B u l l e t i n. Preparing for a Sales Tax Audit INTRODUCTION THE SALES TAX AUDIT

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1 Bulletin No. TX 6 File: Taxes B u l l e t i n Preparing for a Sales Tax Audit INTRODUCTION In the best of circumstances, state and local tax audits of construction contractors eventually turn adversarial and are, therefore, not to be treated lightly. It is best to be prepared, organized, and focused on resolving the issues with practicality and technical proficiency. To position yourself best, you should know the process and the rules. Areas typically troubling for construction contractor audits include the following: 1. Exempt purchases: Are they really exempt? 2. Use tax: Did you pay the right jurisdiction or did you pay at all? 3. Leasing transactions: Is the lessor or lessee responsible for paying the sales tax? 4. Services: Should you have charged a sales tax for services? 5. Repairs: What repairs are subject to the sales tax? 6. Fabrication: What part, if any, of the fabrication cost is sales taxable? The answers to these questions are not necessarily addressed here, but are some of the issues you should plan on addressing during your preparation for an audit and/or during the audit process. The best plan of action is to be certain these transactions are properly handled even before you are subject to a sales tax audit. Of course, you also want to avoid paying taxes that are not required. Consult with your attorney and/or tax advisor to help you prepare for the audit and negotiate a fair outcome, if necessary. Once the audit process begins, be as cooperative and accommodating to the auditor as possible. Your positive attitude may ease the process should it become adversarial later. THE SALES TAX AUDIT The sales tax audit process occurs in three distinct phases. Each phase requires you to understand the process, plan, organize, and know your rights. The phases are as follows: 1. Pre-audit 2. Field audit 3. Post audit How you prepare/organize yourself for each step may be the key to the success or failure of an audit. Copyright, Mechanical Contractors Association of America, Inc.,

2 PRE-AUDIT Prior to receiving the audit notification from the state or local government, you should already have a plan on how to effectively defend yourself. When the audit notice is received, make sure it is detailed. It should address the following: 1. Type of audit (traditional or sample) 2. Periods under investigation 3. Commencement date 4. Documentation requested A traditional audit involves the examination of each and every invoice. This is a very tedious and timeconsuming process. Alternatively, states may seek to utilize block sampling, which involves the selection of data that is used to represent the population. Unfortunately, block samples do not always reflect the entire population. Hence, preliminary knowledge of the population and the sampling procedures are necessary to better assess whether a sample audit should be utilized. The taxpayer should examine the periods under audit to insure that the period is within the statutory limitation. The rule varies by jurisdiction, but the range is typically 3 4 years. Also, if the auditor asks to extend the period of examination, proceed with caution. At this point, your accountant or a tax professional should assess the case before allowing any extension. Signing the waiver could destroy any negotiating leverage that the company may have. The waiver serves to extend the statutory period of limitations. Any professional experienced with sales tax audits will be able to assess the advantages/disadvantages of signing the waiver. Reverse Audits The most effective tool for audit preparation is the performance of a reverse audit. A reverse audit is a review of the company s purchases to determine whether the sales tax has been paid properly, and it can result in the identification of inconsistent treatment of purchases or errors resulting in overpayment or duplicate sales tax payments. Due to time constraints or lack of understanding of the rules for construction contractors, the sales tax is often paid erroneously. Examples include certain exemptions on purchases or resale exemptions. The reverse audit can often lead to a refund of overpaid taxes, which is then applied to any impending assessment. Exemption and Resale Certificates Crucial, but often ignored, management tools for the audit are the exemption and resale certificates. They can help you avoid tax assessments when used properly. The auditor will penalize the company when they are not in the file. THE FIELD AUDIT Audits arise either from 1) routine random selection, or 2) a triggering event. There are a number of issues that are considered hot buttons for any particular state, which may trigger the examination. More common issues include the filing of a refund claim, the results of an audit of a competitor contractor (the tax office is focusing on similar businesses with similar transactions) or the results of an audit of your general contractor customer. The prevailing areas of activity reviewed in an audit include: Copyright, Mechanical Contractors Association of America, Inc.,

3 1. Sales 2. Purchases 3. Fixed asset acquisitions 4. Exemption and resale certificate files Sales are reviewed through an examination of the invoices to determine whether a tax was due and charged. Purchases are assessed by reviewing and determining whether the vouchers indicate that a tax was paid or should have been self-assessed (use tax). Fixed asset records are typically examined to determine what assets have been placed in service. Invoices are evaluated to determine whether the appropriate tax was paid at the time of purchase, whether self-assessed or an exemption exists. This evaluation may consider purchases for the purpose of fabrication. As discussed above, exemption certificates are the final area of review by the auditor. Sampling The use of statistical sampling by states in performing audits has gained popularity in recent years. When employed properly, it can result in efficiency. Sampling is flexible and, as a result, it may be manipulated to reflect an inaccurate representation of your business transaction. Hence, care should be exercised in understanding the sampling method and you should be on the lookout for results that, may, in fact, not be a fair representation of your transactions. Block vs. Random A block sample is a technical analysis of the audit period s activity that selects a theoretically representative period to reflect overall activity. Block sampling usually reviews a month or a quarter s transactions rather than the full period under examination. A random sample involves the process of analyzing data through the process of selecting every nth document resulting in coverage of the entire period under examination. POST AUDIT Once the field audit has been completed, several steps need to take place. 1. Review assessments as well as the auditor s rationale from a technical perspective. Are the conclusions reached founded in the law? Discuss clarifications if necessary. 2. Discuss appeals process. Most states have an information hearing process wherein a taxpayer, through representation, files a protest to the formal assessment. Finally, a follow-up meeting is offered to discuss any open issues. Negotiations and trade-offs are available during this process. 3. Statute of Limitations. Remember that all states have a statute of limitations. This is the time within which a complaint may be filed. In most states, the time is 3 4 years and must be kept in mind when negotiating. Although the state will discuss your formal protest to the assessment, it is the responsibility of the taxpayer to timely file a complaint if he/she disagrees with the assessment. Be aware that oral representations by the agent have no effect on the time limit. 4. Closing conference and agreement. A closing agreement is used to terminate and dispose of the dispute Copyright, Mechanical Contractors Association of America, Inc.,

4 between the taxpayer and the state. It is most crucial as it closes out any open years. Closing agreements are binding on the parties as to the matters agreed upon and may not be annulled, modified, set aside, or disregarded in any suit or proceeding unless there is a showing of fraud, malfeasance or misrepresentation of a material fact. This is a general rule and varies by state. Closing conferences are necessary to discuss any adjustments, negotiation points, or mathematical errors in the work papers. This is also the setting to discuss interest, penalties, and the flow of any information. PRACTICAL OBSERVATIONS In conclusion, keep in mind the following: In dealing with the inevitable audit, the best defense is preparation. A reverse audit performed by your accountant or tax professional will identify risk issues as well as improve the compliance process. The right professional has the technical expertise to dispose of non-issues raised by the auditor. Your accountant or tax professional will also identify potential refund claims that are available to offset any assessment. Treat the auditor with respect, but segregate the auditor from the accounting and financial staff to minimize their communication without supervision. Keep your ultimate result in perspective. Ultimately, the conclusion of an audit is the product of lengthy negotiation on several points. Being prepared and organized is critical as it shows the company s commitment to tax compliance. Your commitment to tax compliance may be the audit s most overriding theme for the success of the audit. PREPARING FOR A SALES TAX AUDIT Exempt Purchases Exempt purchases do not require collection or payment of a sales tax. For example, some states may exempt materials and supplies purchased for work involving the U.S. Government; state government; nonprofit educational, religious, or charitable organizations; farmers, and other organizations deemed exempt from sales tax. The rules vary widely by state, so contractors need to check the rules in each jurisdiction in which they work. Use Tax Use tax was implemented in most states to complement the sales tax. The difference between the sales tax and the use tax is that the use tax is paid by the contractor when the goods are consumed outside the jurisdiction in which they were purchased. For example, if a contractor buys materials in Maryland to use on a Maryland job, the purchase is subject to Maryland sales tax. However, if the contractor buys materials from a supplier located in Maryland and has them delivered to a Virginia job site, the contractor pays the tax to Virginia. Copyright, Mechanical Contractors Association of America, Inc.,

5 Fabrications Sales tax audits also address issues of fabricators. A fabricator is a business that manufactures, processes, or assembles property for sale that becomes a component for real property upon installation. Fabricators often also act as contractors and actually do the installation. Fabricators generally purchase materials for resale and thus issue exemption certificates to the vendors to avoid paying sales tax on the materials. Upon sale and installation, the fabricator/contractor collects and pays sales or use tax to the jurisdiction in which the installation occurred, even if the installation resulted in a capital improvement. The fabrication for sales or use tax is valued at the price at which similar items are offered or, if there are no comparables, at the cost of all materials used in the fabrication. The fabricator is also usually required to collect sales tax on installation charges when the installation does not constitute a capital improvement. In those situations in which a fabricator sells products to others for installation by the buyer, the fabricator collects and remits sales taxes based on the selling price. The Management Methods Committee gratefully acknowledges the contribution of this information by: Eric J. Purnell, JD, LLM and Tim Cummins, C.P.A. of Aronson & Company, Rockville, MD Copyright, Mechanical Contractors Association of America, Inc.,