Preparing your Online Business for an Out-of-State Sales Tax Audit
The day has come that your online business has been issued a sales tax audit notice. How do you prepare for this painful process, especially in a state in which you don’t reside? Each state and locality has different procedures and authority when it comes to auditing your business. That’s not to mention the varying sales tax laws themselves. The reality is that all audits are not treated equally and approaching them as such can result in a terrible assessment down the line.
Online businesses are especially susceptible to audit complications because they typically have little to no physical presence in many, if not most of the states in which they do business. An audit from a foreign state can be scary, as the taxpayer likely is not familiar with all the technical sales tax laws of all the states in which they do business and the procedures and rules for conducting an audit vary dramatically across the country. It is vital for online business owners to start an audit as prepared as possible, and these five steps can help in that preparation.
1. Identify the Type of Audit
First, it is important for online business owners to identify exactly what kind of audit notice they’ve received. We’ve all seen those scenes in the movies where a patient receives a terrible diagnosis and then the doctor’s subsequent words garble together unintelligibly. The same thing happens with taxpayers and audits. They see from the document they’ve received in the mail that they’re under audit and the blood runs cold in their veins. It’s important to understand, however, exactly what type of audit you’ve received.
Perhaps you’ve received a reemployment tax audit or a corporate income tax audit. Often times, it may be a sales and use tax audit. What type of tax are you dealing with? It may not even be tax! You could be looking at an unclaimed property audit that is something entirely different than you feared. Depending on what kind of audit you are under, the potential liability could range substantially. Furthermore, the audit process itself could be completely different. Auditors will request and evaluate different records and rely on entirely different statutes in calculating an assessment. You must first be clear on the type of audit you are under before you can begin to respond.
Next, exactly where is this audit notice coming from? States often have revenue offices outside the boundaries of their state, so even though the return address on your envelope is located in Texas, it could be the Florida Department of Revenue knocking on your door. Knowing the state is not necessarily enough. While audits are commonly conducted on the state level, you could also be under audit by a city, county, municipality of even a special taxing district.
Finally, is the notice you received initiating a full audit or a limited scope audit? Sometimes, states will discover untaxed items entering their borders and simply want information limited to those items. States will initiate limited scope audits for other reasons as well. Typically, these audits are quicker and simpler in nature, however, they must be handled with extreme caution. A simple misstep can result in a limited scope audit being referred for a full scope audit.
Moving forward with an audit without knowing precisely what kind of audit you are dealing with can result in the Department over-assessing tax. Providing records outside the scope of the audit can expand the audit or result in the wrong state obtaining tax they are not entitled to. The worst thing a taxpayer can do upon receiving an audit notice is to take a bad situation and make it worse by making decisions without being properly educated on what they’re dealing with.
2. Be Clear on Timing
Each state audit operates under the ticking clock known as the statute of limitations. The statute of limitations determines how far back an auditor can go in assessing tax and also how long the auditor has to conduct an audit. Both of these dates are vitally important for limiting exposure.
It is not uncommon for an auditor to make an error in establishing the scope of an audit. Sometimes, the auditor will go farther back than they are entitled to. Other times, the auditor will fail to complete the audit within the statutory period. The audit supervisor, and the Department as a whole, will generally move forward as if nothing is wrong when a statute has been violated. The burden lies on the Taxpayer to realize the error has been made and to challenge the state to invalidate the assessment. Such errors in the statute of limitation can result in months, years, or the entire audit being removed.
But timing is not only something the state needs to worry about when conducting an audit. Taxpayers under audit are subject to a series of timelines both during and after the audit. During audit, taxpayers are given sometimes statutory and other times arbitrary dates by which they must provide records, respond to Department emails or phone calls, fill out a questionnaire, or other tasks. It is important to know which deadlines are set by rule or law and which deadlines are set by an auditor. Deadlines set by auditors are often negotiable whereas deadlines set by rule or law are not.
The auditor will try to set the pace of the audit to meet their statutory deadline of completing the audit within a specified period. Meanwhile, additional time is usually what taxpayers want to carefully gather, inspect, and prepare their records for audit. Taxpayers often feel overwhelmed by the audit and intimidated by the auditor, and hastily provide records the state is not entitled to or records that fail to accurately reflect their business. These errors made during audit can result in devasting assessments, so it is important for taxpayers to take control of the audit early on and understand the scope of the auditor’s authority in establishing deadlines.
When an audit is complete, timing becomes more important than ever. If a taxpayer disagrees with the result of an audit, they are given a short time to contest the assessment. Once those protest rights expire, the assessment becomes permanent, and the taxpayer has no right to challenge it further. Taxpayers must know what the deadlines are not only for informally protesting an assessment within an agency but also for contesting an assessment in court. It is a common misconception that you can challenge a tax assessment long after it is issued. In fact, there is often only a month or two to move forward challenging an assessment.
To make matters worse, these deadlines vary state-to-state. If your business is under audit by multiple states, you will need to be especially careful not to confuse the deadlines and miss your opportunity to challenge an erroneous assessment. It is important to consult a tax professional to identify technicalities that may not be apparent on the notices you receive with the deadlines. For example, if a notice gives 30 days to respond, it may not be clear from what date that 30-day period begins. Being off by even a day is risking getting stuck with an assessment that you would have otherwise challenged successfully. When it comes to the timeline of an audit and the subsequent deadlines, it is vital for taxpayers to be aware of them and prepared to respond to them in a timely fashion.
3. Know Your Rights
It may not feel like it from the way many auditors will treat you, but as a taxpayer under audit, you do have rights. In fact, these rights are often spelled out for you in a document called the Taxpayer Bill of Rights. At the beginning of an audit, you should be provided the Taxpayer Bill of Rights, which may go by another name some states. If you are not provided with this, you should request it on your first communication with an auditor.
Taxpayer rights come in a variety of forms. First, taxpayers are generally entitled to all information relating to their audit. During an audit, taxpayers are entitled to an open audit to understand fully how their assessment was calculated. This may include the methodology in conducting the audit and any statutes or rules relied upon. Depending on the industry, the auditor may have an industry manual they rely upon, which taxpayers likely are entitled access to as well. The more educated a taxpayer is at the beginning of and during a sales tax audit, the better off they are moving forward in the process. When an audit is completed, you may request auditor notes, case activity reports, and any other documentation. Some states may also allow you to receive and review email correspondence between the auditor and his or her supervisor.
Taxpayers may also be entitled to the freedom of penalties and the abatement of interest in certain circumstances as well as the right to challenge an assessment. Many states promise taxpayers the right to seek review, through formal or informal proceedings, any adverse decisions relating to the determination of an audit. In addition, states often allow taxpayers the right to a reasonable administrative stay while the challenges progress.
Just like defendants in criminal trials, taxpayers are often guaranteed an expeditious audit under deadlines, as described in the previous section. Finally, taxpayers may be promised the right to a fair and consistent application of the sales tax laws of the state.
The rights guaranteed to taxpayers by states vary, but one common theme tends to linger under the surface all such Department promises: there is little teeth to them. A state taxing authority may issue a Taxpayer Bill of Rights making tons of promises to business owners, but what happens when the Department violates that bill of rights? Unfortunately, there usually is no real consequence.
Now, in cases where the rights provided are guaranteed by statute or rule, the taxpayer may have a valid case to challenge such a violation of the Taxpayer Bill of Rights. However, if the rights are simply invented by the Department of Revenue or other taxing authority and not supported by law, there is generally no basis upon which to hold the state accountable.
Ultimately, knowing your rights and holding the taxing authority accountable to them throughout the audit process is important for preventing yourself from being taken advantage of by an aggressive auditor. Use your rights to define the scope of what you need to provide to the state and when you need to do it. Meanwhile, when it comes to promises from the state, be careful not to rely on them as if they were written in the statute because any violations will likely go unpunished on their end.
4. Understand Your Records
In a modern economy, the digitization of records has resulted in a rapid flow of information. In fact, the flow is so fast that it sometimes goes right onto important returns and other records without proper review for mistakes. In theory, the digitization of records should result in more accuracy by removing human error, but the automatization of important returns can result in isolated errors flowing through to multiple documents, tainting financial records completely by the time the are under the eye of an auditor.
It is not uncommon for a taxpayer to be completely out of the loop when it comes to their financial records, relying instead on the automated procedures in place. Often the owners are busy running the business and delegate the recordkeeping to either an in-house accounting department or outsource the work to an accounting firm. It is often not until an audit, and sometimes not until an actual assessment, that business owners will take a closer look to their own accounting practices.
One of the worst things a business owner can do is to take these unreviewed or automated records and turn them over to the state without carefully evaluating them for accuracy. Many audits have moved forward based on inaccurate records even when taxpayers have eventually identified and notified the state of their inaccuracy. One thing that cannot be taken back is the moment poor records unreflective of the business are provided to the state.
Therefore, prior to turning over records, taxpayers should review them carefully. The picture the records paint should mirror the owner’s actual understanding of his or her business and accurately reflect actual sales and purchases. If something odd appears in the records, the source of the error or abnormality must be uncovered and reconciled.
Before the auditor receives a single record, the taxpayer under audit should know exactly what those records say. If there are any liabilities lurking, it is important for the taxpayer to know first and to be able to prepare any defenses to them. By the time the auditor discovers any liabilities, the taxpayer will already be prepared to challenge them. Few things are worse than the auditor discovering a liability for the firs time, leaving a taxpayer scrambling to get records to defend itself in what is usually a very short period of time provided by the auditor.
Ultimately, it is vital for taxpayers to fully understand their records prior to handing them over. Sometimes, business owners will have multiple ways to identify sales and purchases and it will be at their discretion to rely upon the documentation that best reflects their business. But once records are turned over, they cannot be taken back. Auditors will push to trick an anxious taxpayer into turning everything over so that the auditor can use the records as they wish to paint whatever picture they desire of a business’s operations. Only the taxpayer educated on their records will be able to prevent this from happening by taking control from the start.
5. Find a Sales Tax Professional
The earlier you involve a sales tax professional, the better. Often, taxpayers want their trusted CPA to handle the sales tax audit because the CPA knows the business the best. Unfortunately, most CPAs are not trained in sales tax. While they may know the business better than anyone, their lack of expertise when it comes to sales tax laws and procedures could result in an assessment of tax that could have been avoided.
It is usually once that assessment comes that CPAs and business owners alike decide to move forward in hiring a sales tax attorney. However, the damage is often already done by that point, and the sales tax attorney will have to work an uphill battle to reduce the assessment.
Hiring a sales tax lawyer at the very beginning of an audit can set the tone of the entire case. A sales tax lawyer is not lost in the weeds of the audit itself, but instead methodically moving through the audit process with a bigger picture in mind. A sales tax lawyer is not so much concerned with completing the audit as using the audit to lay the groundwork for challenging an assessment, and potentially winning a case, down the line.
In addition, hiring an attorney from the onset of an audit may keep the auditors and other Department representatives in line because they know the attorney has the resources to challenge an assessment in court. A hearing would mean these auditors and other representatives could be put on trial and questioned by an attorney in court. Therefore, auditors are much more likely to follow the rules when they see a potential hearing down the road. Meanwhile, if an accountant handles the audit, the auditor will feel a sense of security that the accountant will only take the case so far before the business owner will need to give up fighting and pay the tax. The result is, the Department will very likely be more aggressive towards accounts and more reasonable when faced with a lawyer and the possibility of a trial. To decide if a sales tax lawyer is right for you, give them a call! MSD gives free consultations up to one hour. Bring in your audit notice, your records, and your concerns and speak with an attorney who focuses solely in state and local tax and has the experience necessary to defend your case. What do you have to lose? If the fit is right, you will feel confident in hiring the sales tax lawyer to defend you. The point of hiring a sales tax lawyer is to take the burden of an audit off your shoulders and put it on to someone else’s. With your business under attack by the state, especially if that state is foreign, you will want to be sure you’ve picked someone qualified to defend your business.
Out-of-State Sales Tax Defense, by Jeanette Moffa, Esq., June 18, 2019
Jeanette Moffa is an attorney who concentrates on state and local taxes at Moffa, Sutton, & Donnini, P.A. She is an executive council member of the American Bar Association Tax Section State and Local Tax Committee and the Florida Bar Tax Section. Ms. Moffa is an author of both the CCH’s Expert Treatise Library: Sales and Use Tax as well the ABA’s Sales and Use Tax Deskbook. In addition, her regular columns on state and local tax issues can be found in State Tax Notes and Actionline, a publication from the Florida Bar’s Real Property, Probate, and Trust Law Section. She also serves as assistant editor to the Sales and Use Tax Deskbook and Actionline. Ms. Moffa is a regular speaker at the American Bar Association Tax Section conferences, the Institute of Professionals in Taxation, the Florida Bar Tax Section, the Florida Bar Real Property, Probate, and Trust Law Section, and the FICPA. In her free time, she teaches as an adjunct professor at Broward College.