Eight ways to increase your company's sales tax audit risk
Because every business loves to be audited...
Unless they have a vintage flair, most people wouldn’t dream of using a rotary phone when a cordless or cell phone is available. Yet the same people might not think twice about handling core business functions with similarly outdated tools. Take sales tax compliance. In many ways, using a spreadsheet to track sales and use tax obligations is analogous to using floppy disks to store data. This approach requires manually reviewing rate, rule, and boundary changes for each jurisdiction into which taxable sales are made. It also involves an encyclopedic knowledge of product and service taxability, rigorous tracking of state and federal statutory changes, and an expert-level grasp of exemptions, destination-based sourcing, and other sales tax related minutiae.
The stark reality is that most companies cannot afford to screw up sales tax. The consequences of making mistakes (mistakes far more likely with error-prone manual processes) are dire. As states look for ways to boost uncollected sales tax revenue, sales tax practices are increasingly under the microscope. While sales tax compliance is no laughing matter, the following list of what to do to increase sales tax audit risk hopefully demonstrates the right approach to ensuring real compliance. Here are eight (tongue-in-cheek) surefire ways to increase your company’s sales tax audit risk.
1. Underestimate the true costs of manual sales tax compliance
Skeptical that upgrading and automating sales tax compliance is necessary; many managers unknowingly expose their business to audit risk. Some companies might even budget for negative audit findings rather than invest in an automated solution to mitigate risk (like budgeting for fire damage to one’s home rather than purchasing smoke detectors).
In their report, “Effective Sales and Use Tax Management: Reducing Errors and Increasing Productivity,” the Aberdeen Group identified an alarming statistic— Many financial officers underestimate the cost of sales and use tax compliance by 50 percent. These CFOs often assume sales tax compliance is handled, due to the limited visibility of sales tax transactions and their lack of integration within manual billing and procurement processes. Given that the average penalty cost of a negative sales and use tax audit is $130,000 per occurrence, this assumption could bring ruin to many small- and medium-sized businesses.
The report also indicates that managing sales and use tax compliance manually takes a full 24 accounting days per year. Furthermore, when other hidden costs are taken into account, the annual cost of manual compliance process is approximately $22,000. These figures help explain why more companies are turning to automation to help keep their sales tax reporting current, compliant, and cost effective. From a cost versus benefit perspective, not automating simply poses too much risk.
2. Address sales tax compliance reactively, rather than proactively.
Despite their best efforts to comply with statutory sales and use tax requirements, many companies fail to address risks proactively. The implicit assumption, that the company’s audit risk is nominal and can be addressed at a later date, can become a self-fulfilling prophecy.
According to the Aberdeen Group report, “The errors associated with such a methodology have contributed to negative audit results subjecting the companies to have fines/penalties and cost of corrective labor.” Auditors typically insist on a provable rationale behind calculations and computations. As many companies can sadly attest, auditors tend to be skeptical if there is no easily understandable and provable process. It is an omission bound to lead to a negative finding and a major hit to the company’s bottom line.
In short, automation is all about preparation. One of its most appealing functions is the ability to provide a consistent, documented, and predictable process, which is exactly what state examiners want to see.
3. Only keep paper copies of relevant tax documents
Documenting processes, certificates, exemptions, and sales tax holidays, and etc. requires a more comprehensive approach than keeping paper copies in a file cabinet in the back office. Provisions for sales and use tax compliance are often made on the fly, or in reaction to an audit notice. Without an overarching strategy, companies are often unable to provide sufficient documentation at the time of audit. These oversights cost businesses dearly.
According to John Trippier, deputy auditor of the Ohio Department of Taxation, a comprehensive and well-documented sales and use tax compliance process is critical to resolving any potential issues. “Sometimes there is no process,” he said. “Without a process, it’s more difficult for a company to justify its calculations and payments.”
Automated sales and use tax reporting, on the other hand “…definitely help.” Said Trippier, “I’ve found that their reports contain a substantially correct amount of liability.”
Executive Envelope, an envelope and printing solution provider in California, can attest to the shortcomings of using manual sales tax compliance processes. The company, a leading provider of printing projects, graphics, and trade show materials with annual sales of $15 million, underwent four consecutive sales tax audits triggered by their outdated manual accounting practices. “Our old-fashioned manual process didn’t work for us and it was truly broken,” said Claudia Brake, office manager.
While recognizing the need to automate its transactions, the company also required integration with its tax filing process. Executive Envelope chose an automated program that easily integrated into their ERP.
Since automating, the company’s audit vulnerability has decreased and it has not faced any significant audit issues. Because the company no longer manually updates schedules or rate and boundary tax modifications, Executive Envelope estimates an annual labor cost savings of $36,000.
4. Fail to register with the correct state and local tax jurisdictions
Businesses can and should expect an audit notice from the state under some conditions. A decision to audit can be based on a statistical sample of business reports, or triggered by information provided to the taxing authority, such as a third party complaint.
Trippier (the Ohio auditor) notes that he is often surprised by companies’ lack of knowledge about use tax compliance, and their failure to register with the state. “We estimate 380,000 companies …have failed to register. When we question them, what we usually hear is they didn’t know they had to register or were unfamiliar with requirements,” Trippier said.
For registered Ohio companies, auditors require only four years of documented transactions; for the unregistered, auditors need to see seven years of transaction records. Such audits and penalties can be costly.
5. Remit sales tax collections incorrectly
Businesses may wonder how states determine which businesses to target for an audit. There is no clear answer. A state’s formula for selecting the businesses is never disclosed. States often base audits on a sampling of tax returns; however, other processes and patterns can cause closer scrutiny.
One obvious pattern is a questionable or inconsistent payment process that lacks adequate calculations, formulas, and other documentation. State tax computers are likely to red flag any reporting that fails to stand up to what the tax authority views as a consistent and verifiable process.
6. Ignore exemption certificates and use tax management responsibilities
According to Ohio auditor Trippier, mishandling use tax and having incomplete exemption certificate records puts businesses in an auditor’s cross hairs. “From an audit perspective, 96 percent of our use tax audits generate liability—a figure that should make any financial officer want to evaluate the company’s tax compliance process.”
Exemption certificates are especially tricky. Taxation departments tend to question whether all non-taxed transactions are in line with the certificate, so a thorough analysis of such transactions is a mandatory part of an audit protection plan. “Many vendors don’t get properly completed exemption certificates,” said Trippier.
If auditors determine that critical information is lacking, a business is likely to be targeted for an audit. The last thing any company needs is for examiners to question the rationale behind reports and conclude they are merely constructs designed to avoid payment of legitimately owed taxes. This is a point that cannot be understated. Auditors want to see processes that comprehensively explain and justify each transaction.
Automation contains sophisticated logic that can work with complex formulas in any state, and justify all non-tax reporting as permitted by the certificate. It can greatly reduce, if not eliminate, audit exposure for non-taxed transactions.
The challenge was even greater for the Miner Corporation, an industrial equipment supplier and service provider based in Texas. Miner conducts business in all 50 states, as well as Puerto Rico, Canada, and Mexico. The company has to deal with thousands of taxing jurisdictions.
Miner estimates that it endures from 700 to 900 changes in boundaries, tax rates, and regulations yearly. In its previous manual approach, Miner had to calculate its sales tax liability based on each customer’s delivery address. Then, sales agents had to conduct time-consuming research to determine the proper tax rate for each locale and enter it into the sales order. It took an inordinate amount of time, approximately 10 to 14 days each month, to research tax changes, determine proper rates, and file returns.
Recognizing that automation was its only answer, Miner selected an automated system that performed as promised. Michael McGinn, Miner’s senior tax accountant, said that an audit covering the period before and after implementation of the new system was telling in what it revealed.
The company no longer spends costly accounting time researching jurisdictional liabilities. The automated system, which is constantly updated, quickly resolves any questions.
7. Identify state sales tax nexus obligations incorrectly
At one time, companies could use the decision by the U.S. Supreme Court in Quill Corporation v. North Dakota (1992) as a guideline. In that case, the court found that states could not require companies to collect state sales tax unless those companies had substantial nexus in-state. Substantial nexus, here, means a significant physical presence, like a warehouse or storefront.
Now some states are redefining substantial nexus because of widespread Internet business. That creates even more tax planning problems and audit concerns for businesses—a problem that is more effectively addressed with an automated solution.
8. Ignore the rapidly changing sales tax landscape
In the current economic environment, cash-starved state governments and the tax auditors who represent them, grant companies little latitude on sales and use tax calculations, compliance, and remittance.
Their relentless efforts appear to be paying off, as the U. S. Census Bureau reported in a recent summary of state and local government tax revenue. According to the report, state tax revenue was up 5.21 percent. General sales tax revenue demonstrated a similar trend—rising to $72.1 billion, 4 percent over the same quarter in the prior year.
Despite a down economy, state taxation departments have increased collections by finely analyzing sales tax payments. State coffers are being filled by the fines and penalties paid by companies that have failed audits. These failures can often be attributed directly to inadequate, out-of-date, and manual tax management policies.
The costs associated with negative audit findings can wipe out the profits of a small- to midsize business. Companies that rely solely on manual accounting solutions or disconnected tax tools do so at their own peril. They may be unintentionally pulling a trigger that could lead to an audit notice. Automated solutions are the most effective protection against audit that a company can utilize.