What triggers a sales tax audit?
A joint study by Avalara and Peisner Johnson & Company
Using extensive data acquired from the Texas Department of Revenue and the California Board of Equalization (BOE), this report aims to shed light on:
- the most common industries that get audited
- the most common compliance errors by business type or industry
- the typical costs in audit penalties and fees, and audit support and defense
It’s safe to say that most professionals understand that businesses get audited for sales and use tax, but only a small percentage are aware of the material impact to their company should a state auditor come knocking on their door. Unless you’ve been audited in the past, you might not know why certain businesses are targeted, the most common types of errors auditors look for, and most importantly, how much it will cost the business should the audit outcome not weigh in your favor.
Note on the data used for the report:
Through a request of information from the Texas Department of Revenue, Peisner Johnson & Company and Avalara received sales and use tax audit data spanning 1989–2016. The analysis includes a breakdown of approximately 64,000 audits with 4,252 currently in progress. This report also uses supplemental findings from the California State Board of Equalization (BOE) Annual Report, which details the state’s sales and use tax audit revenue and supporting demographic findings.
Who gets audited and why?
It should come as no surprise that state audit divisions aren’t looking for companies that are managing their taxes correctly. After all, audit penalties and assessments provide enormous revenue and help shore up budget deficits. According to the California State Board of Equalization (BOE) 2013–2014 report, the state generated over $21 million in revenue from their managed audit program.
But why do some companies get selected while others don’t? Sometimes, it’s a case of bad luck, but as data suggests, companies are most often not selected at random but evaluated by a number of factors, which include:
- Past audit history
- Volume of sales a company reports to the state
- Volume of exempt sales claimed
- Ratio of exempt sales to total sales
Most of these factors might seem obvious. Companies with a history of negative audits usually get targeted until they get their act together. High-revenue companies, on the other hand, find themselves in a perennial audit whereby any number of auditors from multiple state agencies set up residence at their headquarters, even if they’re meticulous with their compliance processes. It’s also not surprising that companies that report a high ratio of exempt sales to total sales raise a flag, especially if that ratio isn’t consistent with their industry peers.
What’s less evident to most people is the first criteria: industry. This factor is accounting for more and more audit activity across the U.S. and doesn’t show any signs of slowing down. Here’s why.
Target industries – error prone or opportunity for the state?
Certain industries tend to put themselves at risk in two ways. One is based purely on how the industry operates: bars, restaurants, grocery stores, and liquor stores are all cash-based businesses, and auditors are all too aware of how cash goes unreported. However, while cash-based businesses routinely put themselves in compliance risk, the effort to find the errors might be too high for many auditors to even bother investigating, especially if it’s a small operation.
The other main reason certain industries get targeted is that historically they don’t adhere to state and local sales and use tax regulations, which are complex, ever-changing, and require a lot of research and due diligence on the part of the company’s accounting and finance teams. There are many ways a company can make a mistake in their compliance, but as the data from the California BOE indicates, the following account for the majority of errors (see Figure 1):
In the 2013–2014 fiscal year (according to the California BOE), the top three industries (see figure 2) found to have large assessments were retail, food service, and manufacturing.
Conversely, the State of Texas varied slightly in their top industries under audit. While retail and manufacturing remained high like in California, auditors also targeted the construction industry and wholesale/distributors (see Figure 3).
Compliance errors by key industries
Let’s take a closer look at some of the compliance challenges these industries face and what an auditor might look for in his or her assessment.
Note: This information applies to large industry segments and generalizes compliance challenges. Each company is different and may face a different audit experience.
Audit Triggers: errors in product taxability, failing to remit in states where nexus is established
It’s not surprising that auditors target the retail industry. From a revenue perspective, they are a primary source of recovery, as state deficits have dramatically increased due to the explosion of ecommerce. According to eMarketer and Forrester projections (see Figure 4), online sales will account for $385 billion to $440 billion in the U.S. by the end of 2017 and are projected to reach $414 billion by 2018. States have felt the brunt of the wholesale shift from brick-and-mortar to online buying.
To give this shift perspective, the California BOE outlined statistics from the U.S. Census Bureau (see Figure 5). Their annual report highlights the loss in millions that states are facing due to ecommerce.
Figure 5 shows annual business-to-consumer use tax revenue losses, which rose from $171 million in 1997 to $763 million by 2011. In 2012, with the decrease in unregistered out-of-state sellers (nexus percentage) from 37 percent to 23 percent, the tax gap declined dramatically, to $477 million. This amount decreased from 2006.
Making sense of product taxability
Understanding product taxability is particularly challenging for many retailers as most tangible products are subject to sales tax in the U.S. However, product taxability rules and rates vary widely from state to state and change frequently. If that wasn’t bad enough, certain goods and services fall into a nebulous category called “sometimes taxable” where use can make a difference in how an item is taxed.
As retailers grow, they’re more likely to operate across state lines, which can trigger nexus, a “physical presence” in a state that creates an obligation to collect and remit sales tax. As such, they need to pay closer attention to where customers and partners are located and ensure point of sale, ecommerce systems, and shopping carts are set up to calculate the correct tax in each state and jurisdiction in which they now have nexus.
Knowing where you’re obligated to remit (understanding nexus)
A growing number of states have recently expanded the definition of nexus (a company’s connection to a state, whereby an obligation to collect and remit sales and use tax is established) to include activities such as employing remote staff, attending tradeshows, warehousing inventory, or using drop shippers or third-party fulfillment.n fact, many states are now adopting “Economic Nexus” laws that require businesses to collect and remit tax on the basis of generating at least $250,000 worth of sales from that particular state. Other states base economic nexus on the number of transactions by its residents. These factors, and many more, can make sales tax compliance particularly difficult for affected retailers. And state auditors are all too eager to turn these challenges into opportunity. These factors, and a lot more, can make sales tax compliance particularly difficult for affected retailers. And state auditors are all too eager to turn these challenges into opportunity.
Audit Triggers: undocumented exempt sales, failure to remit use tax, failure to remit in states where nexus is established
State auditors are all too aware that manufacturers expose themselves to risk at many points along the supply chain. Whether they’re selling to retailers, directly to consumers, or supplying wholesalers and distributors, they have several challenges throughout the process.
There are three primary activities that pose sales tax risk:
- Managing exempt sales when selling to retailers
- Managing taxability rules when selling directly to consumers
- Remitting use tax
Managing exempt sales when selling to retailers
For manufacturers selling directly to retailers, the main challenge is effective management of exemption certificates. After all, errors managing exemption certificates are one of the primary issues an auditor looks for. Common mistakes include simple things like a missing signature, or incorrect name or address. Or, more significantly, filling out the wrong certificate and filing with the wrong state, or using expired certificates. On top of that, requirements for sales exemption can vary from state to state.
Managing taxability rules when selling directly to consumers
When a manufacturer sells directly to a consumer or end user, the sale is subject to the raft of sales tax rates, rules, and boundaries that apply to any retailer. One problematic area is determining the correct tax rate and provisions on the products it sells and complying with nexus, the connection between a seller and a taxing jurisdiction that results in a sales tax obligation. This is particularly problematic for multistate manufacturing operations.
Every time a manufacturer makes sales into a state in which it does not have a physical presence, it might face additional sales tax responsibilities. Lacking a federal mandate, many states have instituted rules broadening definitions of nexus to include remote sellers, such as manufacturers selling into a particular state, even when they don’t have a physical presence within that location.
Remitting use tax
Use tax is tricky for companies. How you “consume” certain items in your business is often the determining factor. Common triggers may include:
- Inventory transfers
- Equipment purchases
- Charitable donations
- Fixed assets purchasing
If these items were intended for resale and you didn’t pay sales tax at the time of purchase, then you are now obligated to pay use tax. Or, if you bought equipment or furniture for your office and then moved locations, and the tax rate is higher in the new location, then you may owe the difference in use tax. This is where most auditors spend their time — checking that expenses, fixed assets, and inventory transfers have been properly taxed. It’s also where most mistakes occur. As the audit data suggests, use tax errors are the number one audit risk and the bulk of assessments come from use tax not being paid.
Audit Triggers: failing to remit in states where nexus is established, errors in product taxability, failure to follow correct drop shipping rules
For wholesalers and distributors, the first thing auditors look for are missing or incomplete records and certificates on exempt sales. In order for exempt purchases to be documented properly, a distributor must maintain exemption certificate information for each state or locality where the reseller receives product. Distributors must also ensure their own tax-exempt status is maintained and exemption certificate information is provided to each manufacturer or supplier they work with. After all, they’re considered a reseller in a manufacturer or supplier’s eyes.
Direct sales to consumers include sales of spare parts, updates, replacement wear items, and a lot more. It is the distributor’s obligation to ensure that accurate and current sales tax rates, taxability rules, and boundaries are applied for each taxable sale.
Working with a drop shipper
Distributors or wholesalers will sometimes request the manufacturer to drop ship their product to either their location or sometimes to their customer’s location. If an item is being shipped directly to the distributor, and the product is considered tax-exempt for resale, then no tax is required — only resale documentation. However, if shipping is done on behalf of the customer, the transaction may be taxable. Knowing what documentation you need to maintain for which states becomes a major challenge — especially as ship-to destinations may vary widely if your customer, the distributor, has you ship to their customers in numerous states.
Audit Triggers: errors in use tax remittance, errors in product taxability, failing to remit in states where nexus is established
Sales and use tax compliance for the construction industry and contractors in general is no walk in the park. That’s because auditors find holes in compliance throughout the supply chain, especially among companies that perform services and purchase goods in other states.
Managing use tax correctly
If a contractor does not understand or remember to accrue and remit incremental use tax due on projects, and the state audits the project, that contractor’s profit margins might quickly erode.
There are many other compliance hurdles the construction industry faces. Some of these include:
- No registration for sales tax ID number
- Not filing in states where they hove nexus
- Large volume of exempt sales without documentation
- Failing to remit sales and use tax on equipment purchases and rentals
Cutting costs by cherry-picking the best rate
When contractors source materials from out of state, they might get a great rate on sales tax at initial purchase, but auditors look to see that in the end the contractor remitted the right amount to the jurisdiction where the materials were eventually used.
Here’s a simplified example: A construction firm constructs a building in Austin, Texas, but purchases materials for the project in Oklahoma and transports them across state lines. Let’s say the tax rate in Texas is 9 percent compared to Oklahoma’s rate of 7 percent. One might believe the contractor was smart and saved 2 percent on the purchase. Not so. In that scenario, a Texas auditor will be verifying that an additional 2 percent was remitted to the state of Texas to make up the difference.
Understanding this concept is simple, but applying the correct rates and following the right remittance process across multiple jurisdictions is where it gets complicated and harder to manage.
Rules and rates vary state to state
If a contractor is located in one state and performing work in another, where (the jurisdiction) you owe tax and how much is owed varies dramatically. Most states view contractors as the “end consumer” of materials used on a project and will typically require the contractor to pay sales tax on property at the time of purchase, or expect them to accrue and remit use tax on materials that were sourced from out-of-state vendors.
Audit Triggers: unreported cash transactions, errors in product taxability
Food service providers are often cash-based businesses: bars, restaurants, grocery stores, liquor stores, etc. As mentioned earlier in the report, auditors are all too aware of how cash transactions can go unreported but proving noncompliance is a challenge. Nonetheless, audit data from Texas and California indicates that these businesses are carefully reviewed regardless.
Outside of unreported cash transactions, diligent tax professionals can still expose themselves to tax risk when they don’t carefully evaluate the varying (and ever-changing) tax rules on the products they sell. Understanding what’s taxable versus tax exempt is not straightforward. Example: candy is normally a taxable item, unless the product contains flour, in which case it’s tax free. The same type of rule applies to energy drinks versus soda.
These are just minor examples, but they reflect a global challenge when you apply disparate rules across thousands of products in inventory. Charging sales tax on a packet of Oreos might not be a big deal, but when you fail to charge tax correctly on hundreds of items over the course of several years, an audit might reveal a hefty tax obligation.
Which states are the most aggressive in auditing companies?
Many states across the U.S. are getting more aggressive with sales and use tax audits because increasing budget deficits are demanding them to take action. Generating revenue through tax audits doesn’t constitute new or higher taxes, rather it’s a collection on what’s already owed. For that reason, it’s a popular strategy among legislators that’s getting bipartisan support and minimal resistance from the Supreme Court as to whether states can go after businesses outside of their state.
What are the odds of getting audited by more than one state?
Odds are pretty good. If it weren’t for nexus, sales and use tax audits would stay local, but in recent years newly established rules are giving states greater latitude than ever before, as auditors are setting up offices all over the U.S. to conduct audits on companies that have nexus in their home state.
Data from the Texas DOR supports this claim, as one-third of their 4,252 audits in progress are being conducted out of state. Research also shows that Texas has a total of 595 auditors with 78 of those permanently based out of state.
Texas has a lot at stake, as it’s the 11th largest economy in the world, but it’s not alone in this trend. According to Steven Walters, producer at nonprofit WisconsinEye, the Wisconsin Department of Revenue is hiring 102 new tax auditors. By increasing their audit division by one-third, many of these auditors will be based out of state in New York, Chicago, Minneapolis, and other locations “so they can focus on auditing corporations that claim a ‘nexus’ — or business connection — with Wisconsin.”1 The state estimates that the new auditors will generate upwards of $88 million additional revenue each year.
California is also proving to be just as aggressive. While data on the number of auditors and their locations isn’t available, Bloomberg Business estimated that they’ve added approximately 100 auditors in the past few years to collect upwards of $371 Million annually.
How costly is an audit?
Wakefield Research found that a typical negative audit can cost even a small to medium-sized business more than $114,000.
If you’re a large organization, the amount can exponentially grow. What’s harder to assess than penalties and fees is the time and disruption to your business. On average, sales and use tax audits can last 30 to 45 days and auditors can be on-site for two to four weeks, during which staff and leadership are taken away from their more productive tasks.
Going alone versus hiring a tax expert
Getting outside help to prepare and represent your interests in an audit can potentially save you time and considerable costs. Consider getting audit representation if any of the following exists:
- You’ve never been audited before. An experienced representative will help you prepare and cut down the time it takes to resolve the audit.
- You lack staff. If you can’t divert enough high-level staff members to do a pre-audit and deal with the auditor while he or she is onsite, hire representation.
Perhaps you’re comfortable handling the audit yourself, but need additional help with a few projects to prepare for the audit? Here are some of the things that make sense to outsource:
Pre-audit: Conducting a pre-audit or reverse audit, prior to an auditor coming in, can ensure you have no nasty surprises. Outsourcing this makes sense because internal staff will try to avoid showcasing mistakes they’ve made or might not even be aware of those errors. You need substantial lead time before the auditor shows up on your doorstep to do this.
Exemption certificate management: If staff has not been on top of exemption gathering, this may be a good task to outsource.
Expert advice: If you choose to handle the audit yourself, paying for a little advice now and then can make a big difference. Consider getting a tax representative to bounce questions off of.
When you think about compliance, consider these simple tips that go a long way toward a quick and painless audit:
Collect and remit correctly
The single best defense any business has against an audit is getting rates and product taxability right. Even the most meticulous record keeping won’t protect your business from fines and penalties if customers have been charged incorrect rates or you’ve been remitting less to the state than you’ve been collecting. Getting this complex step right can take a lot of effort — especially if you sell a wide variety of products.
Keep documentation organized
If you’re filing documents manually and showing your auditor stacks of paper, it’s likely you’ll be in for a long slog. Missing or expired exemption certificates are a particularly pesky problem, as many businesses don’t realize that they’re required to keep these certificates ready for auditors to look at. Bottom line: If you can’t produce the certificate, you will be assessed.
Understand the audit process
If your business receives an audit notice, it’s important to know enough about the audit process to prepare adequately. These tips from former auditors can help you get ahead of the game in case you are audited in 2017 with advice for what to do – and what not to do. You may also consider whether you need to bring in outside help to make your audit run more smoothly. The big takeaway? If you make things easy on your auditor, you’ll make things easier on yourself. If your records and processes are in good order, you don’t have anything to fear from an audit.
The bottom line: Reduce risk by automating sales and use tax
Managing transactional tax can be overwhelming, especially if you’re obligated to register, collect, and report sales and use tax in several states. It is survival mode just trying to keep up with different rates, rules, and regulations. You’re on the hook to get it done and held liable by states (and state auditors) if it isn’t done right. Automating sales and use tax compliance in your accounting system, ERP, or ecommerce system can alleviate much of this strain and put you on a more even keel.
Avalara’s tax management software ensures accurate tax calculation, proper management of tax exemptions, and streamlines the remittance and filing process for sales tax returns in every U.S. jurisdiction. Make 2017 the year you rescue yourself from the hassles of sales tax and sail through compliance with ease, confidence, and Avalara sales tax automation software.
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