1. Expect an Audit
One of the first questions that may run through your mind is why your company was selected for an audit. There are numerous reasons for a company to be identified but here are some of the more common:
• Often jurisdictions will target certain industries for an audit. These industries generally have new or complex taxing rules that result in a high likelihood of you making a mistake along the way. Service industries or internet companies are some examples of recent targets.
• An audit of one of your customers may result in the review of your invoices and a determination that you’re not charging tax appropriately. The auditor will follow the trail of breadcrumbs back to you.
• A disgruntled employee that knows you are not charging tax correctly in a jurisdiction may report you to a tip-line.
• A random drive-by past one of your locations, or recognizing a delivery truck or employee at a trade show in their jurisdiction by an auditor could result in an audit.
• Unfortunately, sometimes audits are a result of chance.
• Jurisdictions do speak with one another which can lead to additional audits.
Once identified, you should expect a regular audit cycle especially if the initial audit findings were advantageous to the jurisdiction.
2. Maintain Compliance Documentation
Compliance documentation should be maintained in a fashion that is easy for an auditor to interpret. Many businesses find themselves in an audit without the appropriate documentation. When this happens, auditors will assume transactions to be taxable and in situations where you don’t have appropriate invoice or sales data, the auditor will make historical projections or an arbitrary assessment of taxable sales. Documentation typically required by an auditor to conduct a proper review includes the following:
• Sales tax accruals – Sales tax should be stated in your general ledger as a separate GL account number.
• Invoices – Both from a sales perspective and a purchase perspective.
• Returns/credits – Be sure these are clearly identified in your accounting system and appropriately invoiced.
• Exemption Certificates – Maintain accurate and complete exemption certificates for each exempt customer.
• Bad debt – Most states allow a deduction for bad debts that have been written off for Federal income tax purposes. Again, be sure this is clearly identified/documented in your accounting system.
• Miscellaneous adjustments – Any adjustments taken on your return should have supporting documentation. Most companies keep this documentation with a copy of the return filed.
• Consumer use tax accruals – These should tie to specific purchase invoices.
• Summary reports – Summary financials and tax reports should reconcile to the tax returns filed.
• Returns – All audits begin with a review of the sales and use tax returns but most auditors will request income tax returns as well. Gross receipts should reconcile between income tax and sales and use tax returns.
3. Assess Your Records
Once you’ve been notified of an audit, you’ll want to assess your own records and determine where you have gaps. You should make every attempt to identify your exposure prior to the audit. For example, you may recognize that you do not have the appropriate exemption certificates on file. Identifying this issue proactively may provide you the necessary time to go back to your customers and secure the missing certificates. Other exposure areas that are uncovered may lead you to manage the audit in a particular fashion. For example, if you discover a problem with your accounting system or a significant gap in taxability measures during a specific period of time during the audit statute, you will want to avoid sampling that period(s) if possible. If the period is identified and reviewed in detail by the auditor, you may be able to isolate that period from any sample as an outlier.
4. Process Review/Outline
It’s always helpful to provide an explanation of your business to the auditor. Be concise, but be specific in the way your business operates. Be careful about facility tours as these often turn up exposure areas. In a facility tour, an auditor will see the inner workings of your warehouse or manufacturing facilities. They may ask questions about how much time a forklift spends moving raw materials from the receiving dock to the initial step in the manufacturing process vs. how much time it is used to move finished goods in the warehouse. These two situations can have different tax implications.
5. Manage the Relationship
The auditor should always be treated with respect and dignity, just like any other business relationship you have. Keep in mind that auditors do have discretion in their findings. Additionally, you are likely to deal with the same auditor in a subsequent audit. So maintaining a good relationship can pay dividends in the future. You should align the auditor with one person from your firm to manage all questions and information requests. In some situations, an outside consultant can be helpful to align with the auditor to manage these questions and requests for information.
6. Manage What the Auditor Has Access To
Be careful about leaving the auditor alone in an environment where they have access to records or other employees. Prior to the auditor coming onsite, instruct employees that could come in contact with the auditor to not answer any questions but direct the auditor to the person you have selected to manage the audit. There are many examples of an auditor overhearing “water cooler” talk that led them down a path that resulted in an assessment.
7. Setting the Audit Sample
A typical audit will be conducted using a sampling methodology. Sampling methods vary from jurisdiction to jurisdiction and from audit to audit. It is important that you understand your historic business cycles and evaluate any proposed sampling method prior to acceptance. For example, if your business is cyclical, you will want to avoid a “block” sample (block samples apply the liability from one period, or account, across the entire audit period evenly). A statistical sample is usually ideal, but you should make sure you understand the statistical program used by the jurisdiction in its entirety before accepting this method. The goal should be to align your exposure with the periods in which the exposure has occurred or has the possibility of occurring.
8. Disclose Insignificant Items Proactively
In your pre-audit internal assessment, you may find that you did not charge tax on a particular item for a short period of time. Depending on the materiality and the likelihood the auditor will find this issue, it may be a good idea to disclose it proactively. This will give the auditor the perspective that you are willing to help them and may cause them to review your situation with less scrutiny. At the very least, it will provide additional rapport with the auditor and make the negotiation of ambiguous issues start to lean more in your favor.
9. Have a Process to Manage Exemption Certificates
Having a process around exemption certificate management is critical to a successful audit in many situations. Exemption certificates should be requested at the initiation of the order, reviewed for completeness and validity, and then managed for easy retrieval and for renewal upon expiration. With an effective process, initial audit exposure is reduced and hours of intrusive client contact requesting certificates after the fact are eliminated. As previously stated, after you have been notified of a pending audit, you should be able to assess whether or not you have a material weakness in your exemption certificate process. If you do, you have some time to request the certificates from your clients prior to the audit beginning. Similarly, in most situations, after an audit is assessed, you will have the opportunity to request exemption certificates in an effort to minimize your exposure. Requesting certificates before the audit and after the assessment can have its difficulty. First, you may find that some of your customers are no longer in business. You may also find that they are no longer customers and are unwilling to help you with this documentation effort. The best bet is a strong process on the front-end at the time of order processing.
10. Negotiate the Findings
The auditor will attempt to “sell” you on their findings. There’s usually some ambiguity associated with an auditor’s assessment that provides you an opportunity to negotiate the findings. Try to work with the auditor to understand their thought process and interpretation of the law as it relates to a particular transaction. You will want to maintain a good relationship in the event you are audited again. You should not unnecessarily go over the auditor’s head to their supervisor as this could create animosity. Also, mitigating an assessment through the appeal process can be time consuming and expensive. Of course, this may become your only viable option depending on the circumstances.
Brian Greer is a Partner at TaxConnex, LLC ( http://www.taxconnex.com ). TaxConnex is a sales and use tax specific consulting, advisory, and outsourcing firm focused on the small and medium-sized businesses. TaxConnex delivers our service through a network of CPA and CPA-trained Tax Practitioners. For additional information about TaxConnex and our sales tax audit support services please visit our website.