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Navigating the Sales and Use Tax Audit

an auditor closely inspecting an invoice

What do you do when your company receives a letter that it has been selected for a sales and use tax audit? There are things that you should and should not do before the audit starts. We call this the Pre-Audit because the auditor’s letter is the first signal to “circle your wagons” and call a professional in asales and use tax.

In this blog we will discuss what the auditor wants you to do and what your representative will likely recommend you do. If you just received an audit letter then we recommend the following: stop, breathe, don’t talk to the auditor without representation, and call an expert in sales and use tax.

The Sales and Use Tax Audito

We want to remind our readers here that we respect the job that auditors do, and we always aim to engage with them respectfully and fairly. Unfortunately, the nature of an audit is that it’s easy to see it as adversarial. So, what should you expect from the auditor? The auditors’ general premise is that they have the law on their side so the taxpayer must comply with their requests. Those requests are going to be demanding and, in some cases, unreasonable. As a taxpayer, it’s OK to push back on some of these requests.

In California and other states, initial contact is generally made via a letter informing the company about the audit and requesting books and records. In some cases, the company may receive a phone call from the auditor. We will talk about the books and records letter in a moment, but the trickier situation is when an auditor calls before the books and records letter is received. Consider these questions:

  • Who in your company might receive the call?
  • What questions will the auditor ask them?
  • How might your employee answer the questions?
  • Will your employees’ responses to the questions be correct?

Hopefully your employees know who to direct the auditor to. Then, we recommend that the initial contact employee respond with a short comment: “Thank you for the call, please give me your name and phone number and we will get back to you. I hope you have a great day. Bye.” There are very few “random” audits. The state only has so many resources, so it is likely that the company was selected for audit for a reason. Somewhere, there was a flag. And it’s important to perform the Pre-Audit steps to get ahead of what those reasons might be.

The Initial Request For Information

As mentioned above, the CDTFA always sends a “books and records” letter to let the company know it will be audited and to request certain books and records. The standard books and records letter will ask for the following for at least the last three years:

  • Sales and use tax returns, including related worksheets.
  • General ledger and related journals – they want them electronically.
  • Sales invoices – again, they want them electronically.
  • Purchase invoices (paid bills) for consumable supplies and fixed assets (for example, furniture, fixtures, and equipment).
  • Documentation supporting claimed exempt sales; delivery documentation for out of state sales; and all of your resale and exemption certificates.
  • Federal income tax returns, including depreciation schedules and 1099 statements.
  • Property tax statements.
  • Sales invoices for fixed assets sold during the audit period.

Before sending any data, take the time to prepare to be audited. Hopefully, you’ve done the Mini Sales and Use Tax Audits (“MSUTA”) and are ready to have a call with your consulting firm. Even if not, during this call your advisor will want to better understand your business and determine where your risk is. What are your sales and use tax reporting strengths and weaknesses? If you have done MSUTAs we will want to review those working papers: the tests conducted, the extent of the testing, the findings, any corrections already made and when those corrections were made. This will give us a good picture of the company’s potential exposure during the audit period. And let’s not forget about the possibility of refunds.

If the company has not performed any MSUTAs then the discussion will be more comprehensive up front. We will want to learn about the company in-depth including reporting habits over the period to be audited; and where the company has exposure. We will want to work with you to determine the most reasonable method of testing the books and records for both sales and purchases.

Auditors look long and hard at nontaxed sales and purchases. Do you have support for untaxed sales? Have you made purchases of fixed assets or expenses that were not taxed? Both could be exposure areas.

The Meeting – Company, Advisor And Auditor

After we have met with company representatives, completed our evaluations, identified your areas of exposure and possible refunds, and developed our plan, it is time to contact the auditor. We will need a properly executed power of attorney in order to contact the auditor. The power of attorney allows us to act as the company’s representative regarding the audit.

Our first call with the auditor will cover many topics – the following is a brief list of what we will discuss:

  • We will ask for copies of all records for any prior audits. We want to see how prior audits were done and if the auditor provided any advice in error or if we can apply prior percentages of error to the current audit;
  • We will discuss the possibility of doing a Managed Audit Plan (“MAP”). A MAP is an audit that is conducted by the representative/taxpayer and it provides a fifty percent reduction of any interest liability from under-reported tax, this can sometimes result in a significant savings. Penalties are also often waived under this program;
  • We will discuss what will be tested and how it will be tested – is statistical sampling the best approach or block samples (testing a month, a quarter, or a year) or an examination of every transaction?

In Summary

There is a lot to consider in the initial stage of an audit, and much that we will do to make sure that you are receiving the best audit defense. The key point we hope you take away from this article is that what you say to an auditor is like the proverbial bell that has been rung – it can’t be un-rung. Please call a professional before you talk to an auditor.

Once we work with you to determine risk areas, a plan for working through the audit, and a timeline, we can refine interactions between the parties. But we always recommend to put someone like us (your consultant) in between you and the auditor. It’s not because you have anything to hide. You just have other areas you specialize in within the Company. We specialize in state sales tax matters and in minimizing both the possible tax exposure AND inconvenience of engaging in the audit. Allow us to help.

Hopefully, your company has followed the suggestion in our third blog and hired an experienced representative to drive the company’s audit defense. An experienced representative is your best protection for a favorable audit outcome.

Published: September 19, 2023

Source: Tax connections

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