Slam Dunk Your Next Audit with These Sales Tax Audit Preparation Tips
Updated March 2021: It's March Madness month, which leads me back to this article about sales tax audits for manufacturers. Just like the basketball tournament, audits are still being conducted with special protocols in place. In fact, we've already seen an uptick in audit notices, so I expect we will continue to see states conducting more audits to help make up for lost revenue from the economic shutdown caused by COVID-19. What has not changed are the steps manufacturers can take to simplify the audit and reduce assessments.
Basketball season is upon us. I am not an expert, but I do love to see the players slam dunk the ball. It exudes such a feeling of control. Unfortunately, manufacturers often feel lack of control during audits. The ball is in the hands of the auditor. But like basketball, training and preparation will help make your next sales tax audit a slam dunk.
Assessments are often simply the result of missing or invalid documentation, not incorrect interpretation of sales tax regulations. So here’s my eight tips to help you come out a winner for your next sales tax audit.
Tip #1: Missing AP Invoices
I’m convinced a great big black hole somewhere in the universe contains every missing invoice an auditor has every requested. Unfortunately, most auditors penalize you for missing invoices with tax assessments.
When creating a statistical sample of purchases under audit, make sure you have a plan to deal with the inevitable missing invoices. Perhaps agree with the auditor to select a few invoices in reserve to replace the missing ones. Otherwise, you’ll be asking the auditor for a time out to make frantic calls to your suppliers tracking down old invoice copies.
Tip #2: Depreciation Schedules of Fixed Assets
Auditors often look to depreciation schedules to audit fixed assets. If you can’t tie every number to a specific purchase, the auditor likely is going to assess you tax on what is listed on the depreciation schedule.
My record-keeping tip: Set up a Fixed Asset Digital File with copies of all invoices, journal entries, project requests and approvals. Keep all documentation that will support a tax exemption if one was taken. Collating this information together in one central file will go a long way to making the audit process run more smoothly. The auditors will have all the information they need to tie the purchases to the depreciation schedules.
Share audit survival ideas with key employees by downloading this tip sheet:
Tip #3: Clear Paper Trails of Use Tax
Make sure that you can easily reconcile and recreate your use tax payables. I’ve seen far too often journal entries and manual adjustments made to correct use tax accruals prior to filing the return. In hindsight, several years later, no one can make heads or tails of the adjustments, and the returns are difficult and sometimes impossible to reconcile.
Tip #4: Exemption Certificates
For each exempt transaction made by your company, a valid exemption certificate from your customer must be on file. It sounds easy, but in reality, this is one area where companies need coaching to develop a good process. In preparation for an audit, many companies attempt to obtain exemption certificates from customers. Inevitably they run into problems. Perhaps the company is out of business or they discover the purchases should have been taxed.
2021 Update: Auditors are aggressive at assessing tax on transactions with no exemption certificates.
My record-keeping tip: Before the audit letter arrives put some procedures in place to make sure your exemption certificates are well managed. Who is collecting them? Who is validating them? Who is handling the renewals? Where are they stored?
Also, conduct quantitative analysis to determine your company’s exposure due to missing exemption certificates. If this is one area where your company needs help, start with this article: How Exemption Certificates Impact the Bottom Line for Manufacturers.
Tip #5: Document Everything, Especially Audits
I have one client that created a master spreadsheet of all the audits that her company has undergone. This information includes the state, the audit period, the initial assessment, the final assessment, any overpayments applied to offset the assessment, the basis for the assessment (sales/exemption certificate issues; purchases/fixed assets; purchases/expenses) and any negotiated issues that were resolved in the audit. Now that’s a slam dunk! Not only does the spreadsheet provide a great replay of the company’s audit history, but it also showcases her audit proficiency and highlights her management of the company’s sales and use tax procedures.
2021 Update: Now with most audits being conducted remotely and taking even longer because of COVID-19 restrictions, keeping good electronic records of all communications is especially important.
Tip #6: Create A Plan for Improvement
If an audit or reverse audit indicates areas that need improving, create a playbook to address the problems. Does your staff need training on sales tax? Are exemption certificates missing? Do team members have a good understanding of when use tax is due? Do controls need to be tightened on exemption certificate management? A sales and use tax management playbook gives you a game plan that makes everyone accountable. Periodically spot check to see if processes are being followed and improvements are made.
Tip #8: Build a Team
On the surface, sales tax may not seem complicated, but imagine if every time a basketball team played in a different state they had to follow a new set of rules? The number of fouls issued during games would skyrocket. Sales tax teams need to stay on top of different nuances between states and industry-specific exemptions, as well as a variety of legal entities and ERP systems. Line up a team of resources to ask for help, get opinions and brainstorm solutions.
A good team, good coaching, well-trained players and regular practice are the keys to having a championship sales tax season.