Construction Companies: Important Sales and Use Tax Audit “Red Flags”
In our last blog, we reviewed in detail the importance of the construction contract in determining the rights and responsibilities of the key parties for sales and use tax (SUT) compliance on a construction project — the owner, contractor and subcontractors.
In this and subsequent blogs, we will identify and discuss in more detail some of the key “red flags” that could trigger a sales and use tax audit. Included here are some best practices to prevent or at least minimize a bad audit result for the owner, contractor and/or subcontractors of construction projects.
What are some of those “red flags”?
While any construction company may be subject to a sales and use tax audit, the reality is that states have limited audit resources and therefore, revenue agents, wherever possible, try to focus more of their efforts on companies more likely to produce the biggest revenue bang for the buck. Some key triggers include:
- Companies with large customer bases and/or large supply-chain activity in states where the company does not have a physical presence.
- Companies that perform services and purchase goods in more than one state
- Companies that have been receiving media attention for recent growth both in revenue or M&A activity.
- Companies whose markup or profit of the company are not in line with the rest of the construction industry
- Companies with affiliated companies (e.g., brother-sister, parent-child) that operate in other states
- Companies with a track record of:
- late-filed returns,
- amended returns with large refund requests,
- audits where material deficiencies were found
- federal and state income tax audits
- Companies, whose customers, subcontractors and/or suppliers have been audited recently
- Companies that have received Information requests or other notices from a state asking questions about the business.
- Companies whose financial statements are not reviewed by an outside accounting firm on a regular basis.
- Most private companies have a much greater chance of facing an audit.
- Companies whose contracts do not clearly spell out the sales and use tax rights and responsibilities of the parties to the construction project
- Companies that have not conducted a recent review of the overall sales and use tax process
- Companies whose sales and use tax compliance, including tracking of current state-wide and local rates and rules and tax return filings are not automated — software has not been implemented to handle these functions.
- Companies that do not have a document management system to record and store original document types like change-orders, as well as exemption and/or resale certificates.
- Companies with little or no internal controls concerning material and supplies inventory to determine if there is an accounting for withdrawals and payment of use tax.
An ounce of prevention is worth a pound of cure
There is a growing need for states to find new sources of state revenue to balance budgets and support important state-funded services. This increasing need, coupled with the expanded reach of states to tax companies through economic nexus, is leading to increased state tax audit activity. However, these revenue agents must be “smart” in using their limited audit resources efficiently. They will be looking more closely at companies and industries with complex sales and use tax transactions more likely to produce audit adjustments that give the biggest bang for the buck. One such industry is construction and over the next several weeks we will take a closer look at some of those “red flags” and best practices to reduce the risk of “bad” audit results for these companies.