A Sales and Use Tax Audit can be an Intimidating and Expensive Experience!
Most accountants and attorneys that don’t specialize in sales and use tax matters have little more than a surface knowledge of the laws and regulations. Unlike income taxes, sales and use taxes are addressed on a more limited basis in education and degree programs, professional literature or seminars. The most practical way to become a sales and use tax expert is to work for a state taxing agency.
The majority of our consultants have worked as state auditors. With this inside information, we developed this short guide to help explain some factors related to the sales tax audit process: how sales tax audits are selected, what types of records must be kept (and for how long), and some tips for working with an auditor.
How Did My Number Come Up for a Sales Tax Audit?
Your chances of being selected for a sales and use tax audit depend on a number of factors. In most cases, states select audits according to a system which ranks businesses according to the probability that auditing them will produce additional tax revenue. For example, in California businesses are assigned to “cells” which run from one through seventeen, with the highest likelihood of a tax change beginning at cell one.
Audits of businesses in cells one though five are considered mandatory and are usually ordered for every three year cycle. For cells over five, the number of businesses chosen for audit decreases as the cell number increases. Local audit offices, because of their firsthand knowledge and experience within their community, also have discretion for selecting audits as the cell numbers go up.
Other Ways You Can Be Selected for Sales Tax Audit
Many other components outside the cell system can also trigger an audit. Examples:
• Outside informants, such as disgruntled former employees or vendors
• Audits of your customers or suppliers
• Businesses which are sold, merged or subject to other changes in ownership
• Careless answers to agency questions about deductions or credits on your sales tax returns
• Individual district preferences, biases or audit fads
• And finally, small businesses which otherwise would be bypassed may be selected solely to train new auditors!
Cell ranking is based on two broad criteria: the volume of taxable transactions and the type of business operation. Thus, businesses with complex regulations like:
• Special trade contractors
• Printers and advertising agencies
• Manufacturers
• Providers of healthcare and healthcare products
are more likely to be audited than businesses governed by more straightforward rules which report the same taxable volume.
Regardless of the nature and volume of your businesses, the wisest approach is to operate and maintain records as though you expect an audit. Knowledge and preparation are always your best defense.
Paperwork, Paperwork, Paperwork – Sales Tax Audit Defense
Although no particular accounting system is mandated by law, each taxpayer must maintain the same kinds of books and records that would “reasonably be expected of any prudent business person.” For sales and use tax purposes, this means maintaining source documents such as sales invoices, purchase invoices, purchase orders, paid bills, contracts and so on. Such records and documents can be maintained electronically.
A critical element to supporting transactional level documents is making certain that documents supporting tax-exempt sales, such as resale certificates, other exemption certificates, customer purchase orders and freight bills are maintained.
The auditor generally has a legal right to ask for all documents which are not otherwise confidential or privileged within periods not barred by the statute of limitations. Statutes of limitation vary from state-to-state, but generally fall within three to four years. The period is extended if there is a failure to file returns for periods in which a business had nexus in the state. Generally states require records to be maintained for at least the periods available under the applicable statute of limitations, sometimes longer. Each states’ rules should be reviewed to confirm the period of time records should be maintained.
What to do When the Sales Tax Auditor Calls
Certain general principles apply when dealing with a sales tax auditor. Here are some important suggestions:
Be prepared for the auditor. Prior to setting an appointment with the auditor, make certain that all the requested records have been located and are in good order. If you can’t locate certain documents, proactively seek to locate or obtain them prior to the auditor’s arrival.
Make certain the person that interacts with the auditor is knowledgeable. It is important to provide the auditor with accurate information. Providing inaccurate information can lead the auditor to incorrect and costly conclusions regarding the application of tax.
Don’t just assume the auditor must know the correct application of the law. Auditors don’t know everything about the sales and use tax law, and unfortunately many of them know less than they should. If you have questions about an auditor’s claim, don’t hesitate to request citations to the legal or procedural authority which supports the claim.
Limit the number of contact people. Assign a particular and knowledgeable person to interact with the auditor to help insure she is being provide with accurate information.
Don’t ignore the audit as it progresses. Keep close tabs on the audit progress. Request updated working papers and address outstanding items or issues of concern on a consistent basis. Resolving issues after the audit has been processed becomes more difficult.
Question the final results if you disagree. Many audit assessments are based on tests of one sort or another. Often such tests are flawed, usually in the state’s favor. Irrespective of the method used to perform the audit, the auditor or her supervisor should be asked to support any issues of concern with legal and/or procedural authority. Don’t take the auditor’s word for it, get the support in writing and read it carefully.
File a timely protest. If you can’t reach a satisfactory resolution with the audit staff, make sure a timely protest is filed. This is very important to your sales tax audit defense. Administrative appeal rights may be lost if you don’t file a timely protest with the requisite documents.