You know how stressful it can feel if you’ve received a formal letter with the news of an upcoming sales and use tax audit. So let’s talk about the next steps.
What is an audit?
An auditor goes into an audit with two things in mind.
- They want to determine if your business has collected and remitted the proper sales tax amounts from your customers.
- They want to verify that you’ve paid or self-assessed the correct amount of sales and use tax on the purchases you’ve made during the set audit period. (The set look-back period is typically 3-4 years, but the statute of limitations varies.) The purchases will include both operating expenses and fixed assets.
What triggers an audit?
Several things can trigger sales tax audits. Typically states will use systematic methods and data to determine which businesses are at potential risk for under-reporting or underpaying sales and use tax. This is serious business; sales and use tax revenues account for a significant portion of the state tax revenue.
Here are some of the primary triggers we see.
- High-risk and complex industries: If your industry is known for non-compliance or under-reporting sales taxes, that raises a red flag. The same goes when you operate in a high-revenue, high-volume industry with complexities around sales and purchases. Some examples include oil and gas, construction, retail, and manufacturers.
- A high number of exempt sales: If your business issues resale certificates often or claims a high amount of exempt sales or deductions, auditors like to scope that out.
- A large refund claim: This invokes questions about where the claim came from and why the large refund came about.
- Filing inconsistencies: If you consistently report or file sales taxes late, tax authorities may feel there are things they need to scope out.
- Audit history: If you’ve been audited in the past and sales and use tax liabilities were found, chances are you will be selected for future audits.
These are common triggers, but tax authorities don't need a catalyst to launch an audit. States schedule random audits or use statistics to select an audit. So it’s best to be prepared.
Three steps to prepare for an audit
Providing well-organized documents that are filled out accurately can help ensure a smooth process. Here are the records you need to ensure you are ready.
1. Have the relevant documents ready.
All taxpayers must maintain an accurate, thorough audit trail for taxes charged, reported on a return, and paid to the tax authority. This includes returned items that result in a sales tax credit. Often, an auditor will request the following.
- Federal income tax returns
- Fixed asset schedules
- Sales journals
- Purchase journals
- Sales tax return documentation
2. Ensure your records are accurate.
Before an audit, you need to know whether your products or services are subject to sales and use tax. Make sure you completely understand the sales tax taxability rules, who you’re selling to, and how your customers are using the products or services. This can all affect your audit. It is crucial to be mindful and aware of this and have a simple taxability matrix. This step is vital, and it can be helpful to work with a sales tax expert to ensure you have all your ducks in a row.
3. Make sure your exemption certificates are correctly filled out and up to date.
Certificates are the low-hanging fruit for state auditors. If you have exempt sales, you must maintain the exemptions certificates. Typically buyers submit their exemption certificates to you. However, it is the sellers' responsibility to have the proof. A taxpayer who claims that some of their sales are for resale and not subject to sales tax must be able to provide fully completed and valid resale certificates. This will substantiate the amount of sales for resale. If the auditor finds exemption certificates are missing or incomplete, the auditor may allow you to get a new exemption certificate or affidavit from the purchaser. However, do not rely on this because sometimes these options are unavailable. An invalid certificate can be deemed taxable by the auditor.
It’s important to know whether the products and services you provide to your customers are subject to sales and use tax.
Conclusion
Abraham Lincoln once said, “Give me six hours to chop down a tree, and I will spend the first four hours sharpening the ax.” If you put a reasonable effort into preparing for an audit and sharpening your process, the audit will resolve itself.
Let us ensure you are ready. Contact us for a free consultation through a What’s Next call. We look forward to hearing from you!
