Audit preparedness is crucial, since federal and state agencies have increased auditing to make up for budget deficiencies. In the complex, ever-evolving state and local tax (SALT) landscape, maintaining audit readiness and efficiently managing the audit process can be challenging for businesses, especially for entities operating in multiple tax jurisdictions. Audit success begins with having accurate, complete documentation, an understanding of the complexity of various tax laws, and the right team in place to assist with any audits that arise.
Before the Audit: Laying the Groundwork
Ideally internal systems, controls, and documents are accurate and up to date before your company receives any audit notices. To weather an audit successfully, you need to anticipate what SALT issues may arise and be on the alert for audit notices, nexus questionnaires, and other SALT-related correspondence.
Organize Correspondence and Documentation
With the rise of the remote workforce and with employees scattered across multiple states, businesses need to ensure that correspondence from tax authorities is routed promptly to the appropriate department.
In larger organizations, this correspondence will likely be forwarded to a designee in the tax department; smaller companies should designate an alternate recipient. If your business relies on outside tax advisors and return preparers, it is crucial to send these notices to the outside provider as soon as possible.
Preparing for an audit should start well before any audit commences. Whether handling a request for apportionment information or exemption certificates, companies need to understand how they maintain and organize business records. Additionally, it is important to preserve invoices and other documentation for potential audits. If your company changes its financial reporting system, in the event of an audit the business must maintain and have access to the records in the old system.
One way to assess the state of the business and its audit preparedness is to perform periodic internal audits. By reviewing records annually, a company is better equipped to catch discrepancies, inconsistencies, and overlooked tax liabilities that might attract the attention of auditors. Action items that help to ensure audit preparedness include:
- reviewing sales tax software and taxability decisions;
- maintaining and periodically updating resale and exemption certificates;
- monitoring state and local tax statutory and regulatory updates;
- documenting positions on returns filed that may be questioned on audit and result in substantial liabilities;
- obtaining letter rulings on issues where the law is unclear; and
- addressing customer and employee concerns that may alert the company or a tax agency to weaknesses in tax processes, whether in sales tax, withholding, or other taxes.
Nexus Reviews
Another critical preaudit activity is undertaking an annual nexus review. Nexus is the minimum connection between your business and a state or local jurisdiction that obligates it to pay state and local taxes. The rules around nexus vary among states, but they are especially important for both sales and use taxes and income or franchise taxes.
To ensure compliance, it’s essential to review your company’s operations and determine whether certain business activities create a tax filing or payment obligation. A nexus review calls for determining whether the business has a physical or economic nexus presence in each jurisdiction, because either can create a filing obligation.
Analyzing your business’ physical presence in a state entails analyzing the activities of its officers, employees, and independent contractors in that state as well as its property in the taxing jurisdiction. In addition, the volume of sales in each state needs to be evaluated to determine if economic nexus exists.
Activities creating nexus also can change from year to year. If business activities cross state lines or involve hiring remote employees, new tax filing obligations may emerge in new jurisdictions. Regular nexus reviews may help your business avoid unexpected tax liabilities during audits.
Finally, it is important to view the business from the auditor’s perspective. For example, an auditor is likely to look at your company’s website. Suppose the website says that the company salesperson or truck driver can accept damaged or returned merchandise. In that case, those facts will work against the company in an income tax audit where it is asserting Public Law 86-272 protections.
It is best to periodically review your company’s website as part of the nexus review to ensure there are no statements that may negate your company’s claim of no nexus or Public Law 86-272 protections.
Due Diligence
When involved in acquisitions or mergers, many companies perform thorough state and local tax due diligence. The process should involve taking the recommended steps to remedy any process deficiencies.
If the purchased company asserts that it has no sales use tax exposure because all its sales are for resale, the buyer should ensure that all resale certificates have been collected. Moreover, if a state requires a sales or use tax filing even though the taxable sales are minimal, or not all exemption certificates can be located, voluntary disclosure agreements (VDAs) or prospective filings should be considered.
Even if the audit history of the business seems clean, it is important to ensure that there are no hidden tax exposures, such as unresolved nexus issues or incomplete filings, that could cause issues in the future.
Experienced Guidance
If your internal audits or nexus reviews uncover any irregularities, partnering with an experienced third party can help your business effectively remedy the deficiencies and obtain needed documentation. To minimize the possibility of penalties, interest, or the inability to collect sales or use tax from customers after audit, outside professionals can assist with voluntary disclosures, registrations, late filings, and more.
The Audit: Navigating With Clarity and Confidence
Once you have taken proper steps to prepare for the possibility of an audit, you can enter the process with new confidence. Understanding the audit scope and having clear communication with the auditor are also essential for a successful audit process.
Audit Scope
To understand the scope of an audit, management will want to know what tax type is being reviewed and the relevant tax periods. Requesting an initial meeting with the auditor can provide valuable information about the audit scope, significant audit issues, audit concerns, and any current or pending document requests. A meeting early in the process also sets expectations and establishes clear communication.
Effective Communication
Your company may encounter issues or liabilities during an audit if the auditor does not thoroughly understand the company’s business and what it involves. Even experienced auditors may struggle to grasp the ins and outs of certain businesses, particularly in complex or niche industries like software technology.
To limit liabilities or potential exposure, businesses should establish clear communication early on and develop the audit narrative by thoroughly explaining the business and its operations to the auditor. Designate a single point of contact with sufficient knowledge of the business’ internal processes to assist with the audit process, whether handled internally or externally. Outsourcing this step to SALT experts with experience in specific industries and taxing jurisdictions can help ensure prompt, thorough communication and avoid misunderstandings.
In addition, SALT professionals are adept at maintaining records of audit communication in the event that an issue remains unresolved during the audit process. With extensive experience in the audit process, they can effectively challenge whether requested information is relevant to an audit and advise on how much information the business should provide to an auditor, as well as when too much information poses a risk to the company. Maintaining cordial relations with auditors is highly recommended—it is the way most likely to resolve differences in your company’s favor.
For example, a technology business selling software as a service (SaaS) undergoes a sales use tax audit. Since the company is in a niche industry, its leaders must explain to the auditor:
- how the company delivers the product to customers;
- what customization the company provides and to what degree; and
- the nature of any software maintenance agreements.
If the company provides other services, such as outsourced information technology (IT) functions, it must explain those services, too. These various products or services each can have different tax implications, and it is vitally important that an auditor understand the nature of the business under audit to determine the correct taxability.
Draft Audit Work Papers
Before the audit is finalized, business leadership can meet with the auditor to review the draft audit work papers. This provides an opportunity for your company to address any areas of concern and ensure that the final report accurately reflects the business’ tax position.
If the audit involves a nexus discovery issue or similar notification, your business should determine whether the matter can be resolved by filing prospectively instead of by filing and paying tax liabilities for past periods. In some cases, states may be open to resolving issues prospectively if the dollar amounts are minimal or if the taxing jurisdiction has not provided clear guidance on the issue (for example, nexus).
Experienced Guidance
As in the preaudit stage, it may be necessary to engage SALT professionals for guidance. When seeking advisors, look for firms that have proven success in SALT audit representation, from managing audits and negotiating settlements to providing comprehensive support for tax controversies and litigation. A competent firm should be able to provide the following services:
- reviewing document requests for relevancy;
- developing the audit narrative and explaining the relevant issues to the auditor;
- discussing inconsistencies in the auditor’s application of statutes, regulations, or case law;
- addressing other complex issues as they arise in the audit process, in some cases raising additional issues that may reduce overall tax liability; and
- elevating the issues to the appropriate personnel within the agency as needed if matters stall at the audit level.
Post-Audit Administration: Wrapping Up
Once the audit is complete, your company may need to do corrective work. Specifically, you will need to assess the findings, address any errors, and take corrective action to avoid future issues.
Determine Discrepancies
The first step after the audit is to review the preliminary findings. If your company disagrees with any proposed assessments, explain the basis for the disagreement and quantify precisely where the discrepancies lie. This will help your company to prepare for further discussions with the tax authority or for appeals.
Protest and Appeal Deadlines
Most states have a period for protesting or appealing proposed assessments. Be sure to check the assessment notice date, since the clock starts ticking from that moment. In some states, like Georgia, a business has only thirty days to protest, whereas other states may offer sixty or even ninety days. Missing this window can make the assessment final and enforceable, meaning that your company must pay the taxes, penalties, and interest owed and seek a refund, which may require proceeding to court.
Make Internal Corrections
Once the audit is complete and any adjustments are made, your company should take time to remedy any issues identified during the audit. These corrections can include updating processes, such as how the company gathers apportionment information, collects exemption certificates, or makes decisions on taxability, as well as improving recordkeeping for positions that may be challenged on audit. By addressing these and other procedural deficiencies, your company can prevent similar problems from arising in the future.
Mike Grim, JD, MBA, is director, state and local tax services, and Karen Boyaris, CPA, JD, LLM, is director, state and local tax services, both at Cherry Bekaert Advisory LLC.
