When a taxing authority performs a sales and use tax audit, their primary audit objectives are to review the taxpayer’s purchases and assess tax on underreported purchases subject to use tax and on the sales side, to review the taxpayer’s claimed exempt sales and assess tax on unsupported claimed exempt sales.  While the principles discussed below can be applied in part to sales, the focus here will be on the purchase side of the review.  The objective of such a review is for a company to determine before or during an audit whether they may have some errors in their favor that might lead to a refund.

As noted, the state auditor is generally testing purchases to determine the amount of unreported purchases subject to use tax.  A “reverse audit” takes a more holistic approach by identifying under and over payments of tax as well as the root cause of those errors.  The following text describes at a high level the primary steps of a reverse audit, and why your company might benefit from one

Data Acquisition and Initial Review

The review needs to begin with good data that reconciles to the trial balance.  Starting with a complete and reconciled data set ensures that the starting point is not missing anything like a separate accounting system that feeds into the general ledger.  Also, having a data warehouse of complete and reconciled data can save time and effort in dealing with state auditors.

An initial review of the data is also key.  For example, it is beneficial to sample a few invoices to test the accuracy and reliability of the tax flag indicators, meaning whether an item is coded internally to apply use tax to it.  It is important to understand the data fields that can help focus in on areas of interest such as manufacturing or R&D.  Learning upfront how to identify and match tax only adjustments or vendor credits to the original transaction is also helpful.

With a good understanding of the data (and hopefully some good item descriptions and tax indicators), we should be able to summarize tax by vendor, account, cost center, profit center, or item description. This will build the basis for the analysis.

Understanding the Business

If the goal of a reverse audit is to identify where tax is properly due, it’s important to understand the client’s business first. Plant tours and interviews are invaluable to the reverse audit.  Engaging in tours and interviews knowing where the client has paid tax and on what can make the tours and interviews even more productive.

Communication

Assuming that at this point in the project we have been able to identify the areas of tax exposure and the opportunities for recovery of tax paid in error, communicating this information to the client is key.  Explaining the net tax position allows the client to make informed decisions on how to move forward with vendor claims, claims with the state tax authorities, and how to work with internal constituents who need to make changes to their processes. Filing refund claims may trigger an audit,  so filing a claim when the client’s net position is negative never makes sense.  In some cases, our team will need to contact a client’s vendor to obtain the refund. We will need to know if there are any vendors that we should not contact. Finally, training and education help the client make the adjustments necessary now to fix the problems identified during the review.

All the work done during the review and establishing consensus with the client ultimately leads to making certain that the correct filings are made to obtain the refunds.  Next month we will look at pitfalls and best practices relative to procedural filings as well as the benefits of performing a reverse audit on sales, so stay tuned!

Typical companies benefitting from a reverse audit

While any number of companies can benefit from a reverse sales tax audit, we have found that there are certain companies that tend to be more likely to have made overpayments that could result in refund opportunities. These include health care providers, companies with manufacturing or R&D activities, agricultural enterprises, or the entertainment industry.  These business sectors have sales and use tax regulations specific to their industries that can be somewhat complex. For example, we recently assisted a retailer who had a fleet of delivery trucks.  This client was not taking advantage of a California diesel fuel tax exemption.

Written By Miles Consulting new member Greg Weston.

Have a question? Contact Greg Weston, Miles Consulting.