With the increasing pressure to close budget gaps, state revenue departments must look for opportunities to revitalize their revenue streams. One way is to increase the number and scope of audits performed on taxpayers, thereby allowing states to collect more revenue without enacting new taxes or increasing tax rates. As a result, taxpayers are becoming the target of sales tax audits more frequently.
For some taxpayers, a sales and use tax audit is just another aspect of doing business. Due to their size and the nature of their business, some entities are placed on a regular sales tax audit rotation. For other businesses, however, a variety of factors may contribute to getting selected for an audit. An unusual event, such as a business closure or bankruptcy, may give rise to an audit. The compliance “personality” of a business may also trigger an audit. For instance, high exempt sales, poor compliance records with consistent late filings, a drastic change in sales, or a request for an unusually high refund may result in a sales tax audit.
To make the audit odds even greater, the current advances in technology, an increase in popularity of internet sales, and more small businesses’ partaking in multistate commerce create opportunities for sales tax underpayment among unwary taxpayers. Some states use random selection to identify audit targets. However, this method is uncommon since the financial result from a randomly selected audit may not justify the time and resources invested by the state tax authority. To maximize the return on an audit, many states implement predictive modeling similar to the Discriminant Index Function (DIF) system implemented by the IRS. 1 With predictive modeling, different attributes—such as the type of business, amount of sales, types of products, and many other characteristics—are assigned a number. Generally, the higher the cumulative score, the greater the audit potential.
Since taxpayers are dealing with the reality of more audits, accounting firms and corporate tax departments should develop methodologies to reduce the administrative and other costs that result from the increased workload. This article pulls together tips and best practices for each part of an audit life cycle. After addressing tips, common issues facing state audits are discussed, followed by identifying potential opportunities to mitigate audits in the future. Several of these suggestions and opportunities should be useful for publicly practicing CPAs and taxpayers.
Audit Life Cycle
There are four distinct parts to the audit life cycle: (1) the entrance conference; (2) the sampling methodology; (3) the performance of the audit; and (4) the post-assessment period.
Once a taxpayer is notified of a pending sales and use tax audit, an initial conference normally is scheduled. Generally, during the initial conference the following items may be discussed: the availability of information; what items are being audited; the reasons for and scope of the audit; the auditing methodology to be used and periods under audit; the logistics of the audit (auditor’s access to the premises, auditor’s seating, etc.); and the overall audit plan. Below are suggestions to make the conference successful and productive.
Tip No. 1: The initial contact with an auditor is important, as it sets the tone for the audit process. Cooperate with the auditor and timely respond to the auditor’s requests.
T ip No. 2: It is important to keep a record of all communication between the taxpayer and the auditor, especially any agreements reached regarding sampling, taxability, and timing. Should the need arise, one can refer to the historic record to clarify items, point out timing schedules, and resolve any confusion or disagreements.
Tip No. 3: Require that the auditor issue all questions and requests for documents in writing and agree on a time frame for responding to the auditor’s information document request (IDR). The response time may vary depending on the nature of the IDR and the taxpayer’s ability to respond. For example, if some information is required to be obtained from areas outside of tax records, the taxpayer may need more time to gather the information. The written IDRs and responses reduce the likelihood of miscommunication about the type of information needed and the timeline for the response.
Tip No. 4: Determine how long the auditor expects to be on-site for the audit. Ask if the jurisdiction has a formal policy on how long it can take to complete an audit. If a policy is in place, request a copy. This information may be disclosed in the jurisdiction’s taxpayer bill of rights. 2
Tip No. 5: Set a preliminary date to receive initial audit workpapers. Agree on how long the taxpayer has to review the initial workpapers. After reviewing the initial workpapers, identify the time frame for when the assessment will become final.
Tip No. 6: Often during the entrance conference, the taxpayer will be asked to sign a statute of limitation waiver. The waiver extends the time the auditor has to complete the audit beyond the statute of limitation. Many taxpayers do not have a formal policy regarding consent to an extension of the statute of limitation. If a standard policy does not exist, all the facts and circumstances should be considered before signing the waiver. The waiver may sound disadvantageous to the taxpayer, but there are reasons that signing a waiver can be beneficial. The waiver can delay the audit to a more convenient time and give a taxpayer time to locate requested documentation that was not initially available. It may also be beneficial to agree to the waiver to allow for more time to find offsetting refunds or credits to reduce the assessment. Also, when pressed for time, auditors may issue aggressive assessments resulting in a greater burden on the taxpayer when the assessment is challenged. If a taxpayer is uncomfortable signing a waiver, the waiver can be signed for a shorter term than the auditor requested and then extended if necessary.
The consequences of not signing the waiver need to be considered. In some jurisdictions an auditor may warn taxpayers that the failure to sign the waiver could result in a jeopardy assessment, which is generally a tax assessment based on an estimate that is issued when a taxing jurisdiction believes there is a chance that tax collection may be jeopardized by delay. While a jeopardy assessment made in response to a refusal to sign a waiver may not be a valid use of the jeopardy assessment power, the taxpayer receiving a jeopardy assessment likely will be forced to challenge the assessment either through administrative procedures or in the courts.
Tip No. 7: Taxpayers should review files for correspondence from the jurisdiction to determine if there were any notices that were not resolved and what types of issues were raised in the notice. For example, were there issues related to returns not filed by the due date? In addition, taxpayers should review files to determine if there were any prior audits from the jurisdiction. If the jurisdiction previously audited the taxpayer, the jurisdiction will most likely raise the same issues from the prior audit in the new audit cycle.
Before the audit commences, the type of sampling as well as the sampling period are determined. Sampling is widely used in audits, since it would be very time-consuming, if not impossible, for auditors to audit all the taxpayer’s records for the audit period. The audit sample is examined for errors, misstatements, and omissions, and the resulting underpayment is projected for the entire audit period. Even the smallest, seemingly insignificant errors in a sample can translate into a substantial dollar amount when extrapolated to the entire population of records.
Tip No. 1: Taxpayers should inquire whether they can select the sampling method that is used, as every jurisdiction uses a different approach. Depending on the taxpayer’s availability of records, seasonality of sales, and other business factors, some sample methodologies may be less risky to the taxpayer than others. Block sampling involves the auditor’s selecting a few days, weeks, or months from the audit period to analyze the sales tax treatment of purchases. This method can be particularly inequitable for taxpayers with seasonal sales or sales that are uneven throughout the year for various business reasons (new items and hot items during a certain time of the year) and also may not reflect the taxpayer’s overall sales tax compliance. On the other hand, in some cases, this method may result in a highly skewed sample that works to the taxpayer’s benefit. Given the inherent uncertainty involved in using nonstatistical sampling methods, taxpayers may want to consider encouraging the auditor to use a statistical sample that is likely to provide more accurate results.
Tip No. 2: If a large nonrecurring item ends up in a sample, the taxpayer should negotiate having it removed to achieve fairer results.
Tip No. 3: For use tax purposes, the auditor will generally sample routine purchases for potential use tax assessment and extrapolate an error rate over the audit period. Taxpayers should be cautious when agreeing to sample methodologies. For example, taxpayers in a capital-intensive industry want to be cautious about including fixed-asset purchases in a sample. Use tax on fixed-asset purchases can generate a large error rate that may not be representative of the population. In these situations, it may be more reasonable to agree to a sample methodology for all accounts except fixed assets. If the fixed-asset account is excluded from the sample methodology, however, the auditor may need to review these transactions in detail.
Tip No. 4: The taxpayer should address whether the auditor is focusing solely on instances of underpayment of sales tax or looking for overpayments as well. Historically, the purpose of a sales tax audit has been to estimate the correct amount of sales tax, both overpaid and underpaid. With the increasing demands on auditors, more audits focus exclusively on the amount of tax underpaid and not overpayments, which, if considered, could significantly offset the overall size of a proposed assessment.
During the Audit
Once the auditor has arrived, it is important to follow through with the guidelines outlined in the initial entrance conference.
Tip No. 1: Establish an opening audit guideline and send it to auditors in advance of their visit. The document could provide information such as standard office hours, office security protocol, the audit contact person for the company, and a request for a concluding conference and copies of all workpapers.
Tip No. 2: Request that the auditor issue all questions and requests for documents in writing and, if possible, let the auditor know that all responses to his or her questions and document requests will be provided electronically. If there are documents that the taxpayer cannot provide the auditor electronically, establish procedures that allow the auditor to photocopy documents or provide the auditor with hard copies. If audited frequently, this standard guideline is very helpful.
Tip No. 3: To establish an effective auditor relationship and to gauge how the state department of revenue feels about the case, taxpayers or their advisers should schedule face-to-face meetings with the auditors and/or their supervisors when necessary, follow up regularly with the appeals representative, encourage questions, and follow up promptly with answers. When dealing with the auditor, taxpayers should respond quickly and address delays upfront.
Tip No. 4: It is important to address the questions asked and provide the documents requested. Taxpayers should be careful with the auditor’s information requests and not rush to provide everything requested. At times, auditors may request more data than is necessary to answer a question. With that in mind, taxpayers should find out why the auditor is requesting the information to make sure the data provided to the auditor is the most suitable to address the question. In addition, this will prevent a situation where the taxpayer wastes significant time gathering excessive documentation. Taxpayers should maintain an open dialogue with the auditor to facilitate their understanding of why certain items are requested and offer alternatives when appropriate.
Tip No. 5: Throughout the audit, it is also a good practice to request status reports from the auditor as well as results of the audit segments as completed to avoid surprises and deal with factual misconceptions as they arise.
Tip No. 6: Ask the auditor to provide a complete copy of the workpapers and negotiate a reasonable amount of time to review them before agreeing or disagreeing with the findings. Many auditors will provide draft workpapers before the assessment becomes final. An additional waiver of the statute of limitation may be required, but it may be worth the extra time to resolve issues at the audit level. When a taxpayer disagrees with the auditor’s findings, the dialogue should continue in order to achieve a resolution before issuing an assessment and/or taking the case to a more formal administrative appeals level or litigation. Taxpayers should request meetings with the auditor’s supervisor if needed. The goal is to resolve the most easily resolvable issues at the audit level rather than at the appeals level or litigation, which should be reserved for material areas of disagreement.
Tip No. 7: It may be advantageous for taxpayers to have a third-party adviser represent them in audit proceedings. Not only do the third-party advisers bring expertise and experience to the table, they also remove the emotion from audit negotiations.
Once the auditor has completed his or her work, the taxpayer receives a copy of the assessment. If the taxpayer agrees with the assessment, payment can be remitted and the audit is complete. If the taxpayer does not agree, the taxpayer must evaluate its administrative appeal rights. It should be noted that the appeals process can be lengthy and the taxpayer may need to retain a CPA or legal counsel to represent it.
Tip No. 1: It is important to consider all venues for appeal that are available in a state and select the one with the best combination of favorable attributes. For instance, depending on the circumstances, a taxpayer may choose to use an administrative forum. Some administrative forums do not follow traditional administrative hearing rules and instead may offer the taxpayer an opportunity to argue issues that would not be considered in court, such as arguments about industry standards, hearsay, equitable issues, and conflicting state positions. Although appeals representatives at the administrative forum level generally do not welcome new documents or new issues that were not addressed or reviewed at the audit level, an administrative forum may be the last chance for a taxpayer to present an issue, and the last opportunity to achieve a reasonable settlement before pursuing an appeal through the court system.
Tip No. 2: If the taxpayer receives an adverse determination at appeal, the taxpayer and adviser should explore opportunities to request reconsideration and/or settlement through an offer in compromise or similar authority. An offer in compromise often allows a taxpayer to settle its assessment liability for less than the full amount and may be less risky for a taxpayer than further litigation in court.
Tip No. 3: Once the audit is complete, evaluate the issues that drove the assessment in order to implement changes that will mitigate the results of future audits. For example, system changes or staff training may help reduce future audit assessments. If the taxpayer does not implement measures to address the audit issues, the jurisdiction may not waive penalties in future audit cycles.
Common Issues in Sales & Use Tax Audits
Tax Rate Changes
In a sales tax audit, the auditor will be reviewing sales transactions to determine if the proper tax rate was charged to the customer. If the taxpayer does business in multiple jurisdictions, it can be challenging to maintain updated sales tax rate tables. Taxpayers should review their internal process for updating tax rate tables. In addition, there should be a control process restricting personnel who have access to the rate tables and the ability to change tax rates. If the audit uncovers errors in the rates charged to customers, the taxpayer is unlikely to recover any additional tax from the customer.
The auditor will review exempt sales to determine if the taxpayer has the proper resale or exemption certificate. Ideally before, but definitely after, receiving the audit notice, the taxpayer should review its processes for obtaining resale and exemption certificates from customers. If a valid resale or exemption certificate is not on file, some auditors will allow the taxpayer to obtain one to document that the transaction was exempt. However, this can be problematic if the customer is no longer in business. In addition, auditors may find errors that may range from expired certificates to unsigned certificates or certificates that do not adequately identify the items purchased. Missing, invalid, or incomplete exemption/resale certificates can result in large assessments.
In addition to reviewing sales transactions, the auditor will be reviewing purchases to determine if items are subject to use tax. Taxpayers often purchase items that are consumed in the business from vendors that do not charge tax on the item. If the item does not qualify for an exemption, the item is generally subject to use tax, which may be a source of exposure for the audit.
One area to be cautious of for use tax assessments is the potential for double tax. For example, assume the auditor selects an invoice for employee uniforms on which the vendor did not charge tax. The auditor would assess use tax on that invoice. Assume the jurisdiction has audited the uniform vendor for the same time period and assessed the vendor on that invoice for failure to charge sales tax. Some auditors will check to see if the jurisdiction has audited the vendor so that there is no double tax.
Taxpayers should review each jurisdiction’s guidance on taking exemptions and credits, as well as refund opportunities. For example, some jurisdictions offer sales and use tax exemptions for machinery and equipment directly used in the manufacturing process. As the focus in many audits is on underpayments of tax rather than overpayment errors, the taxpayer may want to consider performing a reverse audit to determine if there are opportunities for refunds. If there is no time available to perform the reverse audit, a number of professional service firms specialize in this area. If a refund claim is identified, the taxpayer will need to determine the correct way to proceed with the refund claim. For example, the taxpayer may need to file a formal refund claim by amending returns or the auditor may accept other documentation to substantiate the refund.
Another frequent challenge in audits is document retention. Since most states have a three-year statute of limitation and most practitioners historically recommend that working papers be retained for five to seven years, it is important to note that if there is a suspicion of fraud, the auditors can question returns beyond the statute of limitation. When a taxpayer does not have sufficient records for the prior period under audit, the auditor may use the current data and extrapolate it back to the period under audit, which will likely result in a larger assessment than if the taxpayer did have records available.
Taxpayers that have had staff turnover or have acquired other companies may have challenges with historical documents. Auditors may want to review sample receipts, purchasing card detail, vendor invoices, and other documents that tax personnel may not easily find. Items purchased with procurement cards (credit or debit cards used by employees to purchase items for the business) can create potential issues for sales and use tax assessments. Some vendors may not transmit sufficient detail to the credit card company to determine if sales tax was paid at the time of purchase. Therefore, taxpayers should have other measures, such as keeping receipts, to support a use tax determination. Taxpayers should designate a primary contact person for the audit and inform other teams that their assistance may be needed to retrieve documents requested by the auditor.
If a taxpayer has received a notice for audit, the taxpayer or its accountant should inquire whether the jurisdiction has an amnesty program. A number of states have enacted amnesty programs designed to collect tax in a short period of time by providing a penalty waiver in exchange for payment of outstanding tax liabilities. Some jurisdictions allow taxpayers under audit to participate in the amnesty program as long as an audit bill or notice of deficiency has not been issued. For example, Colorado held an amnesty program from Oct. 1, 2011, through Nov. 15, 2011, and allowed taxpayers under audit to participate as long as the audit bill had not been issued before Oct. 1, 2011. Taxpayers that participated in the Colorado program were required to pay the full amount of the outstanding taxes plus 50% of the interest owed on or before Nov. 15, 2011. Taxpayers received a waiver of penalties and the remaining one-half of the interest. 3
Voluntary Disclosure Agreements
On uncertain issues with vague or no guidance available, voluntary disclosures or negotiated rulings may be a great alternative for taxpayers. In a voluntary disclosure agreement (VDA), a taxpayer that has a previous filing obligation in a state, but has not filed or remitted sales tax, registers for sales and use tax purposes, files delinquent returns for the lookback period, and remits the sales tax due. Many states have a limited lookback period for VDAs (generally three or four years). In addition, taxpayers may receive a waiver of penalties and some interest under a VDA. A negotiated ruling involves a taxpayer and a state negotiating the terms of sales tax collection and remittance, as well as rates and applicability of sales tax.
With taxpayers undergoing bankruptcy procedures, practical considerations often trump the traditional and often lengthy audit process. The process resembles an offer in compromise on grounds of doubt as to collectibility, not an appeal or a voluntary disclosure agreement. Taxpayers usually work with the audit staff first and then negotiate a settlement with the collections or bankruptcy staff of the state tax authority. Because federal rules apply in bankruptcies, a more favorable settlement of liabilities may be achieved due to the categorization of certain obligations as priority and nonpriority. In addition, the responsible officer/employee liability for uncollected sales taxes often involved in a state tax audit may be avoided in bankruptcy.
Managed Compliance Agreements
An emerging trend is to simplify audits or potentially avoid them by using new or nontraditional methods. Many state tax authorities offer managed audit or self-audit programs where the taxpayer performs the audit with the state’s guidance and review. A written agreement formalizes the arrangement, and the underpaid tax is due at the conclusion of the audit. Some of the penalties and interest may be waived on assessments from a managed audit program. In a managed audit, the taxpayer takes on an active role in the audit of the business, gains a more thorough understanding of how sales and use tax applies to its sales and purchases, and conducts the audit in a less invasive manner than a state-initiated audit.
A managed compliance agreement can offer a great benefit to taxpayers that purchase items frequently. Under a managed compliance agreement, 4 an effective rate is assigned to all of the taxpayer’s purchases, with a few state-specific exceptions (for instance, most states do not include capital accounts in managed compliance agreements). The agreement can assign an effective rate to all of the taxpayer’s purchases or provide for an effective rate for each individual expense account or cluster of accounts. Third-party advisers can assist taxpayers in applying the correct methodology to identify the effective rate and draft an agreement. The agreements are generally used prospectively and remain in place for varying periods of time. Managed compliance agreements reduce taxpayers’ overall compliance costs, may allow for a better quality of sales tax reporting, and should reduce the risk of an unexpected audit.
Some states, such as Texas, 5 only allow taxpayers to undertake a managed audit for sales and use taxes. Other states have broader managed audit programs; for example New Mexico’s program includes gross receipts, compensating use tax, corporate income, withholding, and personal income taxes. 6
Many of the emerging trends in state audits do not favor the taxpayer. Modern-day auditors are more educated about taxpayers’ businesses and use many resources to acquire meaningful information about a business. With longer audit cycles becoming increasingly common, it is critical to retain detailed records for a longer period of time, particularly for acquired or sold business operations. When records are unavailable, auditors are more prone to project the available old data to newer periods or project new data to older periods, potentially distorting the results. To make matters worse, auditors apply knowledge from prior audits of the taxpayer or even other companies in the same industry to the audit at hand. As a result, auditors may assert liabilities that are not supported by the actual audit sample. Finally, with technology advancements, auditors are becoming more tech-savvy and request access to electronic records as well as using computer audit specialists.
Service providers should familiarize themselves with their clients’ websites to anticipate potential red flags and questions and should ask for a copy of the auditor’s file to find out what kind of information the auditors use and have already gathered on the taxpayer under audit. More importantly, the taxpayer and representative should set the factual record straight on day one and proactively deal with any factual misconceptions. By crafting a proper game plan for each audit, managing all of their audits and auditor expectations, and dedicating themselves to document processes, taxpayers can streamline their sales and use tax audit defense function.
1 Internal Revenue Manual §4.1.3, Source of Returns—Priority Programs—DIF and Ordering.
2 See, e.g., N.D. Office of State Tax Comm’r, Taxpayer Bill of Rights (requiring notice of determination be sent no later than 12 months from the commencement of the audit). See also Va. Dep’t of Taxation, Virginia Taxpayer Bill of Rights (audit will be conducted “in a timely manner); Fla. Dep’t of Rev., Florida Taxpayer’s Bill of Rights (audits will be completed “in a timely and expeditious manner”); La. Dep’t of Rev., Louisiana Taxpayer’s Bill of Rights (taxpayers have right to receive information on “estimated time, scope, and extent of the audit”).
3 Colo. Rev. Stat. §39-21-201.
4 Managed compliance agreements may also be referred to in different jurisdictions as simplified procedure agreements, alternative use tax payment methods, single use tax compliance agreements, negotiated rate agreements, or effective rate agreements.
5 Tex. Tax Code §151.0231.
6 N.M. Tax. and Rev. Dep’t, FYI-404, Managed Audits for Taxpayers (January 2012).
Theresa Esparza is director of tax for P.F. Chang’s China Bistro in Scottsdale, Ariz. Jennifer Jensen is a director with PwC in Washington, D.C. Alesia Parfiryeva is a state and local tax associate with PwC in McLean, Va. Ms. Esparza and Ms. Jensen are members of the AICPA State & Local Tax Technical Resource Panel. For more information about this article, please contact Ms. Jensen at firstname.lastname@example.org.