sales and use tax audits: effective strategies and best...
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Sales and Use Tax Audits: Effective Strategies and Best
Practices
WEDNESDAY, MARCH 14, 2018, 1:00-2:50 pm Eastern
FOR LIVE PROGRAM ONLY
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FOR LIVE PROGRAM ONLY
WEDNESDAY, MARCH 14, 2018
Sales and Use Tax Audits: Effective Strategies and Best Practices
Joseph N. Endres, Partner
Hodgson Russ, Buffalo, N.Y.
jendres@hodgsonruss.com
Michael T. Dillon, President
Dillon Tax Consulting, Annapolis, Md.
mike@dillontaxconsulting.com
Joseph F. Geiger, Jr., CPA, Consulting Tax Manager
Vertex, King of Prussia, Pa.
joseph.geiger@vertexinc.com
Notice
ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY
THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY
OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT
MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR
RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.
You (and your employees, representatives, or agents) may disclose to any and all persons,
without limitation, the tax treatment or tax structure, or both, of any transaction
described in the associated materials we provide to you, including, but not limited to,
any tax opinions, memoranda, or other tax analyses contained in those materials.
The information contained herein is of a general nature and based on authorities that are
subject to change. Applicability of the information to specific situations should be
determined through consultation with your tax adviser.
Sales and Use Tax Audits: Effective Strategies and
Best Practices Internal Controls, Risk Assessment, Identifying Pitfalls,
Implications of Tax Reform and More
March 14, 2018
Overview
Background
States are hurting for revenue as sales
tax collections have dropped in recent years due to recession
States love finding out-of-state businesses to audit
Limited resources force tax authorities to refine the targeting of their audit activities
6
Common Audit Issues
Most Common Audit Issues:
1. Nexus Issues
2. Sales Tax Reconciliations
3. Taxability of Sales
4. Taxability of Purchases (Expenses and Capital)
5. Exemption Certificate Issues
7
Nexus rules are in flux and states are currently seeking to expand the “physical presence” standard to include “economic nexus.”
States with Economic Nexus Rules:
Alabama, Indiana, Massachusetts, Maine, Mississippi, Ohio, Pennsylvania, Rhode Island, South Dakota, Tennessee, Vermont, Washington, and Wyoming.
States with Notice Requirements:
Alabama, Colorado, Kentucky, Louisiana, Oklahoma, Pennsylvania, Rhode Island, South Dakota, Tennessee, Vermont and Washington.
Changing Nexus Rules
8
1.) Audits of Other Businesses!
Reoccurring audit cycles for largest businesses
Overlapping audit issues
Exemption Certificate Errors/Misuse
Restaurant buys napkins for resale
How Does a Business Get Chosen for Audit?
9
2.) Whistleblowers
Just about every state’s website has a page asking for information on
tax malfeasance
Unfortunately sometimes these pages are abused
The internet remembers!
Whistleblower laws
New York, a case study
How Does a Business Get Chosen for Audit?
10
3.) Technology – NY’s “CISS” Program
How Does a Business Get Chosen for Audit?
• This is a photo from NY’s
JFK Airport
• “Smarter analytics helped
New York State save over
$1.2 billion in lost taxes”
11
Technology Continued
Corporate tax return sales v. sales tax return sales
The State knows the periods don’t overlap perfectly
Still, there should be some correlation (especially for certain businesses)
How Does a Business Get Chosen for Audit?
12
Technology Continued
Consistent taxable percentage
You might as well add a statement to the tax return that reads, “We’re committing fraud here!”
Ironically, many taxpayers do this because they think its accurate and compliance is too difficult.
How Does a Business Get Chosen for Audit?
13
Technology Continued
Drastic changes in filing pattern
Substantial swings in sales figures for non-seasonal businesses
Suddenly failing to file tax returns without filing a final return
Beware of the registration form!
How Does a Business Get Chosen for Audit?
14
Technology Continued
Certain businesses now have to make informational returns to tax
authorities
New York: franchisers, insurance companies, liquor distributors, and financial
institutions all have to make regular information returns
Several states now require out-of-state internet retailers to make informational returns regarding the identity of their customers (see slide 4).
States can now compare these figures to the returns filed by businesses operating in their jurisdiction.
How Does a Business Get Chosen for Audit?
15
Technology Continued
Compare returns of similar businesses operating within the same
geographic areas
You don’t want to be the oddball!
How Does a Business Get Chosen for Audit?
16
Technology Continued
Cash/credit card ratio out of sync with similar businesses
If cash is low, the taxing authority will be concerned that not all sales are being reported
Again, you don’t want to be the oddball
How Does a Business Get Chosen for Audit?
17
Technology Continued
Parking tickets on vehicles owned by
a business
Be careful about advancing a nexus argument if your business has received parking tickets
This can lead to a fraud investigation
How Does a Business Get Chosen for Audit?
18
Technology Continued
Professional licenses
This usually does not apply to businesses with taxable sales
But be careful – hairdressers/barbers, security guards, sanitation, etc.
How Does a Business Get Chosen for Audit?
19
4.) Tax Professional Malfeasance
If you see your tax professional in a press release from a taxing authority indicating the professional engaged in tax fraud, expect an audit notice.
Maximizing resources – finding one bad accountant may lead to dozens of underreporting businesses.
How Does a Business Get Chosen for Audit?
20
5.) Information Sharing Between States
More states and the federal government are entering into information sharing agreements
IRC §6103(d) authorizes the IRS to disclose federal tax information to state tax officials for tax administration purposes upon written request
FTA Uniform Exchange of Information Agreement – most states and the MTC are signatories
Statutory similarities: Exception to general taxpayer confidentiality rule,
Other state’s representative must be “authorized”.
Reciprocity, and/or
“Tax purposes” only.
Examples New York: N.Y. Tax Law § 202(3).
North Carolina: N.C. Gen. Stat. § 105-259(b)(3).
Florida: Fla. Stat. §§ 213.053(7)(j), 213.0535; Fla. Admin. Code 12-22.007.
New Jersey: N.J. Rev. Stat. § 54:50-9(f).
How Does a Business Get Chosen for Audit?
21
6.) Asset Sales / Transfers
Most states require notification of an asset purchase
Successor liability can compel compliance
Personal liability will attach
How Does a Business Get Chosen for Audit?
22
23
Maintaining Deadlines, Forms, Letters, Agreements and Transaction Data
March 14, 2018
Best Practices for Maintaining Deadlines
Important Dates
• Audit period
• Statute of limitations
• Initial audit conference
• Statute Waiver
• Closing audit conference
• Payment deadlines (for
penalty and interest
calculations)
25
Best Practices for Maintaining Forms
Maintain forms: • Notice of audit
• Audit confirmation letter
• Statute waiver
• Auditor meeting notes
• Sampling agreement
• Transaction data
• Exemption certificates
• Assessment Notice
• Appeal forms
• Audit closing letter
26
Develop Policies and Procedures for Maintaining Forms, Agreements & Transactions
Develop policies to maintain: • Notice of audit
• Audit confirmation letter
• Statute waiver
• Auditor meeting notes
• Transaction data
• Assessment Notice
• Appeal forms
• Documents supporting tax positions
• Audit closing letter
27
Best Practices for Maintaining Agreements
Require an Audit Close Letter: • Require auditor to provide a
letter at the conclusion of the audit
• Agreement should specify the audit results and confirm audit has been closed
28
Best Practices for Maintaining Transaction Data
Do you use software tools such as Excel or MS Access to support
sales and use tax audit defense activities?
Does your company use a sales and use tax system that is
integrated with your ERP system?
Does your company use a system to automate the preparation of
tax returns?
Do you use a certificate management system to store, track and
monitor customer exemption certificates?
Prior to an audit do you extract information from your financial
applications and tax systems to determine your companies
potential audit exposure?
29
Sales and Use Tax Systems Transaction history files contain large volumes of information
• Transaction type
Purchase
Sale
• Tax types stored with transaction details
Sales tax
Use tax
Consumers use tax
• Tax authority information
State, county, city, and district
Primary taxing jurisdiction
» Ship-to, Ship-from
• Taxability captured with individual transaction details
Product codes
• Tax exemption information
Reason codes (e.g. exempt classification)
Customer numbers and exemption certificate information
30
Maintaining Exemption Certificates
Maintaining Exemption Certificates
• Maintain hard copies of certificates
• Maintain images of certificates
• Exemption certificate management system
31
Exemption Certificate Management Systems
What type of information can be provided?
• Customer name
• Customer address
• Customer number (correlates to accounts receivable)
• Customer type
• Customer registration number
• Exemption certification classification Resale, manufacturing, not-for-profit, etc.
• Certificate date, including expiration date, if applicable
• Specific products/services associated with certificate
32
P-Card Programs
Reasons to use P-Cards • Procure goods and services in
a timely manner
• Reduce transaction costs
• Easier to track expenses
• Take advantage of supplier discounts
• Reduce or redirect employees in the purchasing and/or accounts payable functions
• Eliminate petty cash
33
P-Card Reporting
Suppliers accept P-cards for payment utilizing the existing credit card infrastructure for payment processing
Transaction data is captured by a supplier’s point-of-sale (POS) system and transmitted through the card network
The level of data depends on the supplier’s process and technology systems
There are three data levels
34
P-Card Reporting Levels
Level I – traditional credit card transaction, usually includes either address verification information or card swipe data but not tax information.
Level II – adds a few additional elements to the data that is captured at Level I, usually tax information and an invoice number. Level II information is reported back to the company making the original purchase.
Level III – provides the highest level of data capture and reporting.
35
P-Card Reporting Levels
36
Data Considerations – Where to Start
What type of information are you looking for?
Where do you get the information? • Accounts receivable
• Accounts payable, fixed assets, inventory
What are the data source formats? • Structured data
• Unstructured data
What data format is easy to use with data mining tools?
Does the data of interest relate to other data?
How much history do you have for this data?
How reliable is the data (avoid “Dirty Data”)?
37
Technology Can Help the Review Process
Obtain information from General Ledger files
Obtain transaction level data from Accounts Payable system
Obtain transaction level data from billing system
Obtain transaction data from P-Card reports
Review exemption information contained in exemption certificate management systems
Review transaction information recorded in sales tax and use tax system history files
38
Technology Tools Used During Audits
Technology Tools
• Excel
• MS Access
• Document image viewers
• Exemption certificate management systems
• Various reporting tools
39
Technology Tools Used During Audits (cont’d)
Excel • Small volumes of data
• Items scheduled as taxable in sample
MS Access • Manage large volumes of
data
• Sort and filter taxable vs. non-taxable transactions
Document image viewers • Invoices
• Exemption certificates
40
Technology Tools Used During Audits (cont’d)
Combine data from financial applications and tax compliance systems • Exemption information from
financial application
• Tax liability data from tax system
• Analyze data before the audit Data profiling
Data analysis
Data sampling
41
What is the Right Tool(s) for Your Organization
Factors to consider when selecting technology tools
• Size of organization? Multi-state
Volume of transaction data
• Demographics? Centralized vs. Decentralized operations
Location of electronic data
• Complexity of software systems? ERP system(s)
Tax system(s) and integration points
42
Suggested Best Practices
All sales and use tax auditors perform a review of accounts payable transactions testing for use tax accruals
• Operating expenses
• Fixed asset acquisitions
Most audits include a review and test of exempt and non-taxable sales
• Sales revenue journals and customer invoices
• Exemption certificates supporting customer claims for exemption
Understand how your business creates its information
Gather sample data before you begin the audit
• Perform data profiling
• Identify potential areas of exposure
If a computer generated statistical audit approach is going to be applied, then review data for consistency before providing to auditor
43
Suggested Best Practices (cont’d)
Be prepared to discuss data and sampling issues pertaining to the audit with the auditor
Carefully review the auditor’s proposed sampling plan and procedures
Be prepared to negotiate with the auditor prior to beginning the audit:
• Accounts of interest
• Grouping of transactions
• Treatment of missing documents
• Ability to include tax over-payments and refunds in the audit
Sign-off on sampling agreement
44
Suggested Best Practices (cont’d)
Obtain an audit Closing Letter
If a “no-change” audit get it in writing
File appeals timely with supporting documentation
Discuss audit results with management, IT, accounts payable, tax, procurement, accounts receivable
Take corrective steps to address issues raised during the audit to reduce future assessments
45
Sales and Use Tax Audits: Effective Strategies and Best Practices
47
Audit Best Practices
Audit Best Practices
48
Should you receive a nexus questionnaire
• Do not ignore
• Call Your SALT Expert
• States use these for “fishing expeditions” • You may simply misunderstand/misinterpret a question and
give too much
• Some questions can be ignored – e.g., N/A
• NESTOA /SEATA – tax departments talk to one another
• If you determine nexus, a SALT expert may be able to
negotiate resolution
Audit Best Practices
49
Should you receive an audit notice or an XYZ letter from your
supplier/customer
• Do not ignore
• Call Your SALT Expert
• The auditor is basing their inquiry on a small piece of the
transaction, or an audit of a supplier/customer (referral) -
fishing
• XYZ letter: the supplier/customer is asking you justify
nontaxable treatment of a transaction being audited
• Manage expectations and control the flow of information
Audit Best Practices
50
Understanding why you were selected for audit
• Cell System (CA, MD) - Segregates businesses into groups or
cells generally by SIC or NAICS code
o A number is assigned to each cell - Lower numbers (1-5)
indicate greater likelihood of tax changes
• Other Reasons –
o Experience, volume, and complexity
o Law changes
o Change in business entity
o Leads from other audits
o Referrals from other taxing or regulatory agencies
o Company websites
Develop Audit Best Practices and Protocol
Taxpayers are audited by state auditors who are:
• Often inexperienced and poorly trained
• Don’t understand sampling methods
• Don’t understand the taxpayer’s business
This often leads to assessments that are vastly overstated
Audits Focus on
o Taxable Purchases (Use Tax vs. Sales Tax)
o Then Taxable Sales
o Reconcile Sales & Use Tax accounts
o Other unique transactions
51
Develop Audit Best Practices and Protocol
Audit Process Only Begins with a Notice of Intent to Audit
Audit Actually Began 3-4 years ago
Pre-Audit: Audit Thyself!
• Review the Items to be Audited
• Certificates & Documentation
• Determination & Positions
• Review Compliance and Audit History
52
PRACTICAL TIP: Control the Flow of
Information – taxpayers are often
intimidated but they should not turn
over information without agreeing to its
use and implications prior to releasing
Develop Audit Best Practices and Protocol
Initial Meeting & Workplan: Set the Tone
• Introduce auditor to your Company and record-keeping /
compliance processes
• Manage expectations
o Discuss what information you can provide and if
unavailable, suggest alternatives
o Discuss timing of information
• Set milestones and a date for the audit to conclude
• Set site ground rules for when / where audit may work on-site
53
Develop Audit Best Practices and Protocol
Initial Meeting & Workplan (cont’d)
• Discuss how to handle Missing or Insufficient Documentation
o Company purchasing cards and electronic transactions
o Bundled services
o Exemption certificates
• Discuss how to handle overpayments, then get to work
• Document all communications and Request that the Auditor
issue all Request for Information in Writing as well
54
Develop Audit Best Practices and Protocol
Initial Meeting & Workplan (cont’d)
• Sampling – pros and cons
• Statistical vs. Nonstatistical
• Discuss, but avoid written sample agmts
• Discuss if you can select the sample - Recommend any sample
periods that you have previously reviewed and with which you
are comfortable
• Discuss treatment of large, non-recurring items – isolate
• Discuss whether overpayments can be included in the sample
results
55
Develop Audit Best Practices and Protocol
Waiver of Statute of Limitations
• Extends the time the auditor has to complete the audit beyond
the statute of limitation
• Can extend the audit timing to a more convenient time and
enable taxpayer to gather information
• Enable taxpayer to identify offsets – make sure waiver covers
over and under-payments
• Absent a waiver, auditor may issue assessment to protect
period (jeopardy assessments)
• Consider how long to extend – 3 mos / 6 mos / never more
56
Develop Audit Best Practices and Protocol
Based on Initial Conference, draft Audit Guidelines and provide to
auditor
• Security, access to space / records, hours
• All questions to be in writing
• Encourage face to face meeting for all Q&A, then document
Request Updates and Review Workpapers at every step of process
Review Final Workpapers and Sampling Projections
Present Overpayments & Offsets
Closing Conference
57
PRACTICAL TIP: The best way to
reduce potential exposure is to identify
it and develop a strategy to keep it off
the workpapers
Develop Audit Best Practices and Protocol
Appeals
• Expert - if you have not already done so, retain an expert
• Venue – administrative versus courts: administrative hearings
are typically less formal and may be more flexible in the issues
put forth, but they are typically not independent tribunals
• Exhaustion – if the outcome at administrative level is not
favorable, consider seeking a compromise or re-consideration
before appealing to courts (avoid Pay to Play)
Remedial Efforts
• Make sure to address the issues in your compliance processes
to avoid future liabilities on these issues
58
Develop Audit Best Practices and Protocol
Common Audit Issues
• Documentation - Missing / Insufficient
• Resale / Exemption Certs
• Proper rates – automation
• Digital transactions – does invoice indicate elec. delivery
• Bundled / Mixed transactions - “true object” test
• Use tax on purchases
• XYZ to ensure no double taxation
• Invoice presentation
o what does it say / not say about what you sell
o Bill To vs. Ship To
59
Develop Audit Best Practices and Protocol
Best Practices
• Your Company’s audit started 3 – 4 years ago – always be
auditing yourself
• Be kind to your auditor
• Manage the audit and document flow
• Manage expectations
• Reporting and Documentation – paper trail
• XYZ Letters – use them
• Exemption / Resale Certificates – get them
• Invoice presentation – separately stated and tax considered
descriptives for line items
• There are sales tax experts out there
60
Thank You!
Michael T. Dillon, Esq.
President
Dillon Tax Consulting LLC
4 Steele Avenue
Annapolis, MD 21401
Direct: 410.507.9282
mike@DillonTaxConsulting.com
www.DillonTaxConsulting.com
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