that want to minimize the total cost of a sales tax audit for themselves or their clients.
Most executives and business leaders understand that businesses get audited for sales and use tax, but only a small percentage are aware of the material impact to their company should a state auditor come knocking on their door. Unless you’ve been audited in the past, you might not know why certain businesses are targeted, what the most common types of errors auditors look for, and most importantly, how much it might cost the business.
Fun Fact: The word “audit” is derived from a Latin word “audire” which means “to hear”. In a certain sense, the auditor is there to give you a “hearing”.
A sales tax audit occurs when a state agency inspects the books and records of a company specifically evaluating the correctness of sales tax paid on invoices and use tax accrued on invoices. Sales tax paid on invoices can occur in two areas:
This Ultimate Guide is meant to assist you in handling the audit and in keeping the assessment to a minimum. We do not advocate evading taxes that are legally due and we don’t see auditors as your enemy or ours. We do understand the sales tax audit process very thoroughly and through our experience in handling hundreds and hundreds of audits, we know how state auditors work. We’ve worked for companies with revenues of less than $1 Million to companies with revenues of over $100 Billion. We’ve saved our clients over $61 Million in audit assessments. That means our clients were overassessed in the first place by $61 Million.
It should come as no surprise that state auditors aren’t looking for companies that are managing their taxes correctly. After all, audit penalties and assessments provide enormous revenue and help shore up budget deficits. According to a recent California State Board of Equalization (BOE) in 2013-2014 report, the state generated over $21 Million in revenue from their managed audit program.
You can learn a lot from a joint report we did with Avalara called: “Sales and Use Tax Audits Uncovered: Who gets audited, why they get audited, and the impact on companies”.
What companies get audited and why?
What are the common errors by key industries?
How costly are sales tax audits?
Here are some key findings from the Report:
Sometimes it’s a case of bad luck, but as the data suggests, companies are most often not selected at random but evaluated by a number of factors, which include:
Most of these factors might seem obvious. Companies with a history of negative audits usually get targeted until the audits no longer produce results for the state. High revenue companies, on the other hand, find themselves in a perennial audit whereby any number of auditors from multiple state agencies set up residence at their headquarters, even if they’re meticulous with their compliance processes. It’s also not surprising that companies that report a high ratio of exempt sales to total sales raise a flag, especially if that ratio isn’t consistent with their industry peers.
What’s less evident to most people is the first criteria: Industry. This factor seems to be accounting for more and more audit activity across the U.S. and doesn’t show any signs of slowing down. Here’s why.
Certain industries tend to put themselves at risk of an audit in two ways. One is based purely on how the industry operates: For example, bars, restaurants, grocery and liquor stores are all cash-based businesses, and auditors are all too aware of how cash goes unreported. However, while cash-based businesses routinely put themselves in compliance risk, the effort to find the errors might be too high for many auditors to even bother investigating, especially if it’s a small operation.
The other main reason certain industries get targeted is that historically they don’t adhere to state and local sales and use tax regulations, which are complex, ever-changing, and require a lot of research, and due diligence on the part of the company’s accounting, and finance teams. There are many ways a company can make a mistake in their compliance, but as the data from the California BOE indicates, the following account for the majority of errors (see Figure 1):
Top Ten Areas of Errors Found Upon Audit
Figure 1: Source-California BOE Annual Report 2013-2014
Percentage of Audit Assessments Collected by Industry Class
Interestingly, the data told a slightly different story in Texas. While retail and manufacturing remained high as in California, Texas also targeted the construction industry and wholesale/distributors (see Figure 3).
Top Industries Under Audit in Texas
Basically, it boils down to this: the State views everything you buy as being subject to tax. In other words, you’re guilty until proven innocent. We all know not everything is taxable, but you have to be able to prove all of that to an auditor. Your best bet is to keep the auditor from scheduling items in the first place. It’s easier to keep it off the auditor’s schedules than to get it taken off later.
In many cases, using an expert advisor to help will ensure you get the best results. And if you decide to seek outside help, we hope you’ll consider Peisner Johnson. However, it’s also possible for you to handle much of this process yourself. Here’s a breakdown of the chapters in this Ultimate Guide.
First, don’t be shocked that you’re being audited! You should expect a sales tax audit if you sell to customers in other states. You may even be audited by another state before you get audited by your own. In fact, the odds of getting audited by more than one state are pretty good. This is because of the expansion of “nexus”, especially in light of the Wayfair decision by the US Supreme Court in June, 2018. States are setting up audit offices all over the U.S. to conduct audits on companies that now have nexus in their state.
Data from the Texas Comptroller also supports this claim, as one-third of their audits are conducted on businesses located outside of Texas. Research also indicates that Texas has a total of 595 auditors with 78 of those permanently based out of state.
Second, if/when you are audited, don’t be surprised at how much it costs. According to information published by Avalara based on a survey of over 400 U.S. finance and accounting professionals across several industries, ranging from ecommerce, to retail to manufacturing, found that a sales tax audit costs on average $114,147.
In this chapter, we will highlight the statute of limitations for various states and a corollary issue of just how long you should retain your sales tax records.
Almost all state taxing agencies use some form of sampling in their audits. Sales and use tax audits rarely span less than three years, so huge amounts of data can be subject to scrutiny. Detailed verification is neither practical nor desirable (for you or for the state), so sampling is the logical alternative.
Not knowing what the process is with a sales tax can add to the stress for sure. But not knowing how (and WHEN) to deal with the auditor can lead to over-inflated assessments.
The Audit Process
The audit process consists of 4 basic stages. Chapter 1 is all about the pre-audit phase and what you should do there. Then in Chapter 3 we discuss the next phase which is the discussion of the sampling methodology to be used. The third phase is when the actual fieldwork begins or the performance of the audit. That’s the phase we discuss in detail in Chapter 4 (and Chapter 5). The last phase is the post-assessment period where you decide if and how you will appeal the assessment.
Some people seem to get a little uncomfortable with the terminology of “fighting” an audit. Some prefer to call it “sales tax audit defense”. Either way you refer to it, I can assure you the state auditor has one major objective when they audit you: get the most money out of you with the least amount of work possible. Sorry if that sounds a little too harsh, and maybe there are a few auditors out there who aren’t this way, but if there are, we haven’t met them.
By the time you get to this chapter, we’ve already talked about what the audit process is like and how to negotiate with the auditor, with tons of tips. Now we’re going to talk about going on the offensive. Since the focus in many audits is on how much tax you will owe rather what refunds might be due. So it’s a great idea to do a refund review to determine if there are opportunities for refunds.
You know the old saying: “sometimes the best defense is a good offense”. That’s where refunds and overpayments come in. Overpayments can arise in many different situations. For example, in many states there are sales and use tax exemptions for machinery and equipment directly used in the manufacturing process. That’s just one area where refunds could exist, there are many others that we discuss in this chapter.
If you don’t agree with any aspect of the audit, there are many levels of review and appeal that you can pursue. Protest procedures vary from state to state, ranging from simple to complex. A few agencies allow only one level of administrative appeal before compelling you to pursue their cases in court. Most tax agencies provide two levels of appeal, although one is generally an optional informal conference. A few states provide three levels, and some also offer alternative dispute resolution or settlement programs outside the usual administrative appeal process.
You have to be very careful in this phase of an audit that you don’t compromise your rights to sue in court at a later date, should you so choose. Some states, however, require you “to exhaust all administrative remedies” before proceeding to court. So you have to know what your “administrative remedies” are.
Data from the Texas Comptroller indicates that one-third of their 4,252 audits in progress are being conducted out of state. Research also shows that Texas has a total of 595 auditors with 78 of those permanently based out of state. Texas is one of the most aggressive states when it comes to auditing for sales tax. There are some unique aspects to audits done by Texas that you need to be prepared for. We’ll discuss those in this chapter.
Here’s where we put all the checklists and charts in one handy, quick reference section.
A sales tax audit is no stroll in the park. You need to invest the proper efforts internally or seek outside help. Defending businesses against a sales tax auditor is a highly specialized area of consulting. Over the years of working with clients to minimize the tax assessed against them we have gained invaluable experience and it’s our pleasure to share it with you. Whether you use this information to manage your audit completely start-to-finish or to at least gain some familiarity with the process to know how to avoid common pitfalls, then it will have been very valuable indeed.
Should We Bring In Outside Consultants to Help with this Sales Tax Audit?
We can’t answer that without knowing your particular situation, but in this Chapter, we will give you some points to consider as you make that decision.
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