When auditing for sales tax credits, auditors focus on credits that occur in reporting periods other than the one for related sales. Technically the only correct ways to treat a credit are to amend the original return or to file a Claim for Refund. Due to the number of tax credits generated by most businesses, constantly amending returns and/or filing Claims for Refund are impractical for both the taxpayer and the tax authorities. Taxpayers therefore use other methods for handling tax credits when preparing their sales tax returns.
In single tax rate states, an auditor's top two considerations when making audit determinations are typically the statute of limitations and credit validity.
Statute of Limitations
In states with a single sales tax rate, the first concern an auditor will have is whether or not the statute of limitations is involved. The transaction on which the sales tax was originally charged must be in the same audit period as the credit. Otherwise the auditor may disallow the tax credit because the original sale was made outside of the audit period and the auditor cannot review those returns to determine if the transaction was properly reported.
The statute of limitations would also bar the auditor from reviewing the buyer’s records to determine the exemption was valid. If the tax credit is allowed to offset current period tax but the original transaction was not actually exempt, the state would be out the tax with no way of assessing it against the buyer.
Once an auditor has confirmed none of the tax credits are impacted by the statute of limitations, the next step is to determine if the credit is valid. A valid tax credit can be defined as one where the tax has been previously reported and the reversal is properly supported. The auditor will trace the original transaction through the accounting system and onto the sales tax return. The tax accrual account will also be examined to confirm that not only did the transaction hit the return but so did the tax. Finally, based on the reason behind the reversal of tax, the auditor will take appropriate steps. If the sale was unwound, an entry crediting the customer’s account may be adequate support. If the customer has issued an exemption certificate, the auditor will examine the document and confirm buyer is authorized for such a tax exemption. Depending upon the amount of tax involved and other circumstances, it is very common for auditors to send a note to the buyer’s file in the taxing authority’s system. If the buyer is audited, this transaction will be on that auditor’s agenda.
However, in states with composite tax rates, auditors face a more complicated task and need to look beyond the statute of limitations and credit validity issues.
Handling of Local Tax Credits
In addition to the points just discussed, auditors should also be concerned with how tax credits are handled at the local jurisdiction level. For example, the Ohio sales tax return breaks out sales and tax at the county level. In theory, the auditor will examine how a tax credit for a transaction involving Knox County was treated. Was it offset against other transactions in Knox County (intra-jurisdiction netting)? Or was it simply netted against random transactions in one or more counties (inter-jurisdiction netting). In most cases it will be impractical to perform this level of auditing unless the data is available in an electronic format. Sorting paper invoices into piles by county and calculating the total local tax for each usually doesn’t return enough value to justify such an effort.
Considerations for “Home Rule” States
However, treatment of credits for local jurisdictions becomes much more important when the so-called “home rule” states are involved. In these states (primarily Alabama, Arizona, Colorado, Idaho, Louisiana) some cities and/or counties administer their own taxes and taxpayers must file separate sales tax returns with them in addition to filing with the state. It is therefore possible to have not only a state auditor but auditors representing one or more of these local jurisdictions. Local auditors have a different motivation to confirm tax credits were offset only against tax in the same city/county than do the state auditors. It is not unusual for credits to be disallowed in an audit of one city because the credit actually related to another city. The taxpayer will pay the underreported tax plus interest and possibly a penalty to the city where the tax was improperly offset. Then the taxpayer will need to amend one or more returns with the city where the credit actually applies. And that may trigger a visit from that city’s auditor.
Negative Value Returns
So far the discussion has assumed the overall tax return remains a positive value despite the tax credits. But what about the case where tax credits in a reporting period are so large they result in a tax return with a net negative tax due amount? Since states generally will not accept a net negative tax return, the auditor’s interest will be in how the taxpayer dealt with the situation. As mentioned at the beginning of this blog, the taxpayer should either file a Claim for Refund or amend the appropriate return(s). But if the credits will be offset over a “reasonable” period of time and because these actions may increase the chance of an audit, the taxpayer will most likely handle the net negative tax return using one of several different methods. This is where “auditor discretion” comes into play. Is the auditor willing to accept a not-by-the-book treatment of the credits and audit that treatment to assure the results are correct and valid? Or will the auditor disallow the treatment and force the taxpayer to use one of the required approaches? Unfortunately, the answers to those questions depend solely on the individual auditor. But generally speaking, if the end results are correct and the period involved isn’t too long most auditors will not force the issue. There really isn’t much for them to gain from taking a hard line since there is no net change in the tax due and paid over the entire audit period.
Questions? Comments? I would be very interested in hearing how readers deal with their tax credits, especially in the composite states, and if those treatments have been challenged by auditors.
Other recent “Audits and Sales Tax” posts by Lloyd Geggatt:
- Software Audits for Buyers & Sellers – and the 3 Key Questions
- Luxury Audits: Empty Boxes Full of Champagne Wishes & Caviar Dreams
- Sales Tax Audits: Actual Basis Approach Can Result in "Win-Win".
- What Auditors Should Understand About Outsourced Sales Tax Returns
- Auditing Sales Tax Credits: An Auditor's Top 2 Considerations