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 shows 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 e-commerce, to retail to manufacturing, found that a sales tax audit costs on average $114,147.
First of all, let’s review the PRE-audit process: The audit actually starts before the fieldwork begins.
This will be your first contact with an auditor. The letter says you have been selected for an audit. Accompanying the letter will be a questionnaire requesting information about the company.
This is a standard part of the process. It will not do you any good to delay responding or to be incomplete in your answers.
TIP ► We recommend you respond completely and accurately within a reasonable period of time. There is no need to rush, however.
The more pre-audit review and planning you do, the better the prospects for a favorable outcome. No one likes audit surprises and they should be minimized wherever possible. As soon as you are notified of an impending audit, you should appoint your “Audit Coordinator” (AC). This person should have a strong knowledge of sales and use tax laws and procedures. If nobody within the company qualifies, you should consider engaging an outside sales and use tax advisor to manage the audit process.
The AC’s first task will generally be to obtain and review any previous sales tax audit reports and work papers. Unless state procedures have changed, or the business processes have changed significantly, the current auditor will probably follow the same approach as was used in the prior audits. This knowledge will help the AC to identify the necessary supporting data, alert relevant company personnel, and, if necessary, begin locating documentation from vendors and customers.
If there have been significant changes, or there was no previous audit, the AC must assess potential exposure based on his or her knowledge and experience. This may be accomplished by investigating the areas where significant errors are most likely to have occurred.
This is where a “pre-audit investigation” comes in. Such an investigation generally should include discussions with appropriate company personnel along with review and spot tests of records and supporting documents. This will help the AC as they negotiate audit parameters and test procedures before the audit begins.
FAQ ► Why should we do a self-audit before the audit begins?
It’s better to find and correct errors before the audit even starts. You shouldn’t think of a sales tax audit as the opportunity to correct errors. By correcting such items internally, the company saves money in interest, penalties, consulting fees and time. The quicker an audit is resolved and closed out and the fewer mistakes found, the better for the company.
FAQ ► What are the 4 most important areas to review in a self-audit?
In a self-audit, the emphasis of your review is to identify lapses and breakdowns in procedures that could result in additional assessments by an auditor. Following are the four areas you should review before the audit starts.
- Nexus. (Make sure you know where your company had nexus, that’s the first step.)
- Fixed Assets. (Review your fixed assets to determine if tax has already been paid on items delivered and used in the state auditing you. Make sure you have the documents to prove tax was paid. Consider creating a fixed asset folder with copies of all invoices, journal entries, project requests and approvals. Keep all documentation that will support a tax exemption if one was taken.)
- Use Tax Accruals and Sales Tax Payable Account. (Make sure that you can easily reconcile your sales/use tax payable accounts. It’s very simple for a sales tax auditor to simply say that any unexplained debits to this account are automatically assessed unless you can prove that they shouldn’t be. It’s best to keep the accounts reconciled on a regular basis because years down the road when the auditor is in the building, reconciliation can be nearly impossible.)
- Exemption Certificates. (For each non-taxed sale you make, a valid exemption certificate from your customer must be on file. You should do a sample review of non-taxed sales transactions in a prior period just to see where you stand. You may find that you’re in good shape, or you may also find that immediate attention is necessary in preparation for an audit.)
FAQ ► What is a good, on-going tax system we should have in place to minimize future sales tax audit assessments?
Ideally you have designed, implemented, and documented (in your company tax manual) a good system for identifying, recording, and processing any tax liabilities.
Your system should be regularly tested and adjusted where necessary to accommodate business, technology, and tax law changes. That’s the ideal world, your results may vary, but this is what you’re striving for. In any sales tax audit, documentation is critical. A company tax manual can serve not only to remind your team of the periodic tests that need to be done, but also help the team remember to document audit trails, record retention policies, and as a training aid for new staff. In addition to a reliable and dependable tax system, there are specific tasks that should be done periodically.
For example, you should have a plan and schedule to:
- Regularly review the minutes of the Board of Directors and executive committee meetings to identify and plan for significant plant expansions, purchases, contractions, or company reorganizations.
- Periodically review of exempt and resale exemption certificates to ensure that they are complete and in proper form.
- Periodically review company depreciation schedules for any “big-ticket” items will ensure that sales/use tax was either paid or use tax accrued on the purchase (assuming it was taxable).
- Document tax positions taken on gray or ambiguous areas of the law while memories are fresh. The memos and supporting statutes, regulations, and cases should be stored in a permanent file.AND, in your permanent files, you should keep a company tax audit log that tracks the following information:
- Legal entity being audited
- Audit period
- The state that is being audited
- Auditor name and contact information
- Initial audit assessment
- Final audit assessment
- Notes discussing the largest items identified under audit and other areas in which improvement is needed to reduce future tax liabilities
FAQ ► Should we do a refund/tax credit review before an audit, and if so, how do we go about it?
Many companies perform refund reviews and self-audits in anticipation of a state audit. In a refund review, the focus is upon identifying overpayments of tax. It is your responsibility to make sure all refund claims are claimed; you can’t count on the auditor to do this for you. By performing a refund review, you will be in a position to offset any audit deficiency with a refund claim. (We discuss this more in detail in Chapter 5.)
More on Your Audit Coordinator (AC)
The AC should not only understand the business but they should also know who to go to in the company for information. The purpose of having a single contact person is not to mislead the auditor, not at all. Rather, it is to facilitate the information gathering process so that the auditor is satisfied they are seeing everything they need to see to make their judgments. Many times a well-meaning AC says the wrong thing out of ignorance – ignorance of the company’s business practices, and/or ignorance of how those practices could be viewed by an auditor. A company can lose credibility with an auditor by failing to give accurate information the first time. Every time the story is changed the more suspicious an auditor gets. And that suspicion could be totally unfounded. A loss of credibility translates to high assessments and lots of extra time working on an audit.
TIP ► The AC should meet frequently with the auditor to review their tentative list of errors found and to get answers taken care of as quickly as possible.
TIP ► The AC should be thoroughly familiar with particular state’s sales tax law and the policies of their Department of Revenue as they relate to your company.
FAQ ► Isn’t the auditor supposed to educate us about the law?
We hear this a lot. And some auditors say that’s what they do, but you don’t want to make this assumption. Auditor’s are sometimes misinformed about their own law and many times they are not aware of recent cases that have changed how the law is applied.
TIP ► The auditor has deadlines and is working with other taxpayers, but they will work with you to make things convenient to your schedule.
Do not feel that you have to schedule around the auditor’s time. If you are busy during a particular part of the year and less busy in another, the auditor will cooperate. Auditors generally want to complete an audit in the least amount of time possible. You should also state your preference for wrapping things up. It is a good practice to ask the auditor how long they estimate this audit will take and by what date it should be completed. Then try to stick to those dates as you work with the auditor. Our experience is that auditors are much more efficient that way, and that the audit tends to be less problematic throughout.
FAQ ► What is the Audit Coordinator’s (AC) agenda in the preliminary meeting with the auditor?
The AC will handle any preliminary audit investigations and all meetings with the auditor. Most audits will begin with a preliminary meeting of the auditor and the AC. This meeting occurs before the actual fieldwork is begun. It can be done over the phone or in person.
Here are some items for your agenda:
- Introductions: Introduce yourself as the audit coordinator. Provide all of your contact information. Explain that during the audit all questions should be directed to your attention. If possible, provide information for someone higher up in the corporate tax or finance department. This second contact should only be used if the auditor has an emergency and you cannot be reached.
- Establish Rapport: Make yourself an ally, not an adversary. I like the approach of saying something like: “We look forward to working with you to ensure that our company is paying the correct tax that’s due.”
- Exchange Information: Obtain the auditor’s contact information. (phone number and email).
- Inquire: Determine which taxes are under examination.
- Confirm: Make sure to confirm the exact audit period under review.
- Records Needed? Ask the auditor to confirm which records they will need. Auditors will often ask for much more than they really need. This is an opportunity to limit the scope of the documentation and save you some time. Request that the auditor put this request in writing. Do not commit to providing anything at this time.
TIP ► Do not commit to an audit appointment until the following is known:
- The scope of the audit (one state or many, etc.)
- Whether you have the personnel available to obtain and provide the information requested
- The availability of suitable office space
- The schedule of other ongoing audits
- Audit location (where the auditor wants to perform the on-site review of documents)
- Whether a consultant should be used and their availability
- Applicable statute of limitations
- Whether the auditor is travelling (could be helpful to know how many days they’ve allocated for their visit)
- Whether the audit raises sensitive exposure concerns (there were large acquisitions during audit period, nexus issues, exemption certificate issues, etc.)
- Tests and sampling procedures should be discussed with the AC and agreed upon in advance.
- Copies of audit working papers should be given to the AC as each major component (such as the examination of exempt sales, or expenses, or fixed assets) of the audit is completed, along with appropriate explanations and relevant citations;
- At some point during the audit process, the auditor may wish to question other employees in order to clarify factual or procedural issues. (For example, an engineer might be needed to explain some aspect of the manufacturing process; a fixed assets accountant might be asked about criteria for capitalizing equipment.) The auditor should be instructed to request such interviews in advance. The AC then should schedule the meetings, educate the interview subjects about the tax issues beforehand, attend the meetings, and prepare internal memoranda immediately afterward.
FAQ ► How long will this audit take?
Depending upon the taxpayer and the level of activity in a particular jurisdiction, From the initial Request for Information and back and forth on audit schedules, to the assessment and potential appeal, you should expect an audit to go on from one to six months.
It’s not unheard of for an audit to take years to complete. What are the factors?
- Size of the taxpayer.
- Relative size of operations in the state.
- Scope of activities in the state.
Example: Auditing a large manufacturing operation will take considerably longer than auditing a satellite administrative office simply because of the significantly greater number and complexity of potentially taxable transactions that have to be reviewed.
In audits that take the longest, a great deal of time can be spent just selecting the sample, especially in the case of a stratified or statistical sample. This is true because the auditor usually has to go to great lengths to verify the total populations so that he/she can make sure they’re seeing the whole universe of transactions. (We discuss sampling in greater detail in Chapter 4.)
In a business in which most or all transactions are likely to be taxable, auditors will reconcile figures in the books and records to those reported on the sales tax returns and even federal tax returns. Next, they will test the accuracy of the amounts in the records by tracing them to original documents, such as sales invoices, for a test period. This testing and verification can be very time consuming.
From then on, the greatest amount of time is spent in reviewing actual transactions. Then the auditor will generate a preliminary assessment. This portion of the audit is time consuming because it involves the manual review of the transactions on an individual basis and the negotiation of the final taxable amounts with the auditor.
FAQ ► What official authority does an auditor have to audit your business? What are the limits?
State statutes confer broad authority on the state to audit a taxpayer’s records. This is necessary because our system of taxation (both federal and state) relies heavily on voluntary compliance. As such, the state must have substantial authority to audit taxpayers so that compliance can be verified. Absent this authority, we would likely see large-scale evasion.
You might not have known that auditors even have administrative subpoena powers that give them the authority to compel taxpayers to produce information. However, we’ve never seen this authority exercised. It is generally reserved for extremely uncooperative taxpayers.
FAQ ► Is it best to discuss difficult audit issues early on or wait to the end?
Delaying the discussion of a difficult topic until later in the auditor’s visit may be beneficial as it may result in less focus on sensitive details due to the auditor’s desire and the pressure to wrap up the audit.
FAQ ► If there are overpayments/refunds due, when is the best time to bring those up?
First of all, you should always look for tax credits and overpayments that might offset any assessment. Auditors do not see this as their duty and it will be up to you to find them. We usually advise waiting until the end of the field work stage to present your findings to the auditor. Providing an auditor with a refund schedule toward the end of an audit may result in a more limited review of the refund claim. A limited review is good simply because of the time and hassle savings.
Also, once the auditor has announced that they are done with the audit, they would be very unlikely to reopen their review and “sharpen their pencil” to find additional items to assess. It would be very difficult to justify to you and their supervisors why they should spend any additional time on your audit at that point.
FAQ ► Is there any flexibility in when I allow the auditor to come to our business?
Definitely. Auditors have flexibility in their schedules and if there is a conflict in your schedule that warrants delaying and rescheduling the initial meeting, then you should request it. Keep in mind that delaying cannot go on forever as the auditor will not allow periods to lapse to the statute of limitations. In such cases, the auditor may still cooperate with a delay, but he/she will require that you agree in writing to a waiver of the statute of limitations.
FAQ ► What if we are currently registered and filing in the state seeking to audit us? Are there any special considerations in this case?
Yes. If your company is not currently filing in the state that wishes to come in and audit, you should perform a comprehensive pre-audit nexus study. If the study finds that the company did not have nexus with the state for any or all of the audit period, the auditor should be contacted, and any audit appointment put on hold until the nexus issue is resolved.
FAQ ► What are some of the most common errors found in an audit?
For most sales tax audits, the auditor is looking for two things: taxable sales that were not property taxed and taxable purchases that were not taxed. The variations on this basic rule vary by business and industry. Here are a few of the common issues found in sales and use tax audits:
- Missing exemption certificates for untaxed sales
- Sales made to non-profit organizations that you believed to be exempt but are not
- Not charging tax on shipping charges are required
- Not charging tax on other taxable services
- Failure to pay use tax on untaxed purchases used by your business and not resold
- Failure to have receipts to show that purchases using credit cards were taxed by the vendor
- Operating and capital leases that are not taxed properly
- Intercompany transactions that are not properly taxed or documented
- Asset sales or business disposition that are not properly taxed
TIP ► We have a document you can consider sending to your auditor before they come for their initial visit.
It spells out who the contact person is, what time the office is open, etc. It instructs the auditor that they need the contact person’s permission to speak with others and it asks the auditor to provide a written report of proposed adjustments and a timetable for responding to it. Below is the content of the letter, feel free to copy/paste as you like.
To: Mr/Ms Auditor
ABC Company is providing the following information to assist you in efficiently completing the fieldwork portion of your audit. Any deviation from these guidelines should be discussed with the Audit Coordinator in advance. Should you have any concerns regarding these guidelines, please bring them to the attention of the Audit Coordinator.
Our office hours are 8 a.m. to 5 p.m., Monday through Friday. Because of flexible work schedules in the tax department, we request that the auditor arrive no earlier than 8:30 a.m. and leave by 4:30 p.m. Observing these hours will assure that tax department personnel will be available to assist the auditor.
Because of the proprietary nature of the information in the facility, each day, upon entering and leaving the office, all guests must sign in and sign out with the office receptionist. The Audit Coordinator should be listed as the host party. Once you have signed in, the receptionist will notify the tax department of your arrival and you will be escorted to your working location.Audit Coordinator
The Auditor Coordinator for this audit will be:
2 Taxpayer Blvd.
Any Town, USA
All questions regarding the audit should be directed to the Audit Coordinator. To minimize disruption to our team, the auditor should not contact other employees without the contact person’s permission.
Access to office areas requires escort
Auditors are allowed access to the public areas of the office such as the restrooms and the cafeteria. Auditors must obtain consent to visit other areas. Visits may be scheduled through the Audit Coordinator.
Request audit questions in writing
To facilitate completion of the audit and minimize any misunderstandings, we request that all questions regarding the audit be posed in writing. Prompt responses will be provided for all questions.
Request for concluding conference and copies of all work papers
We request that the Audit Coordinator and the auditor have a meeting at frequent intervals throughout (at least weekly) and at the conclusion of the fieldwork to discuss any proposed adjustments and establish a timetable for the resolution of any outstanding audit issues. At this meeting, copies of all audit work papers should be provided to the Audit Coordinator.
LET'S WORK TOGETHER