One of the last things you want to hear is that your company has been selected to undergo a sales tax audit by a state (or scarily a local government authority). Being audited can be scary, dreadful, or even frustrating. Instead of feeling defenseless or overwhelmed, there are steps you can take to manage the audit, take control of the process, and ease the burden. We have assisted many companies with their sales and use tax audits over the years, and in doing so, we have accumulated a vast amount of knowledge about the best practices in managing a sales tax audit effectively.
The first step of any sales tax audit is being notified by the state that you have been selected for audit. Once this notification happens, you can start preparing for the audit immediately. Instead of throwing your hands up, this is your first opportunity to take control of the situation. For the period under audit, the first thing you will need to do is gather the relevant records. This blog post will outline three critical elements that you need to consider to successfully gather and prepare your records for a sales tax audit.
In preparation for the audit, the first thing to do is identify the audit period and check the statute of limitations. Then make sure that all the requested records as well as other anticipated records are available for the specified audit period. Once you determine where your records are stored either physically or electronically, you will need to obtain them. Most records are stored digitally on a company network, but they may or may not be readily available to you. If the records are physically stored in a warehouse, off-site, or managed elsewhere, you will need to determine how long it will take to retrieve any off-site records or digital files managed by others or other departments (e.g., Accounts Payable, Sales, Accounting, Fixed Assets). The records may not be instantly accessible, so you will want to start this process early to allow time for you to gather and review the records prior to providing them to the auditor.
So what types of records will the auditor look for in a sales tax audit? The auditor will probably include a lengthy list of requested items for the audit period in the audit notification letter. These are the ones that are normally requested:
Depending on your legal entity structure and reporting, providing some of the items above may not be a viable option for your business as such records may not correlate at a state sales tax level (e.g., Federal and State income tax, Bank Statements). Identify what you can provide and be prepared to explain items that are not logical to provide.
Once you have compiled the records, you will need to evaluate the condition and completeness of the records ensuring all months of the audit period and all data types are present. If you are finding holes in the records, you will need to track that information down. Because of the time this may take and given potential system or provider changes during the period being audited, again you will want to start this process as soon as possible upon being notified of the audit.
Keep in mind that for expenses and sales, a sampling method is usually the approach of the auditor, so you might not need to provide all the records until discussed with and confirmed by the auditor. Knowing that you have the records available and accessible helps you prepare for the sample selection.
While gathering the records, you may identify issues. These should be addressed prior to the auditor’s arrival or audit start date if performed remotely and may need to be discussed with the auditor during the determination of audit procedures. The following are potential record issues:
The reason you want to be aware of these issues is because they may affect any sampling procedures performed by the auditor. The auditor will need to trace a transaction and, if taxable, trace the tax paid or collected on the transaction.
If there are issues with records such as destroyed or missing records, you will want to come up with alternative options to discuss with the auditor. With electronic records, this audit trail may not be evident, so the auditor will need to review the taxpayer’s procedures on paying or collecting the appropriate taxes on these types of transactions and you will want to know your company’s methodology so you can properly advise the auditor.
With the standard presently being electronic records, where no paper exists, not having a proper audit trail of the electronic records or controls to ensure validity can put the taxpayer under additional scrutiny by the auditor. The taxpayer must have good internal controls when faced with an examination of electronic data. In preservation of electronic records, transparency is critical for the taxpayer. Utilization of standard operating procedures on systems operations and data retrieval will provide internal controls validation under audit.
Once the records have been located, a brief internal review is advisable to identify any major exposure areas. Potential exposure areas may include:
An effort should also be made to obtain any missing, incomplete, or invalid resale, exemption, or direct pay certificates to support all tax-free sales. Review the exemption certificates to ensure the proper form was provided and completed with all required fields (date, signature, purchaser name and registration number, description and use of purchase with exempt reason). This is the time to go back to your customers and obtain valid certificates if you do not already have them. Ideally, this would have been done at the time of the transaction to exempt the sale.
It may also be a good time to consult outside advisors to discuss recent developments in the tax laws or to perform a review of significant exposure areas or potential overpayments or credits. While the auditor is looking for tax underpayments, you should look for tax overpayments and use the audit as an opportunity to request a refund if you discover situations where you accrued and paid sales tax on your purchases or over-accrued in error (non-taxable item). You should also review tax returns and reconcile them to the General Ledger before the audit takes place to ensure there was no tax collected and not remitted.
While we have provided the above information to help you prepare for a sales tax audit and to do so effectively, there is much more information we can share with you that will take you through the entire sales tax audit process and provide useful tips and best practices.
For more helpful information about audit defense, download the Sales Tax Institute’s FREE whitepaper: Best Practices for Managing a Sales Tax Audit. This free whitepaper contains valuable information that can help you proactively prepare for an audit, from before the audit to post-audit strategies.
You can also take the in-depth Audit Empowerment: Techniques and Tips to Pass Your Next Audit on-demand webinar training that will take you through best practices that ensure a better outcome for you at every step of the way – from getting the audit notice to post-audit strategies.
About the Author:Diane L. Yetter is a strategist, advisor, speaker, and author in the field of sales and use tax. She is president and founder of YETTER Tax and founder of the Sales Tax Institute. You can find Diane on LinkedIn and Twitter.