Smile Your Way Through a Sales Tax Audit

When the state auditor calls, a positive attitude—and solid preparation—can really help

If you get called for an audit of your sales and use tax payments, don’t take it personally. Smile, and remember that big businesses are audited more frequently. For a small business, “It’s like winning the lottery in reverse,” says Dan Davis, CPA, a sales and use tax consultant based in California. “It’s more or less a random selection process, so think of it as bad luck, not as being targeted.”

Putting on your game face starts with proper preparation and a positive attitude. Don’t be like the taxidermist that Davis knew, who welcomed the state’s auditor by sticking him in the workroom, amid the carcasses. “The attitude you project should indicate that you assume the auditor’s going to be fair and objective,” Davis counsels. So, even if you think the auditor is a creep, keep your thoughts to yourself. “It’s a matter of self-preservation,” says Davis.

The Paper Chase

What can you expect? Most state bureaus of revenue will look for sales and use tax documentation going back three or four years, depending on the state’s statute of limitations. If you have accurate records, the process should be straightforward. “Everything is about documentation,” says Marshall Romine, tax manager at KPMG’s Albuquerque office. “It really all starts with when you initially file that return—what you file, why you took a certain deduction off your gross receipts, and the nature of the transaction.”

If your documentation is inadequate and the auditors can’t tell which transactions are taxable, they may just assume they all are, until you can prove otherwise. “Auditors use indirect audit methods to estimate taxable activities when the records are not clear, and those estimates are usually high,” says Davis.

If your company is in retail, the rules are fairly straightforward and tend to be uniform from state to state: You remit the tax you collect on every sale. If sales tax wasn’t paid, because the customer was exempt, you must show why.

Use tax applies to tangible property that your company purchased out-of-state or online, which was not subject to sales tax. You are supposed to voluntarily pay use tax, which the state assesses to prevent out-of-state and online businesses from gaining a competitive advantage over in-state suppliers.

While retail sales tax and use-tax regulations vary only slightly, sales tax rules for construction, manufacturing, distribution and other businesses with mixed taxable and nontaxable transactions are all over the map. Most states detail their rules on their Web sites. (Try this map http://www.taxadmin.org/fta/link/default.html from the Federation of Tax Administrators to find your state site).

Some states—like Texas and Washington—offer a managed-audit option. You sign an agreement with the state to self-audit, hire a state-certified auditor, and turn in the results. This way, you control the timing of the audit so it is not disruptive to business. You may have as little as 30 days to complete it, and the state-certified auditor’s fee can vary from a few hundred to a few thousand dollars. Again, check your state’s Web site to see if they offer this option.

Dress Rehearsal

A dry run with your accountant can help you enter the audit with confidence. “Having your accountant take the position of the auditor and playing the devil’s advocate can really help you find errors ahead of time and anticipate what [the auditor] is going to be looking for,” advises Romine.

Davis says another option is to hire an outside consultant who can work full-time on the project and deal with the auditors for you. “The important thing is that the person has a strong knowledge of your particular business and industry,” he advises. Associations such as the American Institute of Certified Public Accountants (www.aicpa.org) can help you find certified audit consultants.

The audit may be conducted at your place of business, or at the office of your accountant or at a consultant’s office. You can expect a visit to your facilities to see your operations, so auditors know what types of transactions to look for in your documentation. Also, your state may dispatch an outside auditor to tour your out-of-state facilities.

Inspections are routine for the use-tax portion of the audit, to see first-hand any tangible property on which you should have paid tax.. “If they come in and see you’ve got lots of equipment, they will compare it [to your tax payments],” Romine says.

Avoid Penalties

Don’t stop smiling, even if you’re unhappy with the audit. You can still appeal. You will have a certain period—30 days, say—to file an appeal, which requires specific documentation. Again, Davis recommends putting someone in charge who is well-versed in the state’s process and can coordinate all the steps.

Something not to smile about: During the appeal, you are accruing interest on the disputed amount, which you will have to pay if the audit sticks. Interest can be as high as 15 percent annually. You can avoid interest penalties by filing an amended return, paying the disputed amount and then filing a refund claim, Romine says.

Turn Yourself In

We know this couldn’t be any of our readers, but there are business owners who have never paid sales and use taxes. They can be liable for monetary penalties for every year in which they failed to pay. But many states offer a way out: voluntary disclosure. “You use a certified third party, who says that they have a named client who wants to pay all of their taxes, and who will enter into an agreement with the state if they will waive all penalties and interest,” Romine says. “It’s another way to avoid penalties.”