As any business that has gone through a sales and use tax examination knows, a field audit can be time-consuming and expensive and can wreak havoc on the business's financial health. Large assessments for uncollected sales tax, under-accrued use tax, interest, and penalties can drain cash, force unanticipated borrowing, impair debt covenants, and, ultimately, cause some companies to close their doors.
As a result, management, attest professionals, and tax advisers are placing greater emphasis on identifying and controlling sales and use tax risk. For companies that report their financial results using GAAP, it can be argued that such risk management is not optional. FASB Accounting Standards Codification Topic 450, Contingencies, requires businesses to record contingent liabilities that are probable, i.e., likely to occur, and can be reasonably estimated. Publicly traded corporations also have the task of ensuring their sales and use tax systems meet the internal control requirements of Section 404 of the Sarbanes-Oxley Act of 2002, P.L. 107-204.
This process extends into the "due diligence" arena as private equity has become a key source of financing for U.S. businesses. Neither the seller nor the buyer of a target company wants to find out at the 11th hour of negotiations that the purchase price must be substantially revised due to unanticipated sales and use tax exposure.
An emerging tool in addressing sales and use tax risk is a "policy and procedures" review. The following sections discuss key aspects of such a review from the perspective of an outside adviser.
There is no standard way of conducting a policy and procedures review. However, to initiate a study, a practitioner should request tax calendars, returns, workpapers, taxability matrices, and policy manuals from the subject company. Collectively, these documents can provide a road map on how the company makes taxability decisions and who is designated as a responsible party for the process. Purchasing, accounts payable, information technology (IT), accounting and finance, and accounts receivable personnel should be interviewed to understand their roles in the sales and use tax compliance system. These individuals can give insights into strengths, weaknesses, and possible process improvements.
An organizational chart should be analyzed for entities that have reporting responsibilities. While disregarded entities are not treated as separate taxpayers for income tax purposes, they may be required to register for sales and use tax. If appropriate, examine intercompany transactions for taxability.
The sales tax review should begin by breaking down the company's revenue streams to learn how it determines the taxability of each component. Companies may use tax matrices or automated software product mapping, both of which should be examined in a policy and procedures review.
Sellers of taxable goods and services should obtain and maintain exemption certificates from their customers. If documentation is not received, tax should be charged, collected, and remitted in all states where the company maintains sales tax permits. The review should determine if and when exemption certificates are collected (at point of sale or during new customer setup). It is also important to determine who is responsible for evaluating the exemption certificates' accuracy and completeness. Upon audit, a sale may be deemed taxable if an exemption certificate is missing or incomplete. Best practices call for the company to collect such documentation even when it is not registered in a state, especially when it may have nexus with the state. Sampling to match sales transactions when no tax is charged to exemption certificates will test the company's procedures.
Practitioners should review how the company applies sales tax rates. The company may do this manually or with the assistance of compliance software. It is critical to understand how the company accounts for state and local tax rates, as there are an estimated 7,500 taxing jurisdictions in the United States. Local sales tax can be a troublesome area since sourcing rules vary among states. Many source based on the destination of a sale, but others, such as Illinois and Ohio, rely on a "point of origin" concept.
Prior sales tax audits will detail areas of concern. Discuss with management whether those weaknesses have been corrected or addressed. If they have not, exposure likely exists not only for tax and interest but also for negligence penalties ranging from 10% to 25%.
Finally, a practitioner should look at sales tax returns and all accompanying workpapers. Testing the sales tax process will ensure the company puts its procedures in practice. Review sales tax payable accounts to make certain all tax collected by the company is remitted timely. Sales tax is a fiduciary tax, and businesses may be liable for fraud penalties if they hold unremitted state and local sales taxes. Reports generated from enterprise resource planning (ERP) software, other accounting systems, or sales and use tax compliance software should be examined to confirm the company is reporting all sales (taxable and exempt) on its returns.
A goal of testing the use tax function is to determine how taxability is considered throughout the purchasing cycle. Taxability considerations may be made at the time a purchase order is issued, when a vendor invoice is received, or when sales and use tax returns are filed.
A company may automate use tax compliance with software by applying a taxability classification to a vendor or purchase order line item basis. If correctly used, the system should automatically accrue use tax on taxable invoices that are processed by accounts payable without tax. The system should work in reverse by highlighting overpayments on nontaxable purchases. An "exceptions report" may be generated by the person responsible for filing sales and use tax returns.
If software is not used, taxability decisions can be made manually, assuming a review process is in place. Interviews can identify persons responsible for reviewing the tax status of individual invoices. Best practices require the responsible person to have procedures for determining taxability, confirming correct use tax rates, and handling rate or tax discrepancies.
It is important to understand where the company spends money, as there may be different processes for procurement cards, IT purchases, fixed assets, or leased property. Purchase orders can be an important source of use tax information. Companies often overlook procurement or purchase cards when accruing tax. Companies should make sure they collect receipts from users and evaluate purchases for use tax. If documentation of sales tax paid is not retained, an auditor may impose tax on all transactions without alternate proof.
IT department purchases of hardware and software can be an area of high risk due to the materiality of some transactions. In today's e-commerce economy, technology vendors often provide IT services and products through a remote connection. They do not maintain sellers' permits in all taxing jurisdictions where sales are made. Tax practitioners should review software contracts, licenses, and method of delivery to determine taxability. Electronically downloaded software and software as a service (SaaS) are taxable in some states but not in others.
Attention should be given to the fixed-asset requisition process where controls may be separate from general purchasing. If the company leases machinery or equipment, examine leasing agreements. Cost centers and general ledger accounts can be used to identify the use or nature of a purchase.
One of the biggest system problems businesses create is failing to register for and accrue use tax. They are, in effect, "rolling the dice" that their vendors will apply the correct state and local sales tax to their purchases. The absence of a use tax permit or use tax accrual general ledger account is both easy to spot and signals the need for an in-depth review.
After the reviewer understands the use tax procedures, the review should turn to testing the system. Request the most recent vendor spend distribution and complete fixed-asset listing. Draw a sample from high-dollar general expense accounts and vendors from which taxable goods and services are purchased. It is good practice to examine all fixed-asset purchases since the amount spent on fixed assets is typically material. Fixed-asset and payable reviews should consider overpayments and under-accruals. Large overpayments represent an equal failure in a company's compliance system and result in an unnecessary cost of doing business.
Do not overlook real property improvements, expansions, or other construction projects. It is common for companies to rely on local contractors to correctly assess sales tax on new construction or repairs. State contractor laws can be extremely complex and vary by state. For example, Texas taxes nonresidential construction if it occurs within an existing building footprint.
The strengths and weaknesses of the company's compliance system should be cataloged and any exposures quantified if possible. The reviewer's conclusions should be discussed with management. Possible recommendations to mitigate observed risk may include establishing written policies or procedures, identifying responsible parties for tax compliance, or providing formal training for company personnel. Industry best practices may also involve exploring automated or outsourced options.
If material underpayments are identified, the company should contemplate voluntary disclosure agreements or amended returns. Overpayments can be recovered by claiming refunds, amending returns, or contacting vendors.
Sales and use taxes are a primary source of revenue for state and local governments. In 2014, they accounted for 47.5% of total state tax collections (U.S. Census Bureau, State Government Tax Collections Summary Report: 2014). It is self-evident why tax authorities are devoting greater resources to identify nonfilers and improve the accuracy of filed returns. The recent adoption of a sales tax economic nexus standard, i.e., physical presence not required, by Alabama and South Dakota is just one example of the growing importance of sales tax revenues to state governments.
The risk posed by state and local sales and use taxes should be viewed in the same manner as other business risks (e.g., product liability, theft, and casualty). Management acts prudently by purchasing insurance to cover these risks to prevent catastrophic damage to operations. A policy and procedures review, properly designed and executed, similarly provides "insurance" from a sales or use tax disaster.
Mark Heroux is a principal with the Tax Services Group at Baker Tilly Virchow Krause LLP in Chicago.
For additional information about these items, contact Mr. Heroux at 312-729-8005 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.