Ever Wonder What's Reviewed in a Sales and Use Tax Audit and Why Exemption Certificates Matter?

States have various ways for determining who gets audited for sales and use taxes. One potential trigger is when another company is audited. For instance, if one of your customers is audited and the auditor reviews one of your organization's invoices that shows no tax, they might investigate whether the customer properly provided an exemption certificate, or if sales or use tax should have been applied. While this doesn't imply your organization did anything wrong, it's important to be aware that your invoices are often reviewed, even when you might not expect it.

Once your company is selected for a sales and use tax audit, the state will notify you in writing, informing you that auditors will review your records for a specific period — typically four years, but it can be longer depending on the audit's duration. It's very important to prepare in advance to ensure the audit runs smoothly and doesn't delay the outcome. As your organization has advanced with technology, so have the states. In some cases, auditors work remotely and request records electronically. Other times, they may visit your headquarters where the records are stored. Auditors may evaluate all transactions or use a statistical sampling method, depending on the state's approach, so you must be ready to adapt.

During a normal audit request, the typical records requested will include but are not limited to, sales and use tax returns, general ledger, expense accounts, fixed asset accounts, sales and purchasing invoices, and exemption certificates when invoices do not include sales taxes. Let's explore the reasons for requesting these records:

What Auditors Request, and Why

Sales and use tax returns

The auditor wants to see copies of the filed returns for the period in question, they will compare them to their records to ensure consistency. Surprisingly, discrepancies can occur in the reported numbers, and this analysis helps identify any differences.

General ledger, expense accounts, purchasing invoices

The auditor will review your general ledger to understand your organization's financial activities and identify accounts of interest. For instance, if there are large expenses under office supplies, they might request to see some invoices to make sure sales tax was paid or use tax was accrued. Office supplies are taxable unless they are being resold, in which case those transactions would appear in the inventory accounts, not the expenses accounts.

Fixed asset accounts, purchasing invoices

An organization often places larger purchase asset invoices in the fixed assets accounts for depreciation purposes. If your organization, such as a manufacturer, has significant fixed asset purchases, these will be reviewed to ensure sales tax was paid or use tax accrued, unless there is a specific exemption that can be applied. Fixed asset invoices typically receive more scrutiny than expense invoices and auditors often review all the fixed asset invoices, whereas expense accounts may be evaluated by using a sampling method.

Exemption certificates apply to both expense and fixed asset invoices. These are used when a decision is made not to pay sales tax by claiming an exemption. However, if an exemption certificate is issued in error or if no regulation supports the exemption, the auditor will assess use tax liability during the audit.

This is important to note that every certificate issued is a decision not to pay sales taxes and acceptance of potential use tax liability. Even more critical is that once the use tax liability is assessed, it cannot be reduced or eliminated, as there is no way to retroactively retract an exemption certificate. In many cases, use tax liabilities can be more significant and costly than the sales tax liabilities, depending on the nature of the business.

All of this contrasts with the process of receiving versus issuing sales tax certificates, which will be evaluated when reviewing sales invoices next.

Sales Invoices

Like expense invoices, sales invoices are evaluated for accuracy. One of the auditor's primary tasks is to verify that the correct taxes were charged on the invoice. The tax rate — whether state, county, city, district, or special district — depends in most situations, on the “ship to” location specified on the invoice.

For sales invoices, as with expense invoices, the auditor might use random sampling or review all invoices from certain periods, among other sampling methods. Due to the typically large volume of invoices, auditors often calculate a projection of errors. For example, if an invoice had an incorrect sales tax rate of 7% instead of 8%, this error contributes to a projected error rate over the entire period under review. To illustrate, a 1% error rate on $5 million in annual gross sales could translate to approximately $200,000 in tax liability, plus penalties and interest.

This is where exemption certificates become crucial. If selected invoices are found to lack sales tax and the transaction was taxable, the auditor will require exemption certificates. Each certificate should justify the exclusion of sales tax; otherwise, a missing or invalid certificate can lead to an increased error rate and potentially higher liabilities.

There is some good news regarding the review of sales invoices compared to expense invoices. Once a sales tax liability is determined, auditors are often willing to give you time to address and reduce this liability by obtaining missing or corrected exemption certificates. This flexibility is generally not as available for use tax liabilities.

However, this process does not guarantee that you will be able to obtain all the necessary certificates. A four-year period is extensive, and customer circumstances may have changed significantly over that time. For instance, the impact of COVID-19 might have led to some customers going out of business or otherwise becoming unresponsive, which could leave you with an unresolved sales tax liability.

This underscores the importance of maintaining accurate and up-to-date exemption certificates.

Assessing Your Readiness

If you're unsure about your exemption certificate liability in any state where your company has nexus, it's a sign that you need to better prepare for a sales and use tax audit. Many companies wait until they receive an audit notice before starting their preparation, rather than being proactive and understanding their potential liabilities in advance.

Consider these questions to assess your readiness: Do you know how many exemption certificates your company currently holds and whether any are redundant? Are you aware of the percentage of certificates that are missing information or have expired? Are your employees spending significant time manually emailing, mailing, faxing, or calling to obtain or maintain these certificates?

Keep in mind that a significant part of the audit process can be the evaluation of exemption certificates for transactions where sales tax was not collected. To streamline the audit and shift focus from the sales tax side to the use tax side, ensure that you are well-prepared and provide the required documents in an organized format to the auditor.

Exemption Certificate Audit Preparation Checklist

To become more proactive, use this exemption certificate audit preparation checklist to establish an effective process:

Educate Your Employees

Ensure that employees in sales and credit departments understand exemption certificates and can communicate requirements to customers seeking exemption. These departments are often the first point of contact for customer inquiries, so knowledgeable staff will help streamline the process and secure valid certificates.

Build a Library

For each state that your company has nexus, identify the most commonly used certificates and create a centralized library for easy access by your organization.

Record Expiration Dates

Certificates have varying expiration dates depending on their type and purpose. For the most frequently used certificates in states where you have nexus, maintain a list of expiration dates to help manage and update them effectively.

Inventory Your Certificates

Review your current certificates for duplicates and sort them into valid and invalid certificates. Consolidate them into one location to facilitate easy access during an audit.

Catalogue Valid Certificates

Separate and organize valid and completed certificates. Providing these to an auditor will streamline the audit process.

Remove Incomplete Certificates

Identify and address incomplete or invalid certificates — such as those missing signatures, dates, or company information. Contact the relevant customers to obtain valid certificates.

Follow-Up with your Customers

Develop a follow-up plan that includes letter templates to clearly communicate what is needed from your customers, making it easier for them to provide the required documentation.

Plan Ahead

Avoid last-minute management of exemption certificates. Develop and implement a sustainable plan for maintaining and updating your certificates.

Utilize Technology

Consider using technology to automate the process of reviewing and maintaining exemption certificates. Automation can simplify the management process and improve efficiency for both your organization and the auditor.

The goal is to reduce exemption certificate audit liability. To achieve this, it is crucial to stay current with frequent state-to-state changes and to establish a system that regularly monitors these updates, ensuring you provide your customers with the most accurate information.

Given the many regulatory changes affecting nexus in recent years, it's likely that your organization now has multiple locations where customers can make purchases. In such cases, it's important to ensure that your systems are integrated to eliminate redundancies and save time in collecting exemption certificates.

Managing expirations can be challenging, so it's crucial to provide your customers with ample notice to submit their most current certificates. During an audit, demonstrate your process to the auditor to show your company's proactive approach in managing this task. The goal is to be well-prepared for an audit, making it easier to identify any gaps in your exemption certificate process. Additionally, this approach will help ensure a smoother experience for your customers when they provide you with their exemption certificate.