Sales and Use Tax Audits (#230)

In this podcast episode, we discuss sales and use tax audits. Key points made are noted below.

The state government may send a team of auditors to a business, to see if it’s been remitting the correct amount of sales and use taxes. If it hasn’t, the business not only has to pay the missing amount of taxes, but also interest on the unpaid amount and penalties.

Your Chances of Being Audited

Who is most likely to be audited? Look at it from the perspective of the government. Audit teams are expensive, so they need to be targeted at businesses that are most likely to end up paying more in fees and penalties than the cost of the teams. This means larger firms are more likely to be targeted. In addition, if an audit team finds a significant problem, the business will probably be put on a watch list, and so is more likely to be targeted again in the future. This does not mean that a small business will never be audited, but it is less likely.

Another possibility is that a company will be audited as the result of an audit of someone else. For example, a supplier is audited, and the auditors note that the company wasn’t charged sales tax on a large invoice. They then target the company to see if it paid use tax on that invoice. Use tax compliance tends to be much worse than sales tax compliance, so this kind of investigation can be easy money for an audit team.

How Auditors Find Errors

How does an audit team find sales and use tax errors? They send a notification to the targeted company, stating which time periods they want to look at. When they arrive, they select a sample of the customer billings and supplier invoices from these periods, and see if there were any cases on these invoices where sales or use tax was not paid. When no tax was paid, the auditors see if there was a valid sales tax exemption certificate that was the basis for the nonpayment. The auditors also check to see if all sales and use taxes were remitted to the government, both in full and by the required payment dates.

The auditors may go even further, and investigate whether any sales made to dispose of old assets had sales taxes charged on them. After this work, the auditors compile a list of all exceptions found, and forwards them to the company controller for review. At this point, keep in mind that the business is assumed to be guilty unless it can prove otherwise, so the controller has to make a valid case for why sales or use tax was not paid.

The Error Rate Extrapolation

If the controller cannot make a persuasive case to the auditors, then the exceptions are included in an error rate extrapolation. What this means is that the auditors extrapolate the error rate percentage they found in their sample to the full population of customer billings and supplier invoices.

For example, if the auditors find that $100 of sales tax was not collected in a sample that comprises ½% of a company’s total sales volume, it will extrapolate this finding to the rest of the company’s sales – which in this case results in a total charge for uncollected sales taxes of $20,000. And then, the auditors add a late payment interest charge onto the extrapolated amount, plus penalties. The result can be a startlingly large amount that has to be paid.

Pursuing Customers for Sales Taxes

It is technically possible that a business could go after its own customers for sales taxes that it never charged them, but this is not likely, either because it damages customer relations or because the sales occurred so far back in time that collecting the amounts due is impossible. So instead, the company has to pay the entire amount.

Damage Mitigation

How can we minimize the damage caused by one of these audits? First, conduct a periodic review of the Department of Revenue’s listing of what is and is not exempt from sales tax. This is most applicable when the company currently is able to not charge sales tax, since that exemption could go away. Second, if customers have submitted sales tax exemption certificates, make sure that they’re up-to-date and completely filled out. If not, the certificates are not valid and sales tax must be charged. Third, make sure that there’s a solid process in place for calculating and paying use tax. This is an area that’s usually quite weak. And finally, conduct your own internal audit to see if any exceptions crop up. If they do, figure out how the process broke down, and fix it.

How to Treat Auditors

An additional issue is how to treat auditors when they show up on the premises. As an overall guideline, these people are professionals, so treat them with respect and give them a decent amount of office space to work in. That being said, there are a few guidelines for minimizing the damage they can cause. First, have them work in an area away from the rest of the employees, so that they don’t overhear conversations that might cause them to expand their audit. Second, have just one point of contact between the auditors and the rest of the company, and have this person carefully review everything submitted to the auditors. Doing so keeps the auditors from ever receiving inaccurate or misleading documents. And third, minimize communications between the auditors and the rest of the company. It is not helpful for the auditors to walk around, quizzing everyone about what they do and trying to dig for more information. So, talk to the accounting staff before the auditors show up, and tell them to only respond to direct questions and to not volunteer information. And finally, don’t volunteer to give them a tour of the company. If they get a tour and then see some large and expensive equipment on the premises, they may want to investigate whether sales or use tax was paid on it.

Parting Thoughts

In general, the key to surviving a sales and use tax audit is to have solid systems in place already, so the auditors won’t find much of anything to include in their error rate extrapolation. This means that charging sales tax to customers should be your default method of operation. Any sales tax exemption certificates from customers should be well-organized and reviewed on a regular basis. There should be a solid use tax calculation system in place. And finally, make sure that sales and use taxes are paid on time, every time.

Related Courses

Sales and Use Tax Accounting