Today, many states continue to face budget constraints and are increasing their audits of taxpayers to find tax liabilities to generate revenue.  One area that is often overlooked is the accrual of use tax on taxable purchases on which the vendor did not charge tax.  With many online retailers still not charging sales tax on taxable sales, this issue is particularly relevant.  The dire economic situation for many states is resulting in more use tax audits and more aggressive use tax audits.  Penalties are being assessed more aggressively for non-compliance with reporting and remitting use tax.  Additionally, subsequent audits of taxpayers where corrective actions weren’t taken are being assessed higher penalties or automatic penalties.

There are a number of ways that states are targeting companies for audits – some of which tend to focus on the sales tax side but will result in finding unregistered companies for all tax types.  Here are some of the most common audit lead methods used by the states:

–  Nexus inquiries – States identify unregistered taxpayers through an audit of one of your customers.  This is most often the case if you are providing a service in the state.  Since services are not taxable in many states, the service provider owes use tax on materials used in providing the service. In this case, you may receive a nexus inquiry letter from a state.

–  Late filed returns – Filing late tax returns can get you on the radar of state auditors.  If you are only reporting sales tax, your use tax obligations are at risk under audit.  Ensure that you are timely filing all tax returns.

–  Large refund requests – If you make a request for a large tax refund, you can also draw the attention of state auditors.  This is often the case when a customer has paid tax and is now requesting a refund.  The seller needs to get the money back from the state – but if you haven’t been reporting use tax,expect that liability to be offset against the refund claim.

–  Large fluctuations in tax liabilities reported – Filing tax returns with widely varying tax liabilities from year to year is another item that can lead to audits.

–  Audits of your partners – If one of your business partners (customer or vendor) is being audited, it’s just a small leap for state auditors to contact you for an audit.  Similar to the nexus inquiry – if you are providing services in the customer’s state, they have proof you’ve been in the state.  If you are charging tax incorrectly to one customer, it is likely you have other errors.  From your vendor’s side, if you’ve issued an exemption certificate that doesn’t seem appropriate, your vendor is likely off the hook – but expect a visit from the state!

–  Recurring compliance issues – Making numerous errors on tax returns – math errors, a page missing from your tax return, other inconsistencies – can catch the eye of auditors and result in you being contacted for an audit.

Any of the items above are ways that you may become a target for an audit.  For this reason, it’s important to make sure that your company is compliant with use tax accruals.  A few items to watch for in particular are internet purchases and converted inventory.  As noted above, some internet retailers are still not charging sales tax on taxable sales.  This creates a potential liability for any individual or business making online purchases.  When making taxable purchases online, make it a standard practice to see if sales tax has been charged.  If not, track the use tax liability that you’ve incurred and report and remit any use tax due in a timely manner.  Use tax also applies to items purchased exempt from tax under one exemption (typically resale), but subsequently used in a taxable manner.  Converted inventory is one example. Converted inventory is taxable because it was purchased exempt from tax under the premise it they would be resold.  If the inventory is not resold, the purchaser owes use tax.