July 12, 2018
A. Authority to Audit or “Can They Do That?”
There are two main issues concerning an auditor’s authority to examine records, ask questions, view premises, take up space, and, in general, be a nuisance:
1. Constitutional Authority
If your company has no place of business or other physical presence in the taxing jurisdiction, the auditor does not have constitutional authority to audit. On the other hand, if your company has a place of business or other physical presence in the taxing jurisdiction (“substantial nexus”), then the auditor has constitutional authority to audit.
2. Statutory Authority
If your company has nexus in the taxing jurisdiction, the issue is then whether the applicable state or local law grants the auditor authority to audit and assess tax.
Ohio law authorizes the tax commissioner or any person employed by him [i.e., the auditor] to, upon demand; inspect the books, accounts, records, and memoranda of any person. Auditors making such a demand are required to produce their authorization to make the inspection. If a person receives at least 10 days’ written notice of a demand to inspect, and refuses to comply, a penalty of $500 will be imposed for each day of non-compliance. The limitations period for assessing tax in Ohio is four years. However, there is no statute of limitations for assessing tax in the following situations: (a) tax collected and not remitted; (b) failure to file a return; and (c) execution of a waiver. In the case of a failure to file a return the maximum time the state can go back is 10-years for vendor’s sales tax and 7-years for consumer use tax. In the case of tax collected but not remitted, the Department may assess tax for all periods for which there is substantial evidence (e.g., primary records, secondary records such as sales journals).
As a practical matter, auditors are only interested in doing their jobs. Even though the auditor’s initial information request may contain a laundry list of records, the auditor normally examines only “the usual” (e.g., exemption certificates, general ledger data, receivables and/or payables reports and invoices, fixed asset lists, and capital project folders).
The company is obligated to cooperate with the auditor and produce the records requested. However, there is no legal or ethical duty to volunteer information not specifically requested by the auditor.
B. Interstate Investigations
It is increasingly common for a business to be contacted by states in which they have no fixed place of business. This is attributable to various “nexus programs” conducted by state revenue agencies. Usually such contacts are in the form of a “nexus questionnaire.” Must you – or should you – respond to such inquiries? That depends. First and foremost, the company must determine whether it has substantial nexus with the inquiring state. The generation of a nexus questionnaire often results from the state matching the list of personal income tax withholders (e.g., employers) with the list of franchise tax and/or sales and use tax filers. It can also be triggered by state audits of vendors or customers.
If the company has substantial nexus, it is important to respond to the nexus questionnaire. Otherwise, the state may issue an estimated assessment to get your attention. However, it is generally better to not fill out the questionnaire itself, but rather to respond by letter. In many cases the company has substantial nexus, but is not filing sales/use tax returns for valid reasons (e.g., it is not making any taxable sales). It is easier to explain such facts and circumstances in a letter than to answer “yes” or “no” questions on a standardized nexus questionnaire. However, more and more states will insist that you complete the nexus questionnaire. Even if the company does not have substantial nexus, it is still probably a good idea to respond with a letter so indicating. In all cases, the goal is to reply to the state in a way that will cause them to stop bothering you.
C. Audit Contact
- In General
State and local tax agencies generally base their decision on whether to audit a particular company on prior audit history or their own research. An Ohio sales tax auditor will initially contact you either by phone or letter. In any event, if you have been selected for audit, the Taxpayer’s Bill of Rights requires the state notify you in writing before the audit commences. This initial contact is in the form of an Audit Commencement Letter along with the following forms:
- Taxpayer Bill of Rights;
- Taxpayer Information Report;
- Computer Assisted Audit Questionnaire;
- Electronic Data Record Layout Form;
- Responsible Party Questionnaire;
- Statistical Sample Overview; and
- Power-of-Attorney form (TBOR-1)
The objective of the audit is to verify that the correct amount of tax was collected and remitted on sales of taxable goods and services and paid/accrued on the purchase of taxable goods when the vendor has not collected the tax.
2. Involve Appropriate Personnel Early in Process
Whenever an audit contact occurs, it is important to notify the appropriate personnel within the organization. This can be a problem with larger businesses. If purchasing, payables and/or tax compliance are decentralized, an audit may occur at a plant, separate division, or similar remote location. Thus, “headquarters” may be unaware of the audit until the assessment is received. Even if the on-site personnel are the “best” people to deal with the audit, there should be procedures in place to allow accounting or
treasury to monitor the audit activity and the potential liability that may exist. If outside practitioners are used, they should be involved as soon as possible. Conventional thinking is that there is no need to involve the practitioner until the auditor’s work is done. Under this theory, the practitioner reviews the audit workpapers and argues
with the auditor at checkout. In most cases, the practitioner will be at a disadvantage since he or she will be up against the learning curve in understanding the company’s operations.
Whoever is responsible for dealing with the audit, their early involvement can accomplish the following:
- Correct obvious problems (e.g., missing exemption certificates) before the audit begins;
- Assure that the audit methodology makes sense and that sampling or test check agreements are reasonable and representative;
- Correct misconceptions and misunderstandings held by the auditor which will reduce the time spent on issues or recurring transactions that will ultimately be removed from the audit;
- Allow identification of overpayments (i.e., refunds) which the auditor may not voluntarily mention to the company;
- Clarify the true areas of contention which will save time when evaluating and/or preparing a protest; and
- Make the audit go more smoothly which will get the auditor out the door sooner (always a desirable goal).
3. Scheduling the Audit
The auditor will schedule a date to begin the audit for, most commonly, a three year period. The auditor is generally required to schedule the field work during regular business hours. In addition, the auditor is required to provide reasonable notice of when he or she will come on-site to perform field work.
D. Preparing for the Audit
Preparation for a state or local sales and use tax audit differs depending upon whether the primary focus of the audit is on the company’s sales or purchases. Sales audits are audits of sales to customers to verify whether the proper amount of tax has been collected and remitted. Purchase audits determine whether the proper amount of consumer’s use tax has been remitted on purchases where the vendor did not collect the tax.
Purchase audits are more common than sales audits because noncompliance is more likely to be found.
1. General considerations
Prior to commencing the audit (whether a sales or purchase audit), the auditor and usually his or her supervisor will have a pre-audit conference with the company. Take this opportunity to accomplish the following things:
- Identify the documents and evidence the auditor wants to review;
- Help the auditor understand the aspects of the business and any accounting or record keeping practices that will be important for him or her to understand;
- Set ground rules for the auditor’s on-site work and establish the tentative work schedule; and
- Determine whether the auditor has any issues or preconceptions at the outset of the audit.
Being knowledgeable about the company’s (or business unit’s) operations and reviewing the audit while it is being conducted reduces the time between the auditor’s on-site work and the audit checkout.
2. Preparing for the Sales Audit
Sales tax must be collected and remitted if:
- There is a sale of tangible personal property that is not exempt;
- The sale has an Ohio source;
- The seller has nexus with Ohio; and
- The customer did not provide a properly completed exemption certificate or direct pay permit number to the seller.
The first thing that should be done is to review the prior audit, if available, before the auditor arrives. If you (or your outside tax consultant) do not know, develop an understanding of what the company sells and a profile its customers.
Before the auditor’s initial visit, review exemption certificates for technical sufficiency. Cross-check exemption certificates with other information (e.g., a printout of the “exempt customers”) to identify important omissions. If the number of customers and/or exemption certificates is voluminous, identify the largest volume “exempt customers” and look at their exemption certificates or other exemption documentation required by that state’s law.
Assure that all sales tax, particularly tax collected from customers, has been remitted to the state. If not, get it paid! If the exemption certificate procedures were lax during identifiable portions of the audit period, try to exclude those periods from anyaudit sample.
Review proposed sample, or test check, periods and methodology. Take time to meet with the personnel familiar with the company’s operations and accounting to make sure the sample periods are reasonable and representative. Do not hesitate to proposebeneficial alternatives.
If you discover that: (1) certain types of untaxed sales; or, (2) untaxed sales to certain customers were not exempt, consider backbilling the tax at once. However, the more time that passes between the transactions and the tax billing, the less likely the taxwill be collected.
If state procedures permit exemption to be established during or after the audit, conscientiously pursue obtaining this evidence until the customer supplies the exemption certificate or other documentation. This will take some persistence.
3. Preparing for the Purchase Audit
Review the last audit, if available, before the auditor arrives. Develop an understanding of the company’s tax accrual/payment procedures. Was use tax accrued on purchases? Was tax remitted to the state? What procedures were used? Are many purchases
made from outside suppliers? From suppliers outside of the taxing jurisdiction? Are exemption certificates issued? If so, by whom and using what criteria? If available, review plant schematics (if a facility is being audited) and explanations of business operations. This will help you hone in on problem areas.
Perform a quick review of major purchases (e.g., look through files of major jobs and review asset ledgers or depreciation schedules). Make sure tax was paid on clearly taxable items. Determine whether there were unusual purchases such computer systems or software. If there is obvious exposure, Ohio allows a preassessment voluntary payment that will reduce penalties and/or interest.
Most purchase audits of manufacturing or fabricating facilities involve a plant tour. Take the plant tour with the auditor. Make notes of “embarrassing” questions to ask on-site personnel later (when the auditor is not present).
Review the auditor’s proposed sample for reasonableness. It may be beneficial to propose a sample methodology yourself. If the use tax accrual was lax and/or exemption certificate issuing was overly aggressive during a discernible portion of the audit period, try to keep those periods out of any sample.
Be on the lookout for overpayments (i.e., refunds). All tax-paid capital purchases made during the audit period should be examined, particularly those charged to areas or cost centers that also include exempt purchases.
For audits that take more than a few days, review the auditor’s “work in progress.” Obtain copies of work papers or, if using a computer, have the auditor print out the listings to date or copy the work onto a diskette. Get clarification from on-site and/or project personnel on any questionable listings. This frequently requires onsite research and internal consultation. Bear in mind that such “research” will have to be done eventually. The benefit of doing this work while the audit is in progress is that the auditor will become “educated” and he or she can then skip over subsequent invoices for the same item, account, or contract.
Always remember: purchases commonly get assessed simply because the auditor did not get information on what something was or how it was used. At the very least, if the auditor still believes that the item is taxable; you will know the reason why (which will be helpful if a protest is made).
If expense accounts are being sampled, check each account as it is being done. The auditor will be less aggravated making adjustments before the projection is calculated.
E. Other Considerations
1. Waivers and Department of Taxation Policy
The auditor must discuss the Department’s waiver policy at the onset of the audit. All audits must be submitted for final review at least 90 days prior to the expiration of the statute of limitations. If all information has not been received, a waiver should be requested. If the wavier is not requested or agreed to, the Department will likely issue an estimated assessment.
The Department’s policy is to issue no more than 2 waivers for any audit period. A 3rd wavier may be possible, but would require an expansion of the audit period. In general, a one-year wavier will be required.
A waiver must be supplemented with an agreed-upon audit project action plan, which will set forth milestone dates for the completion of the various audit steps. If the audit project plan is not followed by the taxpayer, there is a risk of an estimated assessment.
2. Refunds and Refund Offset Policy
The Department will not audit for overpayments (as discussed above, a refund review should be part of any audit).
When filing a refund claim, the Department has taken a position that it can go back to periods where the statute of limitations for assessment is otherwise closed to reduce/offset the refund claim to zero.
The Department will not allow a block or statistical sample to be used to support a refund claim. However, if the taxpayer is under audit and the Department is using statistical sampling, the taxpayer may elect to use the statistical sampling to estimate its refunds. If refund claims have been filed and/or paid for accounts included in the statistical sampling population, this estimation technique will not be available.
Penalties are generally discretionary. The Department has implemented procedures that set forth criteria under which penalties may be imposed. These criteria are based on compliance and cooperation during the course of the audit.
4. Concurrent Responsible Party Assessments
The Department will always issue concurrent assessment against potential responsible parties where taxes are collected and not remitted and in the case where there is willful noncollection of trust taxes. Concurrent assessments against responsible persons may be issued in other cases depending on the taxpayer’s financial status and compliance history.
5. Managed and Participatory Audits
The Department administers two types of “self” audit programs. Managed audits may be considered by smaller taxpayers (e.g., less than $50 million in annual revenues) with relatively straightforward sales/use tax issues. The end result is a voluntary payment resulting in no penalties. The auditor would due a cursory review of the taxpayer’s records at the onset and then verify the taxpayer’s work. Periodic status meetings will be required during the course of the managed audit. No more than 2 managed audits in a row will be permitted without an intervening Department-run audit.
A participatory audit may be considered by larger taxpayers (e.g., $50 million in annual revenues). The end result is an assessment with penalties abated depending upon compliance with the participatory audit program. Taxpayers must agree to do at least 50% of the work and agree to an audit plan. Managed and participatory audits must be requested from, and approved, by the Department audit administration.
Since you are now intimately familiar with the audit and most of your research into controversial issues has been performed, you can make an informed decision about whether or not to protest the assessment. Virtually every state provides relatively informal administrative procedures to protest the assessment. Usually, these procedures can be pursued without legal counsel and great expense. However, even though the procedures are informal, pay attention to jurisdictional requirements such as filing deadlines and pre-payment rules. Any jurisdictional or procedural mandates in the statute or regulations will be strictly adhered to by the revenue agency.
In Ohio, a petition for reassessment (“protest”) must be filed within 60 days of receiving the final determination (“final assessment”). The protest does not have to detail all your objections, although you will need to provide a detailed explanation to a hearing officer at some point in the appeal process. However, you must request remission of any assessment penalty at this time. Under the Department’s penalty imposition criteria, it will be difficult to receive abatement of penalties at the initial appeals level. Should you protest? That depends. Common-sense criteria include the following:
- Are there substantive controversial issues in the audit?
- Do you know what is in the audit? If not, you may need to protest to buy time to review the details of the assessment.
- How much money is at stake?
- Are there any facts that were not presented to the auditor?
- Are there “prospective” issues involved?
- What is the state’s reputation on the disposition (or settlement) of protests?
- Are you comfortable with the quality of the audit? Are you comfortable with your understanding of the applicable law? If not, a protest may be necessary in order to buy time conduct research.
If you are not very familiar with the applicable law, find someone who is. It is not always good to rely on the auditor as your sole source of information. Even though auditors may actually state the “correct” legal interpretation 70-80% of the time, they tend to be behind the curve on recent developments and court decisions because states often do not furnish sufficient resources to keep auditors current. In addition, auditors tend to take very seriously the precept that the “tax is presumed to apply.”