In most states, sales and use taxes are one of the most significant sources for funding public budgets. To combat the impact of the COVID-19 pandemic on various states’ economies, states are now looking for ways to increase their revenues. One approach is to increase the number of sales and use tax audits conducted. Unfortunately for many taxpayers, sales and use taxes can present significant areas of exposure.

What is a Sales Tax Audit?

A sales tax audit determines whether a business has collected and paid the correct amount of sales tax owed to the state for taxable transaction. During a sales tax audit, the auditor will typically take a sample of your purchase transactions, including invoices, credit card charges and more, and determine the percentage out of compliance.

How Are Companies Flagged for a Sales and Use Tax Audit?

Taxing jurisdictions will select a taxpayer for an audit for reasons including the following:

• A customer of the company was audited, and the company did not properly collect tax from the customer
• A vendor of the company was audited, and the vendor did not charge the company sales tax
• Size of the company
• Sales volume of the company
• The company has a high volume of exempt sales
• The company has filed returns with errors
• The company has filed returns late on a continuous basis
• Random selection
• The company was previously audited by the state and the prior audit resulted in tax due to the state

Audit Initiation Letter/Information Document Request

Generally, an audit begins with an auditor issuing an Information Document Request (IDR) to the taxpayer. The IDR will inform the taxpayer of the records the auditor will review in conducting the sales and use tax audit. The list of books and records that are typically contained in the IDR include the following:

• Sales tax returns and work papers for the audit period
• General ledgers
• Chart of accounts
• Sales journals and sales summaries
• Sales invoices
• Documentation supporting exempt sales
• Federal income tax returns and depreciation schedules for the audit period
• Fixed asset details including original purchase invoices for the audit period
• Purchase invoices for the audit period
• Financial statements and trial balances covering the audit period

Records Reviewed in a Sales and Use Tax Audit

Auditors will review several main categories of sales and purchases in conducting their sales and use tax audits to determine if the taxpayer’s sales and/or use tax is underreported on the sales and use tax returns filed with the jurisdiction. These categories include the following:

Sales Tax

Sales Reconciliation – The auditor will compare the gross sales reported on the sales and use tax returns filed to the gross revenue reported on the federal income tax return to see if there is an inconsistency. If gross income reported on the federal income tax return is higher than gross sales reported on sales and use tax returns, the auditor may assume sales are underreported.

TIP #1 – The taxpayer should compare the gross sales reported on the sales and use tax returns filed for that state to the sales by state schedule that ties to the gross revenue reported on the federal income tax return and should be prepared to explain any discrepancy to the auditor. A schedule should be prepared which shows the amount of the discrepancy as well as the reason for the discrepancy. In addition, the taxpayer should ensure that the sales by state schedule agrees to the sales reported on the general ledger to determine if there are any discrepancies.

Taxable v. Exempt Sales – If a taxpayer takes deductions for exempt sales on their sales tax returns, the auditor will request to review a sample of transactions to confirm that the documents required to support the claimed exemptions are accurate and readily available. Taxpayers need to understand that all sales are presumed taxable unless written proof to the contrary can be shown. Many taxpayers run into trouble in an audit because they did not keep the appropriate documentation to substantiate their taxable and exempt sales.

TIP #2 – A taxpayer should keep sales tax return workpapers that reflect the taxable and exempt sales reported on the sales tax returns, as well as the source for those amounts. This will make this portion of the audit process easier on the taxpayer since it is difficult to create these workpapers a few years later when audited.

Sales for Resale – A taxpayer who claims that some of their sales are for resale and, therefore, not subject to sales tax, must be able to provide fully completed, executed and valid resale certificates to substantiate the amount of sales for resale. When the auditor finds exemption certificates are missing or incomplete, most state auditors will give the business the opportunity to obtain either a new exemption certificate or an affidavit from the purchaser that the items sold were exempt. However, this may not always be possible if, for example, a customer goes out of business.

It should be noted that missing and/or invalid certificates can cause a substantial sales tax liability depending on the sample selected by the auditor. This is because the transaction covered by an invalid certificate will be deemed taxable by the auditor and the error rate generated from these transactions will be extrapolated across the entire audit period.

TIP #3 – It is very important for a taxpayer to review resale certificates, exemption certificates and direct pay permits to verify that these types of documentation are completed, dated, signed and valid. If the certificates are not fully completed, signed, and dated, the taxpayer should contact the resale or exempt customers and request replacement certificates prior to the audit. In addition, a policy should be established to review these certificates on a continuous basis even when the taxpayer is not under audit.

TIP #4 – A taxpayer should become familiar with the timing of when certificates must be received from a customer for the certificate to be deemed valid by an auditor. For example, New York State requires that a certificate be obtained from a customer within 90 days of the date of the sale/transaction.

Use Tax

Generally, use tax errors are the No.1 audit risk and most assessments are a result of use tax not being managed correctly.

Fixed Assets - Auditors will review all capital asset purchase invoices to verify that sales or use tax was paid on all capital assets acquired during the audit period. The auditor will typically use the depreciation schedules from the company's federal income tax return or the fixed asset detail from the balance sheet to isolate the capital assets acquired. Generally, if a capital asset is purchased and the vendor does not charge the taxpayer sales tax, the taxpayer will be liable for use tax on the capital asset that was purchased. Taxpayers who do not have a policy in place to review capital assets on a consistent basis can be caught unaware that they did not pay sales tax on these assets and are now liable for use tax.

TIP #5 – Fixed asset invoices should be carefully reviewed to determine whether the item purchased is taxable. If the item is taxable and sales tax was not charged by the vendor, the taxpayer should accrue use tax on the purchase and remit the use tax on their next sales and use tax filing. Putting a policy in place to review fixed asset invoices on a continuous basis (i.e., quarterly or monthly) will help the company determine whether there is any potential use tax liability on these assets, hopefully before an audit arises.

Expenses – Another area of concern for auditors is expense item purchases which the auditor will review to verify that sales tax was properly paid to vendors on purchases made by the taxpayer on a routine basis. When a taxpayer has a large volume of purchases, the auditor will typically request a chart of accounts and ask for the detail of transactions recorded to specific accounts and review those accounts for accuracy. These accounts generally include office supplies and expenses, computer expense, dues and subscriptions, repairs and maintenance, etc. The auditor will then choose a sample period to review, typically one year depending on the volume of purchases.

TIP #6 – It is imperative that a taxpayer retain and have readily available all purchase invoices requested by the auditor. Many taxpayers utilize company credit cards, or P-cards, to routinely purchase expense items. If this is the case, the taxpayer should ensure that all backup invoices for purchases made via credit cards are retained. The credit card statement alone will not be sufficient for an auditor to determine whether sales tax was paid on expense purchases.

TIP #7 - Taxpayers should make sure that purchases are booked to the proper corresponding general ledger account. Many use tax errors can be caused by poor accounting. For example, if the purchase of a computer, which is generally taxable for sales tax purposes, is booked to a general ledger account that use tax is not generally accrued on, the odds of use tax being accrued on that purchase if sales tax was not paid to the vendor are very low.

TIP #8 – It is important to negotiate the selection of the test period with the auditor especially if the company has made improvements to their use tax processes. In that case, the taxpayer would request that the auditor choose to review a period after the process improvements were made. In addition, some taxpayers may not have complete documentation for earlier periods in the audit period and would therefore request that the auditor choose a more recent period to review.

TIP #9 – There may be instances where an auditor finds that sales and/or use tax was not paid on a large one-time purchase and include this transaction as a taxable transaction in the sample. A taxpayer can request that the use tax be assessed on this large unique transaction separately from the rest of the sample, which will reduce the potential liability.

Waiver of Statute of Limitations

It has become a common practice for an auditor who is initiating an audit close to the expiration of a tax filing period to request that a taxpayer sign a statute of limitations waiver form as part of the onset of the audit. This will extend the statute of limitations and enable the auditor to complete their examination before the statute of limitations for any portion of the audit period expires.

TIP #10 – Taxpayers may be unsure whether they should choose to sign the waiver form requested by the auditor. A taxpayer may want to sign the waiver form if it believes there may be potential refunds that could offset the sales and use tax exposure. In addition, it may be a good idea to sign the waiver if the auditor indicates that the state will issue a jeopardy sales and use tax assessment if the waiver is not signed. A jeopardy assessment is an assessment estimating the sales and use tax that the state believes is due for the periods that will expire if the waiver is not signed. A taxpayer should avoid receiving a jeopardy assessment as these types of assessments rarely accurately reflect the taxpayer’s true sales and use tax liability.

Refunds

Although auditors are supposed to determine both underpayments as well as overpayments of sales and use taxes in an audit, the auditor’s main focus is usually to determine underpayments and few auditors will isolate overpayments.

TIP #11 – Taxpayers should consider including refund areas in their sales and use tax audits if the state allows. This is advantageous since interest is typically calculated on the net sales and use tax due. An area of overpayment can be used to offset an area of underpayment within the same tax period in some states, which may reduce the amount of interest and penalty assessed by the auditor.

Note: A taxpayer may want to concentrate on determining use tax overpayments for refunds vs. sales tax overpayments to reduce the overall sales and use tax liability due on audit. This is because in most instances, overpaid sales tax will need to be refunded to the customer that was charged the sales tax in error. This can cause an administrative burden on the taxpayer.

Penalty Abatement

At the end of the audit, an auditor will issue a Notice of Assessment. The Notice of Assessment will include the sales and use tax liability as well as penalties and interest assessed. Depending on the state, penalty rates can range from 5% to more than 50%.

TIP #12 – A taxpayer should request a waiver or abatement of the penalties. Most states require that the taxpayer request penalty abatement in writing and show reasonable cause for underpaying the sales and/or use tax. It may be a good idea to consult a tax advisor to determine what constitutes reasonable cause in a particular state.

Other Tips/Recommendations

TIP #13 – Develop a good working relationship with the auditor. Do not withhold information or cause unnecessary delays in responding to an audit request. The auditor will assume you are trying to hide something and dig deeper to find discrepancies and errors. It is a good idea to make the records easy for the auditor to follow and review. When penalties are asserted, auditors hold some influence over whether the assertion is upheld before the case is closed. A taxpayer who treats the auditor with respect and cooperates throughout the audit process stands a much better chance of having penalties abated.

TIP # 14 – Maintain complete and accurate documentation in a manner that is easy for an auditor to follow and review. When a taxpayer cannot provide the appropriate documentation requested by the auditor or the documentation is incomplete, the auditor will assume the transactions are taxable. This will result in the auditor making historical projections or issuing an arbitrary assessment of taxable sales.

TIP # 15 - Automate your sales and use tax process as much as possible. This will take human error out of the equation and improve efficiency as well as accuracy.

TIP # 16 - Evaluate the taxability of the products and/or services that you sell. It may be a good idea to hire a tax advisor to prepare a taxability matrix if the taxability of the products and/or services you provide is complex.

Reverse Sales and Use Tax Audit

The goal of a reverse sales and use tax audit is to identify and recover overpayments of sales and/or use tax made to a particular state. Many auditors are so focused on finding underpayments throughout the audit process they do not focus significant time and effort on finding overpayments or refund opportunities. Therefore, it’s a good practice for a taxpayer to conduct a reverse sales and use tax audit on a routine basis either on their own or by enlisting the help of an experienced tax advisor.

The steps for completing a reverse sales and use tax audit are very similar to the steps taken in a traditional sales and use tax audit discussed above. A taxpayer should review purchase invoices for fixed assets and expenses and determine if sales tax was paid on items that are not subject to sales tax in a particular state. Once a taxpayer has identified overpayments, they can contact the vendor directly and request a refund of the sales tax paid to the vendor or apply for a refund with the applicable state taxing authority. Some states require the taxpayer to request the refund directly from the vendor while other states allow a taxpayer to request a refund directly from the tax authorities.

A reverse sales and use tax audit can be a useful tool for a taxpayer to obtain refunds on overpayments of sales and use tax. It can also help ensure that the taxpayer does not overpay sales and use tax on issues identified in the future, thereby improving cash flow.

For More Information

For specific comments, questions, or concerns about how to manage the sales and use tax audit process, please contact a member of our team. 

Copyright © 2022, CBIZ, Inc. All rights reserved. Contents of this publication may not be reproduced without the express written consent of CBIZ. This publication is distributed with the understanding that CBIZ is not rendering legal, accounting or other professional advice. The reader is advised to contact a tax professional prior to taking any action based upon this information. CBIZ assumes no liability whatsoever in connection with the use of this information and assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.

CBIZ MHM is the brand name for CBIZ MHM, LLC, a national professional services company providing tax, financial advisory and consulting services to individuals, tax-exempt organizations and a wide range of publicly-traded and privately-held companies. CBIZ MHM, LLC is a fully owned subsidiary of CBIZ, Inc. (NYSE: CBZ)