Auditors are trained to do audits one way. In many cases, the way that they’ve been trained is not the fairest way for the taxpayer. Most audits will require some sort of strategy going into the audit defense process. In the development of a proper sales & use tax audit defense strategy, we perform pre-audit work and we do it for two reasons. The first reason is to get our client ready for the audit. We take the time to learn our client’s business, their products and services, their taxability and the availability of data and documents. We make sure that they have all the documents that will be needed to start the audit. Don’t confuse this with providing the list of documents that the auditor has requested. In many cases, the documents they’ve requested aren’t necessary for this particular audit. If there are missing documents, our client has homework before the audit starts. If there are discrepancies or inconsistencies that the auditor will question, we work with our client to determine the reasons and explanations prior to the commencement of the sales & use tax audit. We want to make the process of sales & use tax audit defense as efficient as possible for both our client and the auditor. Audits are stressful and time consuming and most taxpayers want them over with as quickly as possible.
Having a strategy and ensuring our client has all the documents that will be needed to start the audit puts us a few steps ahead of the auditor. We know what they want, we know what they are going to think when they see it, we know what they will ask for next, etc. which makes the whole process flow more smoothly.
The second reason we conduct pre-audit work is to determine if there is any sales & use tax exposure and develop a strategy to ensure that if the auditor does find the exposure, the tax liability is minimized. This is not to say that we hide the issue and we certainly don’t point it out when the auditor walks in the door. However, if the auditor does find the issue, we want to make sure that we have guided them in a way that doesn’t unfairly penalize our client.
One good example is a Houston-based pipe company who inspects every shipment of pipe before it leaves their yard and they bill their customer for the inspection. Unfortunately, they did not know that the inspections were taxable to the extent that the pipe was taxable. In other words, if the pipe is shipped out-of-state it is not subject to Texas sales tax and therefore the inspections are not taxable. If their customer is a direct pay permit holder and they have a certificate on file, the pipe and inspections are not taxable, etc. However, if the sale of the pipe is subject to Texas sales tax, the inspections are also taxable. They discovered their error about half-way through the four-year audit period which means they had two years of taxing the inspections correctly and two years of not taxing the inspections correctly. The fee for the inspections was $1,500; a drop in the bucket compared to the pipe sales that could be in the hundreds of thousands of dollars for one shipment.
Most auditors when creating a transaction sample for an audit will just take all the transactions and throw them into the population before selecting their sample base. Well, in this case, that could have resulted in an over-stated liability. First, the $1,500 errors only existed in the first two years of the audit and second, extrapolating a $1,500 error across much larger sales invoices would result in an inflated amount of tax due.
We developed a strategy that if the auditor found the issue—and he did—that those errors would not be unfairly extrapolated across a much larger population. Our strategy was to pull the data from our client’s accounting software in a way that allowed us to segregate taxable and out-of-state sales out of the data. This left a list of Texas customers for whom tax was not charged. We presented all the certificates to the auditor who was then able to cull that list down even further and detail the remaining sales transactions thereby not creating a situation where the $1,500 issue could be extrapolated. If the auditor had managed the audit like he was trained—and, the client did not have the right strategy—this audit could have ended very badly for this taxpayer as they would not have known that there was a better way.