This article is the third part of a three-part series regarding the State and Local Tax consequences of doing business in multiple states.  This article will discuss a State Tax Audit. Part 1 discussed Nexus and Part 2 discussed Voluntary Disclosure.

Questions we get from companies regarding its multistate activities are:  “How will states find me?”  “How will states enforce these new economic standards for sales and use taxes and income, franchise or gross receipts taxes?”   The answer is “do you really want to find out!”  The cost of states finding you and then assessing tax, interest, and penalties versus being proactive and compliant with state tax laws, as discussed in Part 1 of this series, can be a lot of money, as tax, interest, and penalties multiply very quickly.

When a state does an audit of a company, the state will ask the company for a customer and vendor list and will ask for invoices.  How do states find you?  If you have a customer or vendor located in another state, and the customer or vendor is audited, your name will be on that list.    Now the state knows you.

What is next?  The state will likely send a nexus questionnaire to complete and return to the state.  The nexus questionnaire will ask questions such as the amount of sales into the state, do you have any property, employees, or other tangible assets in the state, and other background information about the company.  Most importantly, an officer of the company will sign the nexus questionnaire under the penalty of perjury.

A common error by companies when filling out the questionnaire is that they do not answer the questionnaire based on the entity listed on the questionnaire and its activity in the state.  You must answer the questionnaire based on the entity’s name on the questionnaire and its activity in the state.  Do not answer the questions based on your affiliated companies’ activity in the state, if any.  Please note, if you have an affiliated company with nexus in that state, you should be proactive and ask for voluntary disclosure, as discussed in Part 2 of this series, because the state will likely find out about the affiliated company in the near future.

Do not ignore nexus questionnaires from states, because states may impose penalties on your company for ignoring such questionnaires.   We recommend that you have a state and local tax professional review your answers before you submit such a questionnaire to the state.

Please note states have audit offices and auditors working in other states.  For example, Texas has audit offices and auditors in Illinois, California, New Mexico, Oklahoma, and New York.

Once the state receives the questionnaire and based on your answers, the state will likely send you an audit request.  The audit request will ask for your sales activity in the state, a general ledger of your sales activity, and other information. Note, if you have no physical presence in the state, the state will not ask for any expense or asset information.

We believe that it is important to manage your audit.   We recommend having a state and local tax professional during the audit process.  The professional can review the information to be provided to the auditor and review all documents prepared by the auditor.  Also, we believe that the key to a smooth audit is communication with the auditor.  Do not ignore requests by the auditor because if auditors are ignored, they will make a blind assessment of the company, causing you more headaches.

Have a question? Contact Freeman Law, Texas.