Sales and Use Tax Reverse Audits: What to Expect

The sales and use tax reverse audit conducted by tax practitioners is similar in many respects to the sales and use tax examinations conducted by state revenue auditors, except the reviewer or tax consultant is seeking the identification and recovery of sales and use tax overpayments remitted to suppliers or filed directly as a self-assessment of use tax. A sales and use tax reverse audit is designed to help a taxpayer to comply with the state sales and use tax laws and regulations.

Historically, the reverse audit focused on a manual approach to identify erroneous payments of sales and use tax. This approach has, for the most part, changed in the last several years, with the ability to use electronic data downloads of a company’s accounts payable payment files and statistical sampling.

Objective of a Sales and Use Tax Reverse Audit

The objective of recovering erroneously paid sales and use tax can be achieved by reviewing a company’s self-assessment of use tax and the analysis of the sales and use tax remitted to the company’s suppliers on purchases that qualify for various sales and use tax exemptions.

Several factors are responsible for the overpayment of sales and use tax. In many states, state auditors have become very aggressive in auditing taxpayers and denying various exempt sales. Their aggressiveness results in suppliers denying applicable tax exemptions and charging sales and use tax on purchases normally exempt. An inadequate sales and use tax compliance system may allow tax to be erroneously paid as a use tax on purchases and as a sales tax billed to customers on sale transactions.

Generally, it is the responsibility of the purchaser to make a claim for the exemption. If the exemption is not claimed, the supplier will normally charge sales tax. Many companies have their accounts payable group review purchases to prevent the payment of tax on exempt purchases. If the accounts payable group is not properly directed or advised, sales and use tax may be paid to suppliers in error.

Performing a Sales and Use Tax Reverse Audit

The sales and use tax reverse audit generally starts with meetings at the corporate office and/or possibly at the plant locations or both with the appropriate tax professionals, accounts payable manager, capital asset coordinator and systems personnel familiar with tax reports and accounts payable payment files. During these meetings, it is imperative to gain an understanding of the company’s sales and use tax compliance system. Understanding the compliance system will include how taxability decisions are determined at the time purchases are made. Many companies use sales and use tax manuals; others have online systems to communicate the taxability determinations of equipment and supply purchases. It is recommended to review the source of the taxability determinations to identify areas for potential tax recoveries. During the initial meeting, it is important to determine if the taxpayer is a direct-pay holder. The direct-pay permit allows the taxpayer to make purchases without remitting sales tax to a vendor. Instead, the taxpayer is required to self-assess and remit use tax on the taxable purchases directly to the tax authorities.

During the initial meetings, a mutual decision needs to be made between the company and the reviewer to determine if the reverse audit will be completed using either a manual or electronic approach. If electronic data is provided to the reviewer, state-of-the-art computer database analysis software can be used to assist in analyzing purchases to identify those in which tax was paid in error. When combined with statistical sampling, these programs can essentially reduce the time required to complete a reverse audit.

Database software can analyze the accounts payable data files to identify purchases in which overpayments of tax would most likely occur. It can be used to stratify a population of purchase items for review and scientifically select a random sample of invoices for review. The reviewer can select invoices and identify those containing a tax overpayment. Mean estimation can be used to scientifically project the tax overpayments to the entire population. Database software provides the reviewer with a method to quantify the precision and reliability of the scientific population.

Whether the reverse audit will be completed using electronic data downloads or a manual approach, a detailed review of any capital expansion projects or capitalized purchases must be completed. Capital expansion projects and capitalized purchases are generally large dollar purchases included in the strata, requiring a detail review.

During the early stages of the reverse audit, the reviewer should review the sales and use tax returns, self-assessment of use tax schedules, lease contracts, issues from past sales and use tax audits, intercompany transactions and listings of the largest suppliers. The reviewer should understand the statute of limitations for filing refund claims and the state’s position on offsetting refunds against a potential audit assessment.

The subsequent tasks involve examining the actual invoices and payment records to determine whether taxes were overpaid. Several states do not allow the use of statistical sampling to project tax overpayments. A detailed review of all purchases must be completed for these states. For the selected states that allow the use of statistical sampling, a sample of invoices and payment records may be selected for analysis. The results are projected against the entire population to estimate the potential tax overpayments. If statistical sampling will be used to project tax overpayments, the reviewer should meet with the tax authorities to disclose the company and receive written authorization to project tax overpayments.

During the review of the capital asset and supply purchases, the reviewer may identify overpayments in a variety of areas, including:

• Ingredients or component parts of a manufactured product;
• Equipment, replacement parts and supplies used in the manufacturing process;
• Pollution control equipment and supplies;
• Bad debts;
• Exterior and interior signs;
• Packaging supplies;
• Wrapping and packaging equipment;
• Safety equipment;
• Protective clothing;
• Service transactions;
• Prescription drugs;
• Medical equipment;
• Warehouse equipment;
• Software licenses;
• Maintenance fees;
• Reduced tax rates; and
• Selected tax credits.

Recovering Overpayments

The reviewer needs to fully understand a state’s procedures to recover tax overpayments. Many states require the taxpayers to request refunds from the suppliers where tax was originally remitted. Other states allow the taxpayers to request refunds directly from tax authorities.

Once the reviewer has completed the analysis of the erroneous payments and prepared the necessary schedules of tax overpayments, the reviewer should prepare the overpayment schedules for the taxpayer and present the overpayment findings to the company.

Company management should review and discuss the overpayments to identify any potential issues and concerns that may arise with filing refund requests to suppliers and tax authorities. Company management needs to be aware that a refund request can result in a sales and use tax audit that may negatively affect the potential refund.

After the company’s management has approved the tax overpayments and given the reviewer the approval to request refunds, refund request letters should be prepared for taxes erroneously remitted to the suppliers. The refund request letter should explain the reason for the overpayments and be accompanied by exemption certificates, schedules of payments and supplier invoices. If the use tax was directly remitted to the tax authorities, a claim for refund or amended sales and use tax return must be prepared and filed with the tax authorities. Many states will allow an assignment for rights to the refunds. This assignment transfers the right to the taxpayers and enables the company to seek refunds directly from the state.

Final Report and Recommendations

Once the sales and use tax overpayments are received, the reviewer should schedule a closing meeting with the relevant company management. At the meeting, the reviewer should present a sales and use tax reverse audit findings package containing a written report of the audit procedures followed, the tax overpayments identified, and the success of the tax recovery efforts. The findings package should also include relevant schedules and correspondence with the suppliers and tax authorities. To the extent the reviewer believes improvements can be made to the sales and use tax compliance system, specific recommendations should be included.

From Martin A. Joseph, Oak Brook, IL