Sales tax audit best practices.

• Author: Esparza, Theresa

With the increasing pressure to close budget gaps, state revenue departments must look for opportunities to revitalize their revenue streams. One way is to increase the number and scope of audits performed on taxpayers, thereby allowing states to collect more revenue without enacting new taxes or increasing tax rates. As a result, taxpayers are becoming the target of sales tax audits more frequently.

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For some taxpayers, a sales and use tax audit is just another aspect of doing business. Due to their size and the nature of their business, some entities are placed on a regular sales tax audit rotation. For other businesses, however, a variety of factors may contribute to getting selected for an audit. An unusual event, such as a business closure or bankruptcy, may give rise to an audit. The compliance "personality" of a business may also trigger an audit. For instance, high exempt sales, poor compliance records with consistent late filings, a drastic change in sales, or a request for an unusually high refund may result in a sales tax audit.

To make the audit odds even greater, the current advances in technology, an increase in popularity of internet sales, and more small businesses' partaking in multistate commerce create opportunities for sales tax underpayment among unwary taxpayers. Some states use random selection to identify audit targets. However, this method is uncommon since the financial result from a randomly selected audit may not justify the time and resources invested by the state tax authority. To maximize the return on an audit, many states implement predictive modeling similar to the Discriminant Index Function (DIF) system implemented by the IRS.' With predictive modeling, different attributes--such as the type of business, amount of sales, types of products, and many other characteristics--are assigned a number. Generally, the higher the cumulative score, the greater the audit potential.

Since taxpayers are dealing with the reality of more audits, accounting firms and corporate tax departments should develop methodologies to reduce the administrative and other costs that result from the increased workload. This article pulls together tips and best practices for each part of an audit life cycle. After addressing tips, common issues facing state audits are discussed, followed by identifying potential opportunities to mitigate audits in the future. Several of these suggestions and opportunities should be useful for publicly practicing CPAs and taxpayers.

Audit Life Cycle

There are four distinct parts to the audit life cycle: (1) the entrance conference; (2) the sampling methodology; (3) the performance of the audit; and (4) the postassessment period.

Initial Conference

Once a taxpayer is notified of a pending sales and use tax audit, an initial conference normally is scheduled. Generally, during the initial conference the following items may be discussed: the availability of information; what items are being audited; the reasons for and scope of the audit; the auditing methodology to be used and periods under audit; the logistics of the audit (auditor's access to the premises, auditor's seating, etc.); and the overall audit plan. Below are suggestions to make the conference successful and productive.

Tip No. 1: The initial contact with an auditor is important, as it sets the tone for the audit process. Cooperate with the auditor and timely respond to the auditor's requests.

Tip No. 2: It is important to keep a record of all communication between the taxpayer and the auditor, especially any agreements reached regarding sampling, taxability, and timing. Should the need arise, one can refer to the historic record to clarify items, point out timing schedules, and resolve any confusion or disagreements.

Tip No. 3: Require that the auditor issue all questions and requests for documents in writing and agree on a time frame for responding to the auditor's information document request (IDR). The response time may vary depending on the nature of the IDR and the taxpayer's ability to respond. For example, if some information is required to be obtained from areas outside of tax records, the taxpayer may need more time to gather the information. The written IDRs and responses reduce the likelihood of miscommunication about the type of information needed and the timeline for the response.

Tip No. 4: Determine how long the auditor expects to be on-site for the audit. Ask if the jurisdiction has a formal policy on how long it can take to complete an audit. If a policy is in place, request a copy. This information may be disclosed in the jurisdiction's taxpayer bill of rights. (2)

Tip No. 5: Set a preliminary date to receive initial audit workpapers. Agree on how long the taxpayer has to review the initial workpapers. After reviewing the initial workpapers, identify the time frame for when the assessment will become final.

Tip No. 6: Often during the entrance conference, the taxpayer will be asked to sign a statute of limitation waiver. The waiver extends the time the auditor has to complete the audit beyond the statute of limitation. Many taxpayers do not have a formal policy regarding consent to an extension of the statute of limitation. If a standard policy does not exist, all the facts and circumstances should be considered before signing the waiver. The waiver may sound disadvantageous to the taxpayer, but there are reasons that signing a waiver can be beneficial. The waiver can delay the audit to a more convenient time and give a taxpayer time to locate requested documentation that was not initially available. It may also be beneficial to agree to the waiver to allow for more time to find offsetting refunds or credits to reduce the assessment. Also, when pressed for time, auditors may issue aggressive assessments resulting in a greater burden on the taxpayer when the assessment is challenged. If a taxpayer is uncomfortable signing a waiver, the waiver can be signed for a shorter term than the auditor requested and then extended if necessary.

The consequences of not signing the waiver need to be considered. In some jurisdictions an auditor may warn taxpayers that the failure to...