Most companies register more than a touch of anxiety when they receive a letter from their state’s revenue division. Perhaps the most dreaded notice is that of an impending sales tax audit. But what most businesses don’t realize is that there are ways to mitigate the impact of an examination by your state’s revenue division.
For example, did you know that you can converse with your auditor about the necessary information to be provided and when you should provide it? Or that credits identified during the audit period as overpayments of tax may reduce any liabilities uncovered by the audit team? Read on to learn more about how personnel typically conduct a sales and use tax audit and what you can do to minimize the usual pain and concern related to audit activities.
This is usually the first question our clients have when they receive that letter from a revenue division. There are many factors that come into play regarding the selection of a business for an audit. An audit may be occur is a company is very large and conducts a significant amount of business in the jurisdiction. Or, a business might be selected due to the surfacing of an indication of non-compliance such as a lack of registration or failure to file returns while conducting business. There may even be a case where a business is selected due to issues identified during the examination of a completely separate business, perhaps a customer or vendor (This is sometimes called a “whipsaw” audit or audit by association). Finally, it might just be your turn due to normal review scheduling.
If the company you work for is qualified as a large taxpayer by a particular jurisdictional authority (usually somewhere north of $150 million in revenue or more), you can typically expect an audit by the revenue division at some point in the future. The larger your company, the more frequently a jurisdiction will audit you and put you in the normal audit cycle. It’s just a fact – more transactions equal more dollars and more dollars open your company up to more potential issues.
Another reason an audit may occur is non-compliance. Companies that forget to file sales and use tax returns are likely to trigger notices from a revenue division and continued non-compliance will trigger an audit. Even worse, some companies might transact business in a jurisdiction and collect tax without remitting it. It may seem like a simple mistake, but this opens your business up to numerous issues and even more severe legal risk in most jurisdictions.
As an example, a company registered as a business with the Secretary of the State’s Office has conducted business in the state for three years before realizing it should be collecting and remitting sales tax. To remedy the problem and begin paying the tax, the company registers with the Department of Revenue. Systematically, the Department of Revenue puts “two and two” together and suspects a company that’s been registered and incorporated for three previous years probably owes some form of tax. This could raise a flag that triggers an automatic audit for all periods the company was conducting business within the jurisdiction.
A “whipsaw” audit can be the result of a company’s business customers being audited if your company is identified as not charging that business customer the correct amount of tax. For example, your company is small but conducts business with a very large company that’s regularly audited by a jurisdictional revenue division. Information unearthed during one of these audits could catch the auditor’s attention if, say, your company isn’t charging the appropriate rate or amount of sales tax. This will flag your business by the revenue division auditors, and thus trigger a future review of your company activities.
Finally, your business could just be subject to a regular audit cycle established by a revenue division. Companies consistently ask “What? I am getting an audit AGAIN?!?!” Unfortunately, some jurisdictions have procedures and cycles in place that will consistently select your business for audit reviews. Hopefully, the information within the next few sections will help you navigate the issues that may be uncovered during these reviews and ease the procedural pain of the audit itself.
The duration of the audit strictly depends on the size of your company and the nature of the issues involved. A general audit recurs regularly, say approximately every three to six years. These audits are usually pretty standard and routine. However, it does not mean they will be any shorter than non-routine audits. If you’re a very large taxpayer and are being audited every three to four years by a revenue division, then you can expect a fairly extensive process, especially if auditors have found issues in the past.
After a company receives the initial audit notice, the next step is the issuance of a statute of limitations waiver that “confirms” the period of the audit under review. Once this has been signed and agreed to between the company and the revenue division, the audit team will issue an initial data request – or “IDR” – which is a notice of all the documentation the auditors would like to see when they come on site. This request also includes a target date for the auditee to gather this info.
Most people mistakenly assume they can’t push back on auditors in terms of timing the visit or providing the information requested by the audit team. This cannot be further from the truth. In fact, you can work with your auditor to make the process more convenient for you. Be aware, however, that the audit team has deadlines as well, so you need to be reasonable. If auditors decide they want to come on site at the beginning of May, and you’re in the middle of an acquisition or other significant transaction, you can explain the situation to them and request a different start date if possible. Most auditors will work with you on this, but they will also need you to sign a revised statute of limitations waiver requesting the extension.
One word of caution about extensions though – they often occur on the part of the auditor. Sometimes audits will drag on for long periods of time. The company submits significant amounts of data, the auditor comes on site and reviews even more information, and then they move on to other projects and you have no contact for six or eight months. Then they might call because the audit team needs you to sign a form to waive the statute of limitations on the audit and keep the period open.
It’s fine to be flexible on signing the waiver. However, be aware that by doing so you’re extending the audit period and allowing the revenue division to continue to dig into information that should be closed under the statute of limitations. If there’s a second request, a good approach is to ask the auditor to provide justification from his supervisor or gain a better understanding as to what is causing the delay in completion of the audit. The bottom line is, waivers are negotiable. Do not just sign a waiver thinking you have no recourse because the auditor is exerting pressure on your company to do so. You can negotiate with the revenue division and your auditor for an understanding of the repeated requests for extension, and most jurisdictions have a Taxpayer Bill of Rights that protects your business from unfair examination practices.
Your audit team is probably going to initially ask your business for everything under the sun. This can include copies of account balances from your general ledger, many months’ worth of invoice information, income tax returns, sales tax returns, etc. Before you gather it all together and present it to the auditors, speak with them about what they are truly looking for. This saves you both an extensive amount of time.
If you just hand him a general ledger with a conglomeration of sales, fixed assets, expense data and other red herrings, they could start chasing their tails for weeks on issues that have no pertinence to the audit whatsoever.
Now, I am not suggesting doing their job for them. However, you can assist in weeding through some irrelevant data. This will cut down on the frustration factor for you and your auditor and get to the true objectives of the examination. As a quick example, let’s say your company is a service-based business and the auditor wants to look extensively at your fixed assets. As compared to a manufacturer who has heavy equipment and a repair parts inventory, your business’ fixed assets amount to some office equipment and personal computers. If you can show the auditor in a few invoices that you’ve paid tax on all these assets, it will save you both a lot of trouble and potentially eliminate this component of the audit examination.
During an initial audit examination, you want to explain your business and help the audit team understand your business model and what you do. Provide a detailed description of how your business operates. This will make the auditors feel comfortable with your overall business processes, sales, purchases, and general inventory and fixed assets.
After a business overview and submission of your transactional data and information to an auditor, the process of the audit typically begins with a sample selection for the audit.
Revenue divisions cannot review every transaction of a business. This practice would cause audits to drag on forever and would be significantly cumbersome for jurisdictional personnel to complete. Thus, auditors often use statistical sampling and or block sampling in choosing a representative sample of your data.
Instead of going through every line item for a year, they will look at a period of months and extrapolate the results across the year. If your data shows that you owe a potential liability of $X for June 2012, July 2013 and August 2014, the audit team can project that figure to obtain a total tax for the three-year period between January 1, 2012 and December 31, 2014 and then add on any penalties and related interest.
While this approach saves time and effort, companies that have a cyclical business are vulnerable to a sample selection that skews the true picture of their liabilities. An ice cream company, for example, is going to have its busiest period – and have the most tax exposure – during May, June, July and August. The fact is, the auditor is typically going to try to select periods when you have the highest activity in order to assess you the most. Like the waivers described above, the sample selected is something that can be negotiated with an auditor. Don’t just allow the auditor to dictate a sample selection that puts your business in an unfavorable position. You can negotiate, and you should discuss an approach which makes the most sense with your audit team.
When an auditor comes in to review your company transactions, their primary focus is to look for liabilities on existing transactions. Their primary focus is finding the jurisdiction money.
It may come as a surprise that an audit is also your opportunity to identify situations where you may have overpaid tax. This is sometimes referred to as a reverse audit and can result in an offset to any outstanding liabilities that may be revealed during the audit period or audit review.
A CPA can help you conduct a reverse audit, working alongside your auditor and reviewing the same documentation to locate any opportunities for credits. Through this process, a CPA can also show you the procedural gaps that leave you vulnerable to future audits and suggest measures to resolve them.
Upon completion of all audit field procedures and the preliminary review of the audit team work papers, your company will typically be issued the Notice of Proposed Assessment (or “NOPA” for short). This is one of the last steps in the audit process. This is a document that lists the auditor’s findings and indicates what you potentially owe the jurisdiction. You do not have to sign and immediately pay this bill. If you do not agree with the assessment figures or information provided by the audit staff, there are methods for you to protest.
Usually, the first step in protesting a NOPA is to have a discussion with the auditor, review their work papers and identify any errors. We call this step an “informal” with the audit team. You could also have an informal with the auditor’s supervisor if the auditor is not being cooperative or if you’re not making progress on a particular issue. If you and your company leadership are still not satisfied after the informal process, your company does have additional formal avenues for protesting the audit findings. These procedures vary by jurisdiction; however, the important takeaway is that you are not “forced” into agreeing with the initial audit findings from fieldwork.
Some states will suggest that it is a requirement for your company to pay the fine, penalties and interest prior to formally protesting the auditor’s assessment. Once you pay and successfully protest the audit, the jurisdiction will pay your company a refund if you are successful in defending your position. Other jurisdictions will allow a delay of the payment but will potentially run the interest “clock” as you complete the formal protest process.
Most people automatically view an audit as a bad thing, but it doesn’t have to be. At Smith and Howard, our CPAs help clients make the best of the situation. They’ve worked through audits by many jurisdictions and understand how to keep a relationship on an even keel with the department of revenue.
The silver lining in an audit is that it helps you see where your company may not be in compliance and creates an opportunity to put checks in place. It’s always better for any business to comply with the laws of the jurisdictions in which they conduct business. However, sales and use tax is very complex, and that’s why authorities conduct audits consistently. They know certain businesses are more susceptible to making errors simply because of the complexities inherent in their operations. Especially for new businesses or ones that don’t have a robust tax department; it’s a good idea to get CPA involvement to help you navigate an audit and prevent liabilities in any future audits.
Looking for more sales and use tax expertise? Contact Tim Howe, CPA at 404-874-6244 or contact us online. You may download a printable PDF of this article using the PDF link above.
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