As state governments cast a wider net to identify much-needed tax revenue, sales and use tax reporting has received greater attention. Last summer, the Pennsylvania Department of Revenue launched a desk review pilot program to remotely audit sales and use tax returns, and other states are also working to identify under-reporters or non-filers. Amidst this environment of increased scrutiny, business taxpayers can benefit from better understanding the audit process and proactively assessing their sales and use tax liability exposure.
Why sampling method matters
In a perfect world, all sales and use tax audits would consist of a detailed examination of every transaction that occurred during the audit period. In the real world, however, full transaction reviews are simply not possible due to the large volume of transactions, so state tax auditors rely on sampling to project liability and assess compliance.
Virtually all state sales and use tax auditors use some form of sampling on large corporate taxpayers, but auditors in recent years are trading the block sampling methods of the past for more advanced methods. The complexity of these newer sampling methods requires close scrutiny to verify the accuracy of the results and how they are projected against the entire population of transactions. Remaining engaged throughout the audit process and understanding the methods used can help taxpayers ensure the results are representative of their businesses.
How liability is identified
Most taxing agencies typically apply statistical sampling in sales and use tax audits. In certain cases, an auditor will also stratify the transaction population into groups based on a certain criteria. For sales and use tax audits, stratification is based on the dollar amount of the transaction. This process is intended to improve efficiency, preserve the validity of the sample population and offset the impact of extreme transaction values.
Once the sample transaction population is created and stratified if necessary, auditors examine it for errors like tax overpayments or underpayments. Errors identified in the sample population are projected to create an estimate of the errors in the general transaction population. Positive (overpayment) and negative (underpayment) errors are usually combined to yield a total net error; however, auditors are not obligated to identify overpayments or credits so the positive errors may not always be counted against the negative.
When being proactive pays off
Regardless of the method used, the auditor and the taxpayer must each evaluate the results of the sample and sample projection. It is the taxpayer’s right to challenge the audit outcome or assessment, including specific issues with the audit methodology. Unfortunately, most taxpayers do not have the in-house expertise or familiarity with sales and use tax audits needed to determine whether a challenge is warranted, and seek the counsel of an experienced state tax advisor like RKL.
Sales tax compliance is much more than knowing what tax rate to apply to a transaction – the reliability of a company’s record-keeping systems and the soundness of its financial procedures can also impact the outcome of a sales and use tax audit. Taxpayers who are proactive in managing compliance processes and using technology to increase the accuracy and realiability of transaction data can mitigate potential exposure and stress related to undergoing an audit.
RKL’s State and Local Tax professionals can conduct a sales and use tax process review for companies to better understand their level of compliance and identify improvements that will result in not only time savings but also expenses related to poor audit outcomes. Contact me with any questions about a process review or general inquiries about sales and use tax audits at email@example.com or 717.394.5666.
Contributed by Frank J. Tobias, CGFM, Principal in RKL’s Tax Services Group. He specializes in the area of multi-state planning and compliance, with extensive experience in all areas of Pennsylvania taxation.
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