Mitigate Audit Risk with Your Sales Tax Procedures
Federal tax reform has made big news this year, but the state level is another animal altogether. Each state is almost like a different country when it comes to taxes, and state regulations can evolve from year to year. Therefore, it’s essential to consider reviewing your sales tax procedures on a regular basis. This is especially true if you have been doing business in multiple states for years and have not reviewed your procedures in some time, have never reviewed your procedures, or if you're planning to expand into additional states.
While some of our clients have gone on to recover overpayments on their sales tax, the goal should not be receiving a hefty refund check. Your goals should be avoiding overpayment on sales tax in the first place and protecting your organization in the event of an audit.
The questions you need to ask yourself:
- Do I have nexus in a particular state, and should I be filing?
- Have I been filing in a particular state for years, but have never looked deeply into that state’s rules and regulations?
- Has it been over a year since I last reviewed my sales tax procedures?
And the most important question you should ask yourself:
- Will my sales tax procedures mitigate the risk to my company if we get audited?
In order to properly address all these questions and put the proper procedures in place, you really need to know your business. That is not necessarily an “Aha!” moment for many business owners, but as you’ll see in the following examples, it’s critical to really understand what you’re selling, what you’re buying, and how your business might be classified in a particular state based on the kind of business you conduct there. You may think you know the answers, but the consequences of being wrong can be great in disrupted cash flow, reputation, and penalties.
Properly Documenting Sales Tax Procedures Matters
Case A: Know Your Business and Defend Against an Audit
In this case, a particular state alleged that a client was not properly collecting sales tax. The charge was made during a routine audit of the client, and the basis for the state’s position was that the client was operating as a retailer. As a result, the state assessed the company for a large amount of owed sales taxes.
However, in this particular state, the client believed it was operating as a contractor, not as a retailer. The client had the procedures in place to pay sales tax on materials at the time of purchase and not to charge sales tax at the time of subsequent sale. As a contractor, the client was following the correct procedures they had set in place, and they were ultimately able to defend their position and receive a refund for the taxes they paid as a result of the audit.
While this is a very simple example of how misclassifying a business can lead to less than desirable consequences, the fact that the client truly understood their business and how they were operating in that particular state provided an opportunity to successfully appeal the findings of an audit.
But what if the client had been wrong? Even if the client’s position had been incorrect, having done the due diligence to develop and follow documented procedures may have earned them some leniency with the state. With the complexities of individual state tax laws, having the ability to show that you’ve done your homework, albeit incorrectly, could lead to less severe penalties.
Case B: Develop Rigor in Reviewing Your Procedures
This case involved another contractor—installing into real property—that hired subcontractors to assist on many jobs. The contractor’s tax system was set up to pay use tax on all materials that were installed. But after reviewing their procedures, the contractor realized that they were accruing use tax on one of their subcontractor invoices for the installed materials.
At first glance, the subcontractor invoices looked like a sale of material only. But after a detailed review of invoices and the subcontractor’s contract, it was determined that the subcontractor was actually installing the material—and paid tax when they purchased the material. The contractor should not have been paying use tax on their subcontractor's invoices, and therefore, they received a large refund of overpaid tax.
Avoiding Risk—It’s Not Just About the Refunds
While these examples resulted in large refunds of tax overpayments due to one reason or another, remember that it’s not just about refunds. You need to consider your risk as well. Beyond the risk of not being able to successfully defend against an audit, there are other reasons you need to establish and regularly review your sales and use tax procedures and documentation. For example, if you’re considering a merger or acquisition, you’d better have your ducks in a row. The valuation of your company can be negatively affected by failing to have strong procedures—and the necessary filings—in place.
Analyze and define your products and services for taxability—do you sell repair services, installation, maintenance contracts, SaaS software, etc? If you’re selling a non-taxable service, are you sure that you’re paying correctly on your inputs and/or purchases to provide that service? When you receive an invoice, do you know how to treat it? Do you know how to treat a product or service in different states?
It’s time to review:
- The taxability of your revenue stream (services and products).
- Whether or not sales are being sourced to the correct states.
- Exemption certificates—are they valid and acceptable for each state?
- Tangible personal property vs. real property taxability.
- Purchases to ensure use tax is being paid and also to ensure that tax isn’t being paid on nontaxable items.
If you have any questions about this article or your sales and use tax procedures, you can reach out to Teri Grahn, CMI today to start a conversation.