Red Flags in the Actual Audit
In previous blogs, we identified some red flags that might get the attention of the state sales and use tax auditor both before and during the various stages of a sales and use tax audit of a construction company. In this blog, we focus on some of the red flags that may arise in the actual audit with the construction company. It is at this stage where the rubber meets the road for both the auditor and the taxpayer — at the end of this phase, any adjustments will be proposed formally and that will start the clock on legal process.
Objective of a Sales and Use Tax Audit
The objective of any tax audit is to determine the correct amount of tax, in the most efficient manner, for the state and the taxpayer. Sometimes, the auditor may have more than one way to audit an issue. In making that decision, the auditor has to consider not only efficiency and accuracy of the method, but materiality as well. Items of negligible amounts are considered immaterial and are not relevant.
Computer- and Noncomputer-Assisted Audits
There are basically two audit approaches: computer-assisted audits and noncomputer-assisted audits.
Ideally, the auditor would prefer to use his or her audit software tools to “plug into” the taxpayer’s books and records as seamlessly as possible and select transactions for review. It is in the interest of both auditor and taxpayer to use the most efficient and time-saving methods to get through the audit as quickly as possible. So, the more sophisticated the software used by the taxpayer to gather and process sales and use tax information, the better off everyone is.
However, in many construction companies, the software used to process sales and use tax transactions may not lend itself to computer-assisted audits. In that case, the audit must be done manually—noncomputer-assisted audits. This is much more labor intensive and time consuming for all involved.
Non-Computer-Assisted Audits: potential “red flag” for the auditor
In general, a detailed examination of the taxpayer’s records is the preferred method of determining the correct tax. However, this may be the least practical method because of the number of records encountered. Tests used, frequently referred to as “sampling” often reduce the number of detailed examinations.
In some cases, an examination of only a few invoices may be needed to make a determination or provide enough substantiation to support a position to the auditor’s satisfaction. A simple test, depending on the findings, may later require a more complex test that might include the design of a more substantial sample, such as “statistical sampling.”
There are many types of tests that an auditor could perform, but the auditor determines the test that best fits each case. The auditor may even be face an issue that may require a specially designed test. Some things for the auditor to consider when selecting or designing a test include:
- the volume of records,
- the probability that an error exists, and
- the materiality of any possible error.
Typical Audit Areas of Focus
Verification and reconciliation are the basic functions that should drive the audit. Typical areas of focus would include:
- Tax Collection and Accruals
- Tax Charged Sales
- Tracing to Original Documents
- Checking Rates
- Use Tax Accruals
- Exemptions and exemption certificates
- Purchases – Use Tax Examination
In carrying these audit procedures, the auditor examine the standard books and records of the company’s accounting system—journal entries, ledgers, etc. However, construction taxpayers should be prepared to produce other documents on request such as:
- Billings, both progress and final
- Job cost folders:
- Plans and specifications
- Estimate of costs
- Copy of contract
- Copy of purchase invoices for direct charges to job
- Copy of requisitions for material withdrawn from inventory
- Time cards for both in-plant labor and labor at jobsite
- Files of paid purchase invoices
Construction company issue spotting during the audit
If you have done your “homework” throughout the various stages of the audit process — pre-audit research and in-person interviews, there should be few surprises during the actual audit. Such “surprises” may occur when the auditor traces selected transactions from “start to finish” and gets unexpected results—a big red flag! The more unexpected the results, the more digging the auditor will do.
If a complex issue is spotted, the auditor will “encourage” the taxpayer to provide a statement that supports its position on that issue. This need not be a bad thing for the taxpayer because it is generally better to be the first to frame the issue in a light most favorable to itself. And if it has reliable, accurate and easy-to-access sources for the tax research, these sources will assist in producing a timely, well-reasoned response to the issue that will have the effect of discouraging “fishing expeditions.”
What are some of those issues that construction companies might anticipate?
Of course, auditors in different states may focus on some issues more than others. However, using California and Texas audit guides as examples, here are some of the typical issues that are often raised during the actual conduct of the audit.
Installed property v. property that is not installed
Where any property is delivered to the job and not installed by the contractor, a sale of tangible personal property may have been made, and the transaction is not considered an improvement to realty. If the property installed is “machinery and equipment,” this is a “red flag” if classified as an improvement to realty because “machinery and equipment” is not an accessory to the building and does not serve a function of the building itself.
Matching of actual operations with key documents:
- billing documents (progress and retention) and
- change orders
It is important to note that the contract is the primary document for determining tax. However, if a contract is only verbal, billing and change order documents should be considered as determinative as the contract. If accounting operations do not properly match these key documents, that is a “red flag” that sales taxes may not have been correctly computed and paid.
Is the contractor on a tax-paid or nontax-paid basis?
The auditor is looking to verify that the contractors are actually responsible only for tax on the purchase cost and that all purchases are properly tax paid or reported. The company’s accounting records for costs of operation must reflect correctly the contractor’s actual responsibility for:
- costs only
- costs of installed materials and selling price of over-the-counter sales or
- the cost of materials and billed price for fixtures
If they do not match up, this is another “red flag” for the auditor.
Auditors must determine that the applicable sales tax is the liability of the contractor/purchaser as opposed to the liability of the seller. Therefore, the auditor must obtain a copy of the resale certificate for each such purchase made from the seller for which the contractor is the consumer. If the contractor’s records of such certificates are incomplete or sloppy, that is another “red flag,” and the auditor may contact the seller directly to request copies of the certificates.
Expense and supply items included in costs
If the contractor is not properly charging tax-paid supply and expense items to expense accounts, rather than being included in material purchases, that is a “red flag” to the auditor to dig deeper.
Fixed assets and expense items
According to the California audit manual, a key item to watch for here is the accounting method for transactions involving withdrawals of materials from inventory for own use. Such misuse is another “red flag.”
Interstate and foreign commerce transactions after Wayfair
Auditors will be focused more on nexus than ever before. Why? The Supreme Court, in its decision in Wayfair v South Dakota expanded the reach of states across the country to impose sales and use tax obligations on retail, as well as other businesses up and down the supply chain throughout the country (so-called economic nexus). [Wayfair-related blogs]. These new, often complex requirements demand many more resources and include the obligation to register, to keep records, to track rapidly changing rates and rules, and to collect and remit sales and use taxes.
If contractors cannot show that they have incorporated Wayfair-related changes into their sales and use tax transaction processing, this is another “red flag” that the sales tax on invoices may not be correct.
Every state must also be reviewed for special requirements that auditors may focus on. To the extent that such special requirements are not being met by the contractor, this is a “red flag” that deserves closer review by the auditor.
Examples in California
- Prefabricated cabinets
- Prefabricated buildings
- Factor-built housing
Examples in Texas
- Real Property Services
- Janitorial Services
- Care and Maintenance of Lawns
- Garbage Removal
- Structural Pest Control
- Real Property Service v. maintenance
Day of Reckoning: Auditor’s Written Proposal of Adjustments
During the course of the audit, the auditor should have discussed all major audit issues with the taxpayer as they arose. The audit recommendations therefore should come as no surprise to the taxpayer and should state whether or not the taxpayer agrees or disagrees with the audit findings. The taxpayer then has to decide which issues it will concede and which ones it will challenge, using all of the appeal procedures applicable in each state. Knowing when to “hold” and when to “fold” is a combination of principled and practical considerations. Although there is no “right answer” for all situations, fair and reasonable conduct throughout the audit on both sides of the table is an important factor in making that decision.
Whatever the decision on a particular audit, the company should conduct a post-audit review as soon as possible to review the audit adjustment just made with the objective of making changes to its sales and use tax processes to prevent future audit adjustments of a similar nature. It is almost impossible to overstate the importance of having access to experienced tax professionals who can guide you through this review process and provide sound compliance advice backed up and supported by best-in-class technology tools. This advice and tools can help to avoid all of the “red flags” identified:
- before the audit in order to reduce the chances of an audit in the first place,
- during the audit in order to achieve as favorable an outcome of any future audits as possible, and
- after the audit in order to put in place the fixes needed to reduce the chances of an audit in the future.