Most states have a use tax clause that requires businesses (and most residents) to pay use tax on tangible goods that are purchased and used or stored within their state. But while most companies are aware of their sales tax obligations, very few have a true understanding of how use tax applies to their business. Some have absolutely no idea of the concept… never mind how to address it.
A very small percentage of businesses understand exactly where they have exposure and have controls in place to capture and report the tax; a majority are aware of the basics and make an attempt to be in compliance. Despite these attempts, the California Board of Equalization found, “…the second most costly and the most frequent category of taxpayer noncompliance” is “[f]ailure to pay use tax on purchases from out-of-state vendors.” In 2009-2010, nearly two out of ten taxpayer errors in the state of California were related to use tax. The net total of use tax audit deficiencies found in FY 2010 totaled more than $84 million in unpaid tax.
While those numbers seem imposing, I’m willing to bet the true use tax liability in most tax audits exceeds the use tax actually assessed. This is due to the difficulty in auditing this area.
Use tax transactions can be divided into three high level categories:
- Purchases of assets
- Withdrawals from resale inventory for a taxable use
- Purchases of expense items
Purchases of assets are most likely to be audited correctly. By definition they are larger dollar items and can be identified by reviewing depreciation schedules attached to income tax returns. It is a simple matter to request the documentation behind any assets added during the audit period and review them to determine if they were properly taxed.
Conversion of resale inventory may be the hardest to audit for a couple of different reasons. The first hurdle is recognizing and identifying transactions that result in a use tax liability. In businesses like bars and liquor stores, merchandise given away or consumed by the owners and staff is a standard operating practice. Manufacturing companies may have Research and Development (R&D) and Quality Assurance (QA) departments to which inventory will be charged. These cases are relatively easy to identify by a review of the General Ledger (GL) accounts, a tour of the plant and interviews with the taxpayer.
But things get muddier elsewhere. California Regulation 1501.1 deals with Research and Development Contracts. The regulation clearly defines a “qualified research and development contract” and specifically states that persons who render services in conjunction with these contracts are consumers of the materials. So far, so good. But the regulation also addresses “prototypes” and “custom-made items.” The taxpayer is considered to be a consumer of materials for the prototype but the retailer of the custom-made item. And then there are “phased contracts” …. but you get the picture. Reading a contract which by its very nature involves cutting edge concepts and trying to determine if it is for R&D, for a prototype, a custom-made item or some combination of all three is very challenging.
Assuming he has cleared the first hurdle by correctly identifying all transactions subject to use tax, the auditor must now determine the amount subject to use tax. In those manufacturing plants with many different departments and inventories of fungible items, it can be difficult to identify how much is being pulled out for use in testing, QA or other taxable use. The task becomes even trickier if these items have labor, overhead or other charges attached to them. If the auditor is lucky, there will be a uniquely numbered monthly journal entry to accumulate these costs by category. If the auditor is unlucky, the journal entry number will vary month to month so they must all be reviewed. If the auditor is really unlucky, the company has no formal methodology for tracking these types of inventory movement. The tax is there, the auditor just needs to recognize this is happening and then develop an audit approach to quantify it.
Establishing taxable cost for those R&D contracts can be even harder because much of the material will be purchased directly to the project and not run through an inventory account. Taxpayers who practice job or project accounting may have those purchases specifically identified and tracked. Other taxpayers’ records will not be so transparent and the auditor will need to be creative and determined. (That’s a scary thought.)
Auditing purchases subject to use tax presents its own set of challenges. First of all, purchase transactions are represented by sales invoices from hundreds or thousands of vendors with differing formats, content and configurations. Secondly, little of the information on these invoices actually gets recorded in the buyer’s accounting system. Vendor specific information can be found in the vendor tables but key data points like tax amount, date of sale, shipping point and product descriptions generally exist only on the vendors’ invoices. The result is key data components needed for audits are not recorded. This means the actual vendor invoices must be pulled and visibly inspected.
The need to pull the actual bills leads to another difficulty: determining what to audit. Should the test be on the vendors or on the purchases? If on purchases, should /can expense items be segregated from all other purchases? The answers to these questions are in turn influenced by how the invoices are filed and stored. They may be filed by vendor, by month paid or by the check number used to pay them. Files for the entire audit period may be onsite or some may be archived somewhere offsite.
These are just some of the factors an auditor must contend with when auditing for consumer use tax. It requires a very good understanding of the tax law and how it applies to the business/industry, an open and inquisitive mind and patience.
Next time: Performing the audit for consumer use tax.
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