States are stepping up their audit efforts to identify new taxpayers, create additional tax revenue and close their budget gaps. If you start preparing for a sales & use tax audit the day the audit notification letter arrives from the state taxing authorities, then you are already behind the eight ball. Preparing for your next audit should start as soon as the last audit ends (or even before), correcting the errors that were identified by the previous auditors and establishing guidelines or procedures to improve the audit process. While most companies today are pressed for time and resources, there are number of relatively easy things you can and should do before the audit starts to help you get up to speed on potential issues and prepare for the audit.
Respond to the audit notice
A sales & tax audit will not go away by simply filing the audit notification letter in the old circular file or putting off contacting the auditors to schedule the audit appointment. Before calling the auditor, read through the notice and check the basics (i.e., entity name, taxpayer identification number, audit period, etc.) to determine who is being audited and for what period. This is especially important for companies with complex operating structures and multiple entities, as the extent of an audit for a holding company can be vastly different from an audit of one of its operating companies.
The letter from the auditors usually includes a jaw-dropping list of records, documents, and other information that is needed for review during the audit. It evokes memories of the wish list you wrote to Santa Claus when you were a child. Some of the information requested on the Information Document Request (IDR) is absolutely essential to the auditors, while other requested information isn’t as relevant to the audit. It is important to know the right amount and type of information that will assist the auditors and keep them focused on the audit at hand rather than bog them down with extraneous details. Ask the auditors what records or documents they primarily need to start their audit, then provide additional information as requested. In turn, ask the auditors to provide you with a copy of their audit manual and their state’s Taxpayer Bill of Rights. Knowing your rights and what the auditors’ roles and responsibilities are will help you do your job better and protect your company’s interests.
Finally, when you call the auditor to schedule the audit appointment, take into consideration that you and your staff need time to prepare and gather the records and documents for the audit. Don’t be alarmed if the auditor asks you to sign waivers extending the statute of limitations for periods in the audit that might be expiring, especially if you delay scheduling the audit for several weeks or months. At this stage of the audit, signing waivers and cooperating with the auditors should benefit you and your company in the long run.
Conduct your own review
Once the audit is scheduled, take a closer look at what the auditors will be reviewing. Conducting your own review of the following records, documents, and information will not only help you identify potential issues but also give you some ideas on how to manage the audit process.
- Tax Returns – Review the sales & use tax returns that were filed during the audit period. Verify that your file copies include supporting documentation for taxable and nontaxable sales, as well as any use tax being remitted.
- Sales – Meet with the Sales or Accounts Receivable staff to discuss the availability of sales invoices. A review of prior year’s sales by customer may be warranted to identify large customers and potential issues. Also, check to see that resale and/or exemption certificates have been obtained from customers to document nontaxable sales.
- Fixed Assets – Meet with the Fixed Assets staff about capitalized purchases and related records and invoices. A cursory review of recent years’ assets additions will help identify potential exposure or refund opportunities.
- Payables – Meet with the Accounts Payable staff to discuss expense purchases and related records and invoices. A review of prior year’s purchases by account will highlight potential accounts the auditors may want to review based on dollar amount or the type of purchases.
- Data – Depending on the size of your company and the scope of the audit, the auditors may request that you provide your general ledger, accounts payable or other data in an electronic format. Meet with your IT professional about the type of data that may be needed. In our experience, providing auditors with electronic data is usually one of the most problematic steps in the audit process; and special consideration should be given to this during pre-audit planning.
- Prior audits – Review reports and schedules from prior audits to determine what issues caused past assessments, and determine if these issues were corrected going forward. Nothing contributes to the application of interest and penalties by the states more than not correcting prior errors.
Performing a self-audit or review of the above items will not only give you a better idea of the potential issues and exposure that might be identified during the audit process, but will also provide an added bonus of keeping the lines of communication open with other company employees whose functions either directly or indirectly impact sales & use tax compliance.
Develop a game plan for managing the audit
Now that you’ve scheduled the audit and have reviewed your sales & use tax records and documents to identify potential issues, it’s time to develop a game plan for managing the audit process. Identify a point person who will be responsible for interacting with the auditors on a daily basis; someone who can respond to information requests and questions and monitor the auditors’ progress. This individual should be well versed in the company’s operations and have a good understanding of the tax and financial reporting functions. He/she should also be knowledgeable in the audited state’s sales & use tax laws, especially if he/she is going to responsible for defending the company’s position and/or refuting the state’s assessment. Review – or establish – company policies related to auditor access of your facilities including documents and records, copy machines, where they can go and who they’re allowed to talk to. It might sound trivial, but you never know what the auditor might learn from other employees’ seemingly innocent discussions in the hallway or at the coffee machine.
Finally, take some time to consider several important issues that will need to be addressed early in the audit process, including the type of sampling methodology the auditors may want to employ for reviewing sales or purchases as opposed to performing a detailed review of all your records. A significant factor in choosing the sampling methodology is whether adequate electronic data is available, an issue which should be addressed during your self-review. Other things to consider include: your company’s policy for signing off on waivers to keep the statute of limitations from expiring on older periods; how sales & use tax overpayments will be addressed by the auditors; and what your company’s acceptable tolerance is for potential assessments. Addressing these and other issues upfront will make the audit process much smoother for your company.
If you have any questions about this or other State and Local Tax issues, please email Tom Mazurek at firstname.lastname@example.org. For additional State and Local Tax insights and resources, or to subscribe to our quarterly newsletter, visit tsacpa.com.