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Pre-Audit Planning

States are stepping up their audit efforts to identify new taxpayers, create additional tax revenue and close their budget gaps. If you start preparing for a sales & use tax audit the day the audit notification letter arrives from the state taxing authorities, then you are already behind the eight ball. Preparing for your next audit should start as soon as the last audit ends (or even before), correcting the errors that were identified by the previous auditors and establishing guidelines or procedures to improve the audit process. While most companies today are pressed for time and resources, there are number of relatively easy things you can and should do before the audit starts to help you get up to speed on potential issues and prepare for the audit.

Respond to the audit notice

A sales & tax audit will not go away by simply filing the audit notification letter in the old circular file or putting off contacting the auditors to schedule the audit appointment. Before calling the auditor, read through the notice and check the basics (i.e., entity name, taxpayer identification number, audit period, etc.) to determine who is being audited and for what period. This is especially important for companies with complex operating structures and multiple entities, as the extent of an audit for a holding company can be vastly different from an audit of one of its operating companies.

The letter from the auditors usually includes a jaw-dropping list of records, documents, and other information that is needed for review during the audit. It evokes memories of the wish list you wrote to Santa Claus when you were a child. Some of the information requested on the Information Document Request (IDR) is absolutely essential to the auditors, while other requested information isn’t as relevant to the audit. It is important to know the right amount and type of information that will assist the auditors and keep them focused on the audit at hand rather than bog them down with extraneous details. Ask the auditors what records or documents they primarily need to start their audit, then provide additional information as requested. In turn, ask the auditors to provide you with a copy of their audit manual and their state’s Taxpayer Bill of Rights. Knowing your rights and what the auditors’ roles and responsibilities are will help you do your job better and protect your company’s interests.

Finally, when you call the auditor to schedule the audit appointment, take into consideration that you and your staff need time to prepare and gather the records and documents for the audit. Don’t be alarmed if the auditor asks you to sign waivers extending the statute of limitations for periods in the audit that might be expiring, especially if you delay scheduling the audit for several weeks or months. At this stage of the audit, signing waivers and cooperating with the auditors should benefit you and your company in the long run.

Conduct your own review

Once the audit is scheduled, take a closer look at what the auditors will be reviewing. Conducting your own review of the following records, documents, and information will not only help you identify potential issues but also give you some ideas on how to manage the audit process.

• Tax Returns – Review the sales & use tax returns that were filed during the audit period. Verify that your file copies include supporting documentation for taxable and nontaxable sales, as well as any use tax being remitted.
• Sales – Meet with the Sales or Accounts Receivable staff to discuss the availability of sales invoices. A review of prior year’s sales by customer may be warranted to identify large customers and potential issues. Also, check to see that resale and/or exemption certificates have been obtained from customers to document nontaxable sales.
•  Fixed Assets – Meet with the Fixed Assets staff about capitalized purchases and related records and invoices. A cursory review of recent years’ assets additions will help identify potential exposure or refund opportunities.
• Payables – Meet with the Accounts Payable staff to discuss expense purchases and related records and invoices. A review of prior year’s purchases by account will highlight potential accounts the auditors may want to review based on dollar amount or the type of purchases.
• Data – Depending on the size of your company and the scope of the audit, the auditors may request that you provide your general ledger, accounts payable or other data in an electronic format. Meet with your IT professional about the type of data that may be needed. In our experience, providing auditors with electronic data is usually one of the most problematic steps in the audit process; and special consideration should be given to this during pre-audit planning.
• Prior audits – Review reports and schedules from prior audits to determine what issues caused past assessments, and determine if these issues were corrected going forward. Nothing contributes to the application of interest and penalties by the states more than not correcting prior errors.

Performing a self-audit or review of the above items will not only give you a better idea of the potential issues and exposure that might be identified during the audit process, but will also   provide an added bonus of keeping the lines of communication open with other company employees whose functions either directly or indirectly impact sales & use tax compliance.

Develop a game plan for managing the audit

Now that you’ve scheduled the audit and have reviewed your sales & use tax records and documents to identify potential issues, it’s time to develop a game plan for managing the audit process. Identify a point person who will be responsible for interacting with the auditors on a daily basis; someone who can respond to information requests and questions and monitor the auditors’ progress. This individual should be well versed in the company’s operations and have a good understanding of the tax and financial reporting functions. He/she should also be knowledgeable in the audited state’s sales & use tax laws, especially if he/she is going to responsible for defending the company’s position and/or refuting the state’s assessment. Review – or establish – company policies related to auditor access of your facilities including documents and records, copy machines, where they can go and who they’re allowed to talk to. It might sound trivial, but you never know what the auditor might learn from other employees’ seemingly innocent discussions in the hallway or at the coffee machine. 

Finally, take some time to consider several important issues that will need to be addressed early in the audit process, including the type of sampling methodology the auditors may want to employ for reviewing sales or purchases as opposed to performing a detailed review of all your records. A significant factor in choosing the sampling methodology is whether adequate electronic data is available, an issue which should be addressed during your self-review. Other things to consider include: your company’s policy for signing off on waivers to keep the statute of limitations from expiring on older periods; how sales & use tax overpayments will be addressed by the auditors; and what your company’s acceptable tolerance is for potential assessments. Addressing these and other issues upfront will make the audit process much smoother for your company. 

If you have any questions about this or other State and Local Tax issues, please email Tom Mazurek at . For additional State and Local Tax insights and resources, or to subscribe to our quarterly newsletter, visit tsacpa.com.

The Audit Process

Despite all of your pre-audit planning – or your best efforts to postpone the audit – eventually the time will come for the audit to begin. Start building a good working relationship with the auditors on the very first day of the audit. This starts with the opening conference.

Opening conference

At the outset of the audit it is critical that you set the tone for what is to come. While the opening conference is traditionally when the auditors explain their audit program, ask questions about your business and request data and other information, it is also appropriate for you to set ground rules for the auditors, establish a timeline for the audit and begin asking questions about issues that can affect the audit (i.e., sampling, refunds, etc.).

For some companies, setting the tone for the audit means putting the auditors in a dank office with no heat, out in the warehouse, in the middle of winter. This tactic may unfortunately set the tone for a large assessment from now-disagreeable auditors. Treating the auditors respectfully and providing them with appropriate accommodations (i.e., office or conference room, telephone, internet connection, access to bathrooms, etc.) is not only the professional thing to do, but it goes a long way to build a positive working relationship.

At the same time, it is important to establish some ground rules for the auditors. This includes limiting their access to certain portions of your office (i.e., copy machines, file rooms, lunch rooms, and even employees). Sensitive documents or discussions between colleagues not meant for the eyes and ears of the auditors make restricting auditors’ access to certain areas of the company a good idea. Inform the auditor that all questions, requests, and status updates are to be directed to you or your designee (your point person on the audit) and not just any employee that passes by. Schedule specific times during the day to meet with the auditors to answer questions and provide additional information. This will keep the audit moving and allow you to maintain control of the process as well as your workday, thereby minimizing numerous interruptions throughout the day. You may also ask the auditors to email or put in writing their questions and information requests. By doing so, you will have written documentation in your audit file if the same issues are raised again in the future.

Finally, you should ask the auditors to discuss their timeline, not only for the fieldwork that is just beginning, but for the rest of the audit as well. It is important to know how much time you have to provide resale or exemption certificates or other supporting documentation, when you can expect preliminary audit schedules or work papers, or when might the auditors need to return to your office for additional work. Getting the auditors to agree to self-imposed deadlines or milestones should help keep the audit moving. Often, auditors finish their fieldwork and do not contact you for weeks or months afterward.

At that point, you have moved on to a number of other things; and it takes more of your time to reacquaint yourself with the audit issues. It’s always a good idea to get the name and contact information of the auditor’s supervisor, team leader, section head, etc., so that you have someone else to contact if your auditor forgets about you.

Working with the auditors

Once the opening conference is finished, the auditors begin their fieldwork. You can expect the auditors to review your sales to customers in their jurisdiction, as well as any purchases of capital assets and expense items, depending on the location of your facilities.

In most cases, the auditors will have additional questions and request data and other relevant information to complete their review. You need to keep the audit moving, so be responsive to these questions and requests. However, before replying or providing information, take the time to understand the nature of the questions being asked and think about how your answer may affect the audit. You may need to contact a colleague in sales to provide information on products or customers, or a production supervisor or engineer to find out whether a specific piece of machinery is used in production or not. Most damaging to your credibility with the auditor would be to answer a question “off the cuff” and then have the auditor discover your response was incorrect. It may have been an honest mistake, but it will put the auditor on his guard with respect to your future responses. You may need additional time to gather the information requested or have your IT department extract the data needed by the auditor. That is why we stress upfront preparation and having ready at least the basics from the auditor’s initial information request to keep things moving.

After the auditors complete their fieldwork and you’ve followed up with answers to questions and provided additional information, the auditors will typically provide preliminary work papers indicating where additional tax may be due. Now it’s time for you to really start your work. As you are reviewing the auditor’s schedules (request electronic copies that you can sort, filter, etc.), start placing the items listed into different buckets. One bucket may be for items where the auditor still has additional questions; another may be for items that you concede are taxable; while still other buckets may be for items relating to specific issues or sections of the tax law. As you are reviewing your buckets, keep in mind that resources may be limited and you may not be able to adequately respond to all the items. If this is the case, analyze the schedules and turn to the 80/20 “Pareto principle” or similar theory. Addressing the 20% or so items that might encompass 80% of the total dollars is an efficient and responsible way to protect your company, while at the same time making sure other matters do not fall off of your “to-do list.”

Dispute resolution

After multiple telephone and/or e-mail attempts to resolve any issues on which you may disagree with the auditors, you may eventually need to have a face-to-face meeting with the auditors to address your concerns and resolve the issues you disagree with. It is critical that you prepare for this meeting by taking the following steps:

• Research the tax law you believe supports your position and be prepared to discuss how it relates to the issue(s) at hand;
• Provide  documentation (i.e., invoices, purchase orders, proposals, photos, information from websites, etc.) to support your position;
• Present other items you feel should be removed from the audit assessment due to administrative errors (i.e., item is outside the audit period, tax paid or accrued, different jurisdiction or entity, etc.) as well as potential overpayment items that can be used to offset additional tax due;
• Know the impact the items have on the overall audit assessment, especially if sampling is being used and the tax due may be projected or extrapolated across several periods, and
• Be willing to negotiate with the auditors and have a sense for which items you and the auditors may be willing to compromise on, in order to reach an understanding on other issues. Be aware that once the assessment reaches a supervisory review or is finalized, it may be more difficult, if not impossible, to negotiate with the auditors on certain items or issues.

Finally, the likelihood is high that some of your open items or issues cannot or will not be resolved at the audit level. Some matters may need to be addressed with the auditor’s supervisors, especially if your attempts at developing a cooperative relationship with the auditor have been unsuccessful. Before approaching a supervisor or team leader, ask yourself this: Is the auditor being unreasonable or is he just doing his job? If it truly is the former, make a list of substantive examples that you can discuss with the supervisor. Be tactful and do not subvert the auditor to get to his supervisor, as in most cases the supervisor will likely support his staff, especially if your claims aren’t documented. By taking the right approach, you may be able to resolve your open issues with your auditor’s supervisor before a final audit assessment is issued.

If you have any questions about this or other SALT issues, please email Tom Mazurek at .  For additional State and Local Tax insights and resources, or to subscribe to our quarterly newsletter, visit tsacpa.com.