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Sales Tax Audits: Actual Basis Approach Can Result in "Win-Win".

author photo of Lloyd Geggatt

Before computers, most sales tax auditing involved the use of block samples to examine transactions. This involved looking at all the transactions within the same “blocks” of time (months, quarters) or accounts.

With the onset of computer-aided sampling, more robust analysis was possible. Statistical sampling, using data in electronic files became much easier to stratify, sort, and otherwise “manipulate” in order to define populations and select samples from those populations. Test results became measurably more accurate, though 80% certainty +/- 20% margin for error  might seem odd to call “accurate," and represented a huge step forward. Statistical sampling was a win/win for both the taxpayer and the auditor even if it might come across as black magic to some.

Actual-Basis Sales Tax Audits

As I became more informed about how data is stored in relational databases and the various tools and programs for working with that data, I began to see that an even better audit approach was within our grasp. Even the best-designed test is still just that, a test. Sure, the results can be extrapolated with a measurable degree of confidence, but that extrapolation is almost certainly not THE answer. Additionally, if the liability is based on disallowed claimed exempt sales, taxpayers are not able to fully reimburse themselves from their customers. The liability associated with the customers who were included in the sample is known but the remaining liability simply comes from a mass of customers comprising the population base.

But if an audit is performed on an actual basis where every transaction is “examined” then at the end THE number is known as well as how much each specific customer contributed. I began to approach each assignment with the goal of conducting the audit on an actual basis. The key was extracting data directly from the tables underlying the taxpayer’s system rather than relying on data from report writing software sitting on top of the application. This meant data was coming directly from the “source of truth” with much less chance for corruption. The data output was subjected to some analysis to ensure completeness and accuracy, just as other data sources were checked.

Once the data set was accepted, it was run through different queries (filters) to slice it into different subsets —fully taxed, not taxed, partially taxed, shipped out of state, delivered within the state, etc. Each of these subsets might be aggregated by customer, by product code, by ship to address, etc. for additional analysis —confirm exemption certificate was on file, correct tax rate applied based on point of delivery, etc. Basically data was filtered and aggregated by attributes that could be reviewed and accepted or questioned.

A total actual basis audit was not possible for every taxpayer; some could not provide all the fields of information required for the queries or perhaps the data set was simply too large and too differentiated to be able to query the entire population down to unique reviewable attributes. But even in these cases the initial population could always be queried and made more homogenous before subjecting it to a statistical sample.  Since testing a homogenous population generally requires a smaller sample and provides more accurate results, the taxpayer benefited more than if the raw population had been sampled.

My experience has shown that on average actual basis audits can be completed in about the same number of hours as an audit with sampling but the overall elapsed time from start to finish can be less. More time is invested up front with the data extraction and the queries but less time is required following up on questioned items, etc. Taxpayers are also much more likely to accept the audit findings so less time is spent in the appeals process and/or performing re-audits. Overall the actual basis approach is a winning one for both the auditor and the taxpayer; one I suggest every taxpayer consider before agreeing to any type of sampling.

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Comments

3 Responses to Sales Tax Audits: Actual Basis Approach Can Result in "Win-Win".

  • Posted by Kathy on May 30, 2014 3:58pm:

    I love your articles! Thanks so much for sharing!!!

  • Posted by Gordon on July 1, 2013 12:13pm:

    Hi,
    A conversation with a friend about sales tax resulted in a lively discussion about how businesses should handle those taxes. We're on different pages as to how it all "works" and I'm hoping you can provide some clarification.
    Assume you have a legitimate business(Acme Inc.) that buys materials from distributors at wholesale or wholesale-like prices, and resells those materials - either stand-alone or as part of a larger system.
    Now, assume that business receives an order for a system from a commercial customer that is NOT exempt from paying sales tax.
    My friend thinks that Acme Inc MUST pay sales tax on the material it purchases for resale. Then, Acme Inc. MUST charge sales tax to the customer, at the sales tax rate for the state that the system is sold/shipped to.
    Is it correct that tax would be charged twice on the bill of materials used in the system? That doesn't seem correct to me; I think that Acme Inc would have a SUT certificate, and by law would not pay tax on material that is resold to a customer. I do agree that sales tax should be charged to the client, should be at the rate of the state the client resides in, and the tax should then be paid to said state.
    Neither the state that Acme Inc. or its customer reside in participate in the Streamlined Tax Agreement.
    Thanks in advance for your input.
    EL

    • Posted by Author photo of Lloyd GeggattLloyd Geggatt on July 2, 2013 5:33am:

      Hi Gordon,
      Although there are exceptions to virtually every statement whenever sales tax is involved, generally Acme would follow the process that you described above rather than your friend's. The tax status of Acme's customer is irrelevant when determining if Acme should pay sales tax to its vendor(s). The critical question is what does Acme plan to do with the materials/goods purchased? If the materials are intended for resale, either as is or incorportaed into a product, then Acme should issue a resale certificate to the vendor. In the specific scenario you present, Acme would then charge tax on the selling price to its customer, assuming Acme has adequate nexus in the shipped to state and is therefore responsible for collecting that state's sales or seller's use tax. If not, then the customer would be responsible for accruing and reporting consumer use tax to that state.
      As a side note, most states provide a mechanism on their sales tax returns whereby a seller can claim credit for taxes mistakenly paid to the vendor at time of purchase on an item intended for resale that is actually resold prior to any use being made of it. This prevents double taxation on a series of transactions only one of which is a taxable event.
      I hope this helps clarify this use case. Please let me know if you, or your friend, has additional questions.
      Thanks,
      Lloyd

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