When the Sales Tax Auditor Comes
Sales tax audits are on the rise in most states. This is due to budget shortfalls of states across the country. In fact, state auditors are much more aggressive than the auditors at the IRS. The state has the power to do massive damage to a business as a result of a sales tax audit, including arresting the owners of the business.
Fear the state, even more than the IRS.
Sales Tax Audits: The Background
States are allowed to require businesses to collect sales tax if their sales into the state are over a specific threshold. This is true even if the business has no physical presence in the state. This is based on a 2018 Supreme Court ruling in South Dakota v. Wayfair, Inc.
It is incumbent upon businesses to determine where they have sales tax exposure, based on this broad standard. Not surprisingly, states are looking for businesses that are not complying with these rules. Sales tax audits are on the rise. We will discuss in this post some of the issues surrounding sales tax audits. We will also talk about challenging a sales tax assessment and how to minimize the risk of a sales tax audit.
What is a Nexus Letter?
The sales tax audit process typically starts with a nexus letter (sometimes called a nexus questionnaire). This is a letter sent to the company, looking for information about the activities of the business within a state. This letter is meant to look for nexus, where the business exceeds the threshold of activity which triggers the requirement to collect sales taxes in the state.
A sales tax nexus letter is a serious matter and can have significant tax ramifications. A careful, timely response is required, often with a supplemental letter and other documentation to prove the position of the business with respect to sales tax nexus.
If nexus in a state is established, then the business is required to register for sales tax in that state.
Sales Tax and Fulfillment Service Providers
A particular area of focus for sales tax auditors is inventory of a business that is in the hands of a fulfillment service provider, such as the Fulfillment by Amazon (FBA) service. The question is if inventory in a fulfillment center triggers sales tax nexus, especially where the fulfillment center handles the shipping and all other aspects of the order. The fulfillment center may even move the product in and out of a number of states without the knowledge of the business.
It is not clear how the courts will rule on the issue of whether or not inventory in a fulfillment center creates creates nexus (and a sales tax obligation). In some states, the fulfillment center, such as Amazon, is required to collect sales tax on behalf of the business. Nevertheless, the resolution of this issue is currently unclear.
What Triggers a Sales Tax Audit?
Many businesses handle their own sales tax compliance. Most of them do it wrong, failing to match sales on the sales tax returns with receipts on the federal returns, bank deposits, or sales on their Point of Sale (POS) system. If the business fails the matching process that many states use, the resulting error message will automatically trigger a sale tax audit. That is one way that a state picks its audit targets.
CPA Tip: Show your sales tax returns to your CPA before the income tax returns are prepared, so that discrepancies can be corrected in advance, thereby avoiding a sales tax audit.
Mark-Up Percentage
Sales tax auditors often calculate sales subject to sales tax based on a mark-up percentage applied to purchases. These percentages can be based on outdated purchase prices, or they can be totally fictitious. This can result in an enormous bill for under-reporting of sales tax, plus interest and penalties.
Alternatively, the auditor may use a mark-up percentage that is based on industry standards that may not reflect where the the business is located or the actual scope of the business. Or the industry standards used by the auditor could be out of date.
Statute of Limitations and Sales Tax Nexus
To make matters worse, a sales tax auditor can look back many years when investigating a business, depending on the particulars of the state’s statute of limitations. Every state has its own rules.
In Georgia, the state has three years to audit, from either the sales tax return due date or the return filing date (whichever comes later). However, in the case of a false or fraudulent return, or a return filed with the intent to evade sales tax, or a failure to file a return, a sales tax assessment may begin at any time.
In Illinois, the state has three years to audit, from the time when the taxable gross receipts were received. However, there is no statute of limitations when there is failure to file a return or a fraudulent return.
This means that, in Georgia or Illinois, for example, a sales tax audit based on inflated mark-up percentages can cause the taxpayer to appear to be fraudulent, even if they are not, allowing the sales tax auditor to review many years of business activity. This can destroy a business.
Audit Process
A sales tax audit begins in earnest with a letter from the state Department of Revenue notifying the business that it has been selected for audit. The auditor will usually request a meeting with the business owner, although that can be handled by the CPA. Expect a follow up letter in the mail requesting information for the auditor to examine.
Examinations often take place at the taxpayer’s place of business. You will want to give the auditor a comfortable space to work in. If you can give them coffee, all the better. The idea is to make the auditor comfortable and to establish an open line of communication between the auditor and the business. Nevertheless, it is always best to have the CPA handle the process, rather than the staff of the business. The CPA is far more familiar with the rules and is less likely to say something that should be left unsaid.
The CPA should be authorized under a Power of Attorney to speak with the auditor for the tax matters and the years in question.
During the examination, the auditor will compare the sales tax returns with the books and records of the business. Expect the auditor to look at bank records, QuickBooks files, point of sale records (POS), and federal and state income tax returns. The sales tax auditor will also want to see copies of sales tax exemption certificates from customers.
Sales Tax Audit Defense
At the completion of the audit, the auditor will send a list of proposed audit adjustments to the business or their CPA.
Now comes audit defense, which will include a variety of strategies based on the facts of the case and the matters at issue. For example, photos and videos of the business and of what is being sold may be used to disprove the auditor’s assumptions of taxability. Also, the mark-up percentages used by the auditor to calculate sales or sales taxes due may be challenged as out of date or unreasonable for the specific type of business or the location.
By thinking both strategically and creatively, a sales tax audit can often be settled for a fraction of the original bill.
Nexus and the Sales Tax Audit – Powered by Avalara
Nexus refers to a specified level of activity that triggers a sales tax obligation in a given state. Every state has its own rules. Please check out our article on the Georgia Sales Tax for an in-depth discussion of this topic.
For purposes of this post, nexus is an issue that is fundamental to sales tax audits for businesses with multi-state operations. This is particularly true for online sellers, eCommerce and software providers. Thus, an evaluation of nexus is often a critical part of an effective sales tax audit defense.
At Massey and Company CPA, we use software tools powered by Avalara as a foundation for our sales tax audit defense on behalf of our clients. We also use these tools to proactively avoid sales tax audits in the first place.
Here are some example of how we utilize these tools when defending business clients that are under audit for sales tax issues:
- Provide up-to-date sales tax research for all 50 states and the District of Columbia
- Model fact patterns based on real-life scenarios
- Research sales tax obligations in complex multi-state industries, such as SaaS, technology and eCommerce
- Examine industry-wide sales tax practices on a national basis in such areas as business services, construction, food and beverage, restaurant, healthcare, hospitality, manufacturing, retail, shipping and warehousing
- Develop taxability charts per item across all states
- Validate sales tax rates by city, state, county, zip code, and geolocation
In short, we are respectful and friendly to the sales tax auditor, but our sales tax audit defense is robust, strong and fact-based.
What to Do After the Audit?
Always appeal or protest a sales tax audit. This must usually be done, in writing, within a certain amount of time, based on the rules of the specific jurisdiction.
CPA Tip: It is easier to settle your case at Appeals. Generally, the Appeals Officer is more reasonable and open to re-evaluating evidence than the field auditor.
And, while the case is in Appeals pending a settlement, it is often possible to negotiate an Offer in Compromise to further reduce the amount of the tax to be paid.
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Massey and Company CPA is a boutique tax and accounting firm serving individuals and small businesses in Atlanta, Chicago and throughout the country. Our services include tax return preparation, tax planning for businesses and individuals, IRS tax problem resolution, IRS audits, sales taxes and small business accounting and bookkeeping.
