A sales tax audit is a legal action by the State of Texas Comptroller’s Office. Make no mistake—the Comptroller is out to bring in more revenue to the state and the motivation of the state is to find areas of underpayment of tax owed. The auditor who is auditing your business is paid to find under-payments and will ignore over-payments even if they see them. It’s highly possible that the audit process will not be conducted in the fairest manner.
In a legal action, if you choose to defend yourself, it is critical that you emotionally detach from the situation. Unfortunately, the ability to “emotionally detach” oneself from an audit situation is often lost when you get into the middle of it. What would normally be rational and objective judgment on your part can quickly be replaced by feelings of anger, worry, fear, and stress. This is true for almost everyone. As President Lincoln once said, ‘when a “personally vested’ emotional state is combined with all the complexities and nuances that every single legal matter involves, the answer becomes obvious: “He (and even a lawyer) who represents himself has a fool of a client!”
If you believe you are an expert in sales and use tax and you believe you can emotionally detach, then defending yourself may work out. But consider this: learning from your mistakes in a legal action can be very costly. It gets down to (or should get down to) a decision about business risk vs. business expense.
First Let’s Analyze the Business Risk
Risk #1 – Under-reporting or Underpaying
The Texas code for sales and use tax is 497 pages long and it is constantly being reviewed and modified. So, there is always a risk of under-reporting and/or underpaying sales and use taxes. If in fact this is the case, and the auditor discovers the discrepancies, they will assess penalties and interest—these could very possibly be substantial sums. If they can prove intent to under report and/or underpay criminal charges may result. It has been our experience that the business risk in being audited by the state is not a trivial thing for most businesses.
Risk #2 – Auditor Error
We have represented hundreds of companies over the years and one thing is for sure—auditor errors are very common. For example: in a recent audit defense for a local bar and restaurant in Austin TX, the auditor had accessed a tax bill of $415,000 for a relatively small operation. When reviewing the calculations of the auditor our tax specialist discovered that in the auditor’s spreadsheet she had not copied down one of the formulas correctly. Correction of this single error reduced the bill by $385,000. We pointed out the error to the auditor and did not even get an apology. This example is by no means unusual. We find that in more than 80% of our audit defense cases we find auditor errors. It is not just math errors—they can misinterpret the tax rules as well, use adverse sampling and apply the wrong statutes. And, once the final assessment has been submitted to the Comptroller’s Office—right or wrong—it becomes accurate in the eyes of the law. The State of Texas takes the auditor’s report as legally sufficient to establish a fact or a case unless disproved—prima facie evidence. That means if you subsequently find an error, you will have take the State to court to rectify the situation.
Risk #3 – An Unplanned Financial Burden
I will repeat this again, the State conducts audits because they make a great deal of money in doing so. It is not that most businesses are trying to cheat the government out of what is rightfully theirs—it is that the statutes and rules are so complex and ever changing that few businesses can keep up and be 100% compliant.
The statute of limitations for tax audits is four years. When the auditor finds situations of underreporting and/or underpaying, penalties and interest will be assessed going back four years. The total bill can be daunting to most Texas businesses.
Risk #4 – Overextending Valuable Human Resources
Most accountants and financial people take their job very seriously. They understand the impact their role plays in the financial health of the organization and they act accordingly. When under audit, their work is being reviewed and challenged by a third party which means the stress levels get very high. The administrative burden involved in running your own defense is often overwhelming. People under stress do not perform well and their normal job may suffer. Audits go on for months and sometimes even years. High stress levels over a prolonged period equals—well you get the point—it is not good for business.
As an audit proceeds, there are numerous items and conditions that the auditor will commonly look for. Here are the top ten pitfalls that are most likely to trip you up, and what you need to do to avoid them:
Pitfall #1: Use Tax – Use tax is the tax you pay on purchases of everything from office supplies to large fixed assets. If the vendor that you purchase from doesn’t charge you the correct sales tax, you have the responsibility of accruing and remitting use tax directly to the State of Texas on your Sales and Use Tax Return. Unfortunately, many people do not know this until it is too late and they are assessed the tax, interest and penalties in an audit. The only way to ensure that you are compliant in payment of use tax is to implement an accrual process to capture those purchases that should be reported, report them and keep very good documentation. Did you know that if you report use tax but can’t explain to the auditor exactly which vendors and invoices you were accruing and remitting; the auditor will tell you “thank you very much for the use tax” and then assess you on your purchases again? Maintaining the appropriate support and documentation are extremely important.
Pitfall #2: Exemption and Resale Certificates – If you do not have the proper certificates to support your non-taxed sales, you will be allowed to get them during the fieldwork and appeal phases of your audit but as discussed below in the section about “good faith” this can be a slippery slope and it’s best to have a process to ensure exemption and resale certificate compliance at all times.
Pitfall #3: Unreported Sales – Mistakes happen and sales can go unreported. Understanding your businesses’ taxing responsibility is critical and you should have a good accounting system that is set up properly to automatically determine and calculate the tax.
Pitfall #4: Charging the Wrong Tax Rate – Understanding how the “local” part of “state and local tax rates” work is vitally important. In Texas, there is a State rate of 6.25% and then there are county rates, city rates, mass transit authority rates (MTA); special purpose district rates (SPD) and advanced transportation district rates (ATD) and some cities have all of these and multiples of each. It’s important to understand how the rates apply to you and how they apply in each circumstance. For example, did you know that the rate changes if you deliver versus the customer picks up at your location? Did you know that the rate can change if you install versus just selling to the client? Some rates are dependent on your location and some are dependent on your customer’s location.
Pitfall #5: History of Audits and Assessments – Once you have been audited, you are now a target for future audits and as long as the State continues to find significant dollars by auditing your company, they will continue to do so. The best thing that you can do is to know your taxing responsibilities inside and out and put processes and procedures into place and have good documentation to ensure that you are complying with the rules. Adequate documentation makes an audit go much more smoothly, while poor record keeping will prolong an audit and may ultimately cost you thousands of dollars.
Pitfall #6: Unique Rules and Regulations – Some rules are difficult to understand. Taxpayers and auditors alike struggle to determine how to apply specific rules to specific industries. As an example, landscapers mow lawns, they plant trees and flowers, and they build retaining walls and other permanent structures. It’s possible for three different rules to apply to one invoice. As with the pitfalls noted above, knowing how the rules apply to your business along with adequate documentation and processes are necessary to keep you out of trouble.
Pitfall #7: Sales Tax Accruals – Many companies do not properly remit the sales taxes they have collected. The auditor will look at your bank statements, federal income tax returns, general ledgers, invoice registers, invoices, sales journals and summaries to identify and reconcile any discrepancies and assess tax on those discrepancies. The best advice here is to make sure that you are using a good accounting system, set up properly to track your sales and reconcile your sales each month before you report and remit.
Pitfall #8: Acquisitions – A business acquisition can really muddy the waters when it comes to sales and use tax compliance. An acquisition can take you into new markets where you are unfamiliar with the tax rules and then there is the issue of previous liability. When you acquire a company, there are certain steps that must be taken or you automatically assume all previous tax liabilities. Consulting with an attorney and professional tax consultant can help you structure the acquisition so that you avoid or at least minimize future audit liabilities due to the acquisition.
Pitfall #9: Internet Purchases – Many taxpayers are unaware that the purchases that they make online most likely aren’t taxed. That is beginning to change with the recent rules regarding internet sales however, it’s important for you to take note and make sure that you are accruing and remitting use tax due on purchases made over the internet.
Pitfall #10: Audit Questionnaire – The questionnaire that the auditor sends you at the beginning of the audit can seem innocuous at first but beware. There are questions on the questionnaire designed to uncover unregistered businesses and businesses engaged in fraudulent activities. Consulting with an experienced and professional tax consultant before you complete the questionnaire can save you headaches down the road.
Next Let’s Analyze the True Cost and Value of Hiring an Expert
An expert is a person who has a comprehensive and authoritative knowledge of or skill in a particular area. In the case of Brown Goertz & Co we are experts in two areas: sales and use tax and mixed beverage gross receipts tax. Our internal training program for our tax consultants is extensive—over six months in duration—and that is for someone who is already a competent accountant. It would be a rare situation where a member of a company’s accounting team had this kind of knowledge and expertise.
Are you a busy person with lots to do every day—sometimes more than you can handle? Let’s assume you are. Managing an audit is an unwanted distraction and you are likely going to have to do it on top of what you normally do on a daily basis. You can do that for a short sprint but when audits take months and even years to complete it will be very challenging. It is very likely that there will be a negative impact on your productivity as a result of managing your own audit defense.
Our company has never managed an audit defense where the client was 100% compliant. The pitfalls that we catalogued above are examples of where average accounting departments make mistakes. It is no one’s fault—it just happens when you do not have an expert managing the changes in the law and then implementing the correct tax compliant procedures. For a large business, it would make sense to employ a tax expert but for the majority of companies it would not. That is why Brown Goertz & Co is in business—to provide that level of expertise, only when it is required.
To determine the true cost of hiring a tax consultant you need to go beyond the hourly fee and look at other important factors such as:
- Increased stress and lost productivity
- Potential for tax recovery (a large part of our business is doing just this for companies who handled their own defense)
- Getting the audit right and not slanted toward the benefit of the state
- Being able to end up with the correct procedures in place so that your company is 100% compliant
- Eliminating future financial exposure for the stakeholders of the company
When you look at all the costs both hard and soft and do an ROI you will find that we are at the very least fee neutral. And, you have the potential for making money from the investment as more than 60% of our clients do.
At Brown Goertz & Co, professionalism is the hallmark of our company. We get it right every time because our culture supports the passion and perseverance that it takes to make that happen.