What to Expect During a Texas Tax Audit
The Texas Comptroller of Public Accounts (“Comptroller”) sends out audit letters almost every day to businesses. These letters inform the business of the audit to be conducted by the Comptroller’s Office. Unfortunately, this type of letter is only the beginning of a very long and possibly expensive process. The key is to be well-informed of what will occur and in this for the long haul, as audits are rarely completed quickly.
I. HOW TAXPAYERS ARE SELECTED FOR AUDIT
Audits can be selected via any one of a numerous means. Some of these methods include:
| · prior audit of the taxpayer if the prior audit was $10,000 or more
· the result of a complaint against a taxpayer · information obtained due to the audit of another taxpayer · newspaper articles |
While these are just a few of the means the Comptroller uses to select taxpayers for audit, the important takeaway is two-fold. First, the Comptroller obtains information from a variety of sources to select certain taxpayers for audit. There can be multiple sources leading to the audit selection. Second, it may be worthwhile to ask why you have been selected for audit. It may seem obvious but asking can clue you in to what the auditor is looking for in the audit of the business. This knowledge can help you to prepare for the audit requests and potential assessment issues.
II. PRE-AUDIT RESEARCH & REVIEW
Before contacting the taxpayer, the auditor researches the taxpayer’s account to gain as good of an understanding of the business as possible. The goal is for the auditor to:
| · learn more about the taxpayer’s reporting methods and business operations
· understand the taxpayer’s account background and history of reporting · establish preliminary objectives for the audit plan · identify and research possible industry problem areas · become familiar with Comptroller policies and interpretations of law affecting the taxpayer’s industry |
However, this research and review will not answer all of the auditor’s questions about the business. The auditor will need to obtain additional information to better understand the business. This is when the auditor begins his or her contact with the taxpayer.
III. TAXPAYER CONTACT
To kick off an audit, an Audit Questionnaire and Notice of Routine Audit Letter are mailed to the business. Responding to the Questionnaire can set the tone for the entire audit. It is important to thoughtfully but accurately answer the questions. The answers provided may increase an assessment, so if there is any lack of certainty regarding the consequences of such questions, it may be wise to seek counsel. The responses should also be submitted timely if they are to be considered for the audit. If the Questionnaire is not returned at all, the auditor will note the taxpayer refused to complete or sign the Questionnaire as well as the person who refused.
Usually, within two weeks of returning the Questionnaire, the auditor calls the business. The auditor is looking to setup the initial appointment, called an Entrance Conference. The Comptroller likes to have an appointment set for the Entrance Conference within 45 days after this initial contact.
The Comptroller specifically instructs its auditors to document oral statements made by the taxpayer that may be important to support any audit findings. Therefore, you may want to carefully consider what is said to the auditor. You may also choose not to say anything more than you absolutely must. It is very easy for a person unfamiliar with your business to get the wrong understanding of the nature of your business.
V. REQUEST FOR AND EXAMINATION OF RECORDS
After the Entrance Conference, the auditor will eventually send a request for records. The types of records that may be requested include:
| · chart of accounts
· general ledger · general journal · sales journal · purchase journal · duplicate state tax returns with working papers · depreciation schedules · resale and/or exemption certificates · other certificates/affidavits · original source documents (i.e., sales invoices, purchase invoices, customer billings, etc.) for a specified period; federal income tax returns with working papers · job cost/expense files · computer records · annual stockholder reports with audited financial statements and a summary of significant accounting policies · reports filed with other regulatory agencies · settlement statements. |
This is just the first round of preliminary information. Auditors are instructed to stress to taxpayers that more information will be needed. As a result, additional requests for records may occur. Be ready to take a substantial amount of your time away from your business just to interact with the auditor let alone pull the batches of information being requested. Again, it is important to understand the consequences of providing particular records. Competent counsel can assist a taxpayer unfamiliar with the tax implications of turning over various records.
What if you refuse to provide records? At first, the auditor will send a certified letter stating the auditor can request records and provide the legal authority to support this. The auditor will then re-request the records. If the taxpayer does not respond to the certified letter within 30 days, a second certified letter is sent requesting the same records. It may even state a subpoena will be issued if no response is received within 14 days. A subpoena may subsequently be issued if records are not provided.
If after all of this, the taxpayer does not respond, the auditor is going to estimate the assessment. The auditor will attempt to obtain records from banks, the IRS, vendors, customers, as well as other sources. All deductions taken on the tax returns will be disallowed since documentation was not provided.
Assuming records are provided, the auditor will then use the records provided to determine if tax should be assessed. If so, the auditor will schedule the issues into the assessment and use this documentation to support his or her findings. The auditor should be communicating the potential issues to be assessed throughout this process. This should give the taxpayer the opportunity to continue to provide information to whittle down the assessment.
VI. EXIT CONFERENCE
Ultimately, the auditor will calculate an amount he or she believes is due. The auditor will then discuss the audit results with the taxpayer and make suggestions on what is believed to be the correct tax compliance for the future. At this time, the auditor will decide whether penalty should be waived.
This is where you can really begin to make headway at reducing the assessment – i.e., by getting the penalty waived. Criteria the auditor will use as to whether the penalty should be waived are:
| · no prior audits
· errors made in the current audit were not made in the prior audit · current audit error rate is much lower than the prior audit's error rate · taxpayer has shown reasonable diligence · tax collected but not remitted is not an error in the current audit · no resale certificates or an insignificant number of resale certificates were issued erroneously to vendors · taxpayer has an accrual system in place for taxable purchases · taxpayer's records are complete and were made available for the audit · few (less than 1/3 of total returns) or no late returns during the audit period · no delinquencies in other taxes · reliance on advice provided by the Comptroller's office caused the imposition of penalty · unclear or difficult taxability issues · change in Comptroller policy · new changes in the tax law became effective during the audit period · the experience, size, and sophistication of the taxpayer · if complete and comprehensible records are maintained · whether taxpayer is non-permitted (the taxpayer may not have been required to be permitted during all the periods of the audit; whether there is evidence that the taxpayer was previously placed on notice that a permit was required, which would be an unfavorable factor) |
VII. AFTER AN AUDIT
At the end of an audit, a taxpayer may still disagree with the audit results. You have the right to challenge the audit in a variety of ways, but those are outside the scope of this article. The audit process can be a lengthy and time-consuming process. However, the audit does not have to be mysterious. By being better informed of the what to expect next, you can begin preparing for the next step of the audit process ahead of time. Hopefully, this saves you time and heartache throughout the audit. It may even save you from being over-assessed.