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Watch Out for Indirect Tax Audit Triggers

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As a small business owner, you pay direct taxes on the income your business earns, and indirect taxes such as sales and use taxes. Most small business owners are more than aware of the potential for an audit by the Internal Revenue Service (IRS) on the direct tax portion of their tax liability.

 
However, indirect tax audits can be more costly and time consuming. An indirect audit is an audit of the indirect taxes/fees a business owes. A business must pay direct taxes (taxes paid on the money a business earns) and indirect taxes (taxes owed on what the business sells).
 
Your odds of facing an indirect tax audit are actually higher than the odds of IRS small business tax audits. That’s because while the IRS audits 2–12% of the tax returns filed with the agency every year, some states audit up to 20% of the business sales tax reports filed each year.
 
When small businesses find themselves facing an indirect tax audit, one of the most common questions is the plaintive, “Why me? What did I do to draw this attention to my business?” Sometimes it’s just a random chance, when an audit system selects a tax return at random for closer scrutiny. More often, however, a small business has overlooked one of these tax audit triggers.
 
No State Registration
 
In indirect tax audits, state auditors look for what they call a nexus of factors without registration. A small business may have a nexus (or collection) of facts that make it liable for sales and use tax payment and reporting. For example, if a business is paying payroll or unemployment taxes, or has registered with the state worker’s compensation board, but isn’t registered to collect and pay state sales tax or use taxes, an auditor is likely to want to know why.
 
Here are some other tip-offs that may send the state looking for a state registration for sales and use tax payment and reporting:
 
  • Your business is on the Web or in the phone book, on an online press release distribution site, or is featured in a newspaper, magazine or online news report—but isn’t found in the state system.
  • A resale certificate has been issued, but the business is not registered for sales and use taxes. If you registered for a resale certificate but didn’t register for state sales taxes, it’s almost like volunteering for an audit. Be very careful not to use a resale certificate to purchase items that will be consumed or used rather than resold. The penalty for abusing a resale certificate can be enormous.
  • One of your vendors hasn’t charged the proper use tax, gets audited, and your business shows up during the audit of your vendor. One audit leads to another: it’s the primary source of leads for state auditors who are following a money trail to find missed tax payments.
 
A successful and fast-growing business that shows up on an annual list like the Entrepreneur Hot 100, or the local business journal’s list of “40 Entrepreneurs Under 40,” or even in the local Chamber of Commerce newsletter on new businesses in town is a business that an auditor might want to look at. High sales volumes and rapid growth can cause high volumes of errors and omissions—so the more successful your business is, the more likely it is to be fertile ground for direct or indirect small business tax audits from an auditor looking to increase collections and revenues.
 
Paying One Tax, But Not Another
 
Often a start-up business will file for a sales tax permit without realizing that there are associated use tax permits. To an auditor conducting indirect tax audits, filing and paying sales taxes without filing and paying use taxes is like painting a large red bull’s eyes on your business.
 
Another bull’s eye likely to draw small business tax audits is the purchase or sale of a lot of tax-exempt items. Determining what is tax exempt and what is not isn’t always easy, and there’s always room for mistakes, errors, or fraud when dealing with exempt goods and services.
 
People Trigger Tax Audits, Too
 
Auditors are people, too. They buy things, drive around town, attend networking events and social events, and have kids who attend local schools. They don’t turn off their eyes and ears when they leave the office at the end of the day. So one of the ways that a small business winds up on an auditor’s list of companies to check out is quite simply an auditor who:
 
  • Noticed a sign or ad for your business.
  • Visited a construction project, and noted the contractors working on site, or jotted down the names of tenants in an office building or shared work space.
  • Met you or one of your employees, purchased an item from you, or received an email, coupon, flyer or other promotional item for your business.
 
Don’t forget that tax authorities operate hotlines, and pay fees to whistle-blowers. Unhappy employees, upset customers, aggressive competitors, and even neighboring businesses who might be upset with you can call and report a potential tax violation that results in an audit.
 
What to Do If You Get Audited
 
The best way to avoid penalties in the event of an audit is to plan ahead so that your books, records, and returns are ready for close scrutiny. And that means consulting a tax advisor, and being meticulous about keeping your records and receipts up to date. A professional bookkeeper or bookkeeping service is your best defense against audit penalties.
 
Having your tax returns prepared by a CPA from an accounting firm that specializes in small business taxes can help, too. Unlike an online software company, a tax accountant will sign your tax return as the preparer and stand with you in the event of an audit. This can be invaluable in the event of a state tax audit.
 
Last, but not least, don’t panic. Talk to your tax advisor about what to bring with you to an audit, and what to expect. Remember that the auditor can determine that your records and filings are accurate, and you can wind up owing nothing, or even getting a refund.
 
So pay what you owe, document your income and expenses, and don’t paint that bull’s eye on your business by committing these common audit-attracting mistakes.
 
This article was originally published by 1800 Accountant
 
Gary Milkwick is Vice President at 1800Accountant.com, a tax preparation and consulting firm based in New York City that serves thousands of small business owners.  Gary previously worked with Fortune 500 clients at PricewaterhouseCoopers, and with a regional accounting firm in Atlanta, Georgia that provides tax and consulting services to small business owners.
 
Gary earned B.S. of Accounting and Master of Accountancy degrees from Brigham Young University and an MBA from UCLA’s Anderson School.  He holds Series 7 and 66 securities licenses.  He is a licensed CPA with the Personal Financial Specialist designation in New York and Georgia.
 

Published: August 20, 2013
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