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Sales and Use Tax Red Flags – Managing Your Audit Risk

It should come as no surprise that sales and use tax is one of the main revenue streams of state and local tax authorities across the country and that audits are the primary means by which to maximize that stream.  If you have ever been subjected to the rigors of a sales and use tax audit, you know full well the time, effort and drain on your resources involved, not to mention the financial burden that a resulting audit assessment of tax penalties can place on your business.

Most states use systematic methods and electronic data to evaluate and determine those taxpayers who are inclined to under-report or underpay sales and use taxes.  If you know what they are looking for, you can take steps to avoid falling prey to their audit techniques.  With taxing authorities having their proverbial finger on their audit trigger, don’t get caught playing Russian roulette with your sales and use tax.

Here are 12 red flags to avoid that are likely to prompt an audit:

  1. Nexus but no sales tax registration

Nexus, also known as sufficient physical presence, is created when a company maintains a temporary or permanent presence of people or property, such as inventory, warehouses, or offices and is the determining factor in whether a company is required to register, collect and remit sales tax in a particular state.  Nexus is notoriously tricky, with every state having its own rules and definitions and can be created just by attending out of state trade shows, business travel, or consigning inventory.  It is also very likely that you have nexus if you are responsible for other taxes such as payroll in a state.  If you are not a registered sales tax vendor but do pay another type of tax in that state, it is very probable that you will be contacted for an audit.  A state need only do a little cross-checking to uncover your presence.

Over the past decade or so, online sales have become a major source of commerce for many vendors, having placed a significant strain on the traditional brick-and-mortar sales and use tax rules of many states.  Nevertheless, if nexus is evident, online sales made in another state generally require sales tax registration and filing in that state.  Failure to do so can result in an audit.  With the internet at everyone’s fingertips, it is easier than ever for auditors to make this discovery.

  1. Filing sales tax returns reporting zero use tax

The other side of the nexus internet sales equation concerns the purchases your business makes.  Although many vendors may not be registered or even required to collect sales and use tax in your home state, your home state expects some level of periodic use tax reporting by its registrants.  Therefore, if you regularly file zero sales and use tax returns with the thought that all of your company’s sales are either nontaxable or that you are a wholesale vendor, you need to remember to track your out-of-state purchases and report and remit use tax thereon.

  1. You owed taxes as a result of prior audits

A state’s assessment based on audit findings of a prior period usually triggers audits of subsequent periods based on the belief that factors that caused the errors and omissions in the prior audit period most likely still exist.  Some states will compare taxes reported to audit findings.  An audit will be performed in subsequent periods to determine if the ratio of reporting to audited has not changed.

  1. A large amount of, or increase in tax exempt sales

Vendors that report considerable exempt sales or have a large increase in a number of exempt sales are also more likely to be routinely audited since there is some discretion in determining what constitutes an exempt sale.

Alternatively, a drop in taxable sales may cause a business to be more susceptible to audit.  Claiming frequent refunds or large tax credits may also trigger an audit.

  1. Improper use of resale certificates

Using resale certificates to purchase items that will be used rather than resold can result in significant penalties and is a major red flag.  In addition, if you have issued a resale certificate and are not registered for sales and use tax, you are an audit candidate.

  1. Late filing

A common audit red flag is late filing.  Besides the obvious interest and penalties that will be assessed, vendors that continually file late make themselves the perfect audit candidates.

  1. Type of business entity

While there is no guarantee that any specific taxpayer will not be audited, tax departments have determined that sole proprietors are more likely to file self-prepared returns containing errors and are, therefore audited more frequently than other small business entities such as C corporations, S corporations, and limited liability companies.  So if you are a small business, you may want to consider forming a corporation or LLC.

  1. Customer or supplier audits

If a customer is undergoing an audit, and your invoice is selected during sample testing of exempt sales, you may be contacted to verify that you have an exemption certificate on file.  Likewise, if one of your suppliers is audited and they provide an exemption certificate for sales made to you that are clearly taxable, you may draw an audit.

  1. Audit results of, and unique factors or common practices in your industry

State auditors may attempt to extrapolate your competitors’ audit findings to your company such as comparing your ratio of taxable sales to that of your industry.   One circumstance that could also trigger an audit is an industry prevalence of cash transactions whereby cash purchases are made from cash sales (i.e. paying for deliveries from the cash register).  You may be audited to determine that all such transactions are properly recorded and that the corresponding sales and use taxes are remitted.

  1. Incorrect tax calculations on freight and fuel surcharges

Vendors tend to have in place accounting systems based on their home state rules.  If the home state does not tax freight and fuel surcharges, that could pose a problem if they are registered in other states that tax such items.

  1. Beware of whistleblowers

As states are always looking for additional revenue, they are likely to follow up on tips from disgruntled employees, ex-employees and even unhappy customers.

  1. State and federal government information sharing

Today, many states have what seems like unlimited access to information.  For example, the Department of Revenue may compare revenues reported on business income and franchise tax returns to filed sales and use tax returns; or review payroll tax returns filed in their state to determine if employee compensation allocated to the state establishes nexus.  They may also match big-ticket items such as motor vehicles, boats or aircraft to ensure that the applicable sales or use tax have been remitted.

While this list is not intended to be exhaustive, you should take steps to mitigate their potential impact on your business.  You should also consider outsourcing your sales and use tax compliance to a third party such as a CPA firm to provide regular accounting and financial advice.  Another option available to small vendors is to utilize third-party software to manage their sales and use tax compliance may well be worth the cost.

If you have questions, please contact Victor C. Belgiorno at 516-861-3704 or .

 
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