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Sales and Use Tax Audits: Effective Strategies and Best

Practices

WEDNESDAY, MARCH 14, 2018, 1:00-2:50 pm Eastern

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WEDNESDAY, MARCH 14, 2018

Sales and Use Tax Audits: Effective Strategies and Best Practices

Joseph N. Endres, Partner

Hodgson Russ, Buffalo, N.Y.

[email protected]

Michael T. Dillon, President

Dillon Tax Consulting, Annapolis, Md.

[email protected]

Joseph F. Geiger, Jr., CPA, Consulting Tax Manager

Vertex, King of Prussia, Pa.

[email protected]

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


10

3.) Technology – NY’s “CISS” Program


• 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)


12


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.


13


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!


14


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.


15


Compare returns of similar businesses operating within the same

geographic areas

You don’t want to be the oddball!


16


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


17


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


18


Professional licenses

This usually does not apply to businesses with taxable sales

But be careful – hairdressers/barbers, security guards, sanitation, etc.


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.


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).


21

6.) Asset Sales / Transfers

Most states require notification of an asset purchase

Successor liability can compel compliance

Personal liability will attach


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


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


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


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


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


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


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


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


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


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


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


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


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

[email protected]

www.DillonTaxConsulting.com