Avoiding Audit Risk and Improving the Bottom Line
The post-Wayfair aftermath of economic nexus has greatly expanded the reach of states to impose sales and use tax obligations on all businesses whose “economic activity” exceeds certain minimum thresholds of sales, revenue and/or number of transactions. This means that state tax authorities, hungry for new sources of revenue, are sending out field agents more aggressive than ever before in finding not only current year tax, but prior year tax as well.
However, it’s not only about avoiding audit, serious though that may be. A post-Wayfair review can increase productivity by uncovering instances of overpayments of sales and use tax. For example, a good place to start to look for such overpayments is the sales and use tax component of your accounts payable, receivables and capital equipment accounts. In addition, a review can uncover missed opportunities to reduce other costs, increase processing efficiencies and improve cash flows. These in turn improve the bottom line of the company.
Emerging Wayfair-related issues impacting construction companies
Construction companies are facing increased risk of sales and use tax noncompliance because of the generational nexus changes brought about by the Wayfair court’s “blessing” of economic presence. Some of the emerging Wayfair-related issues requiring immediate attention by construction companies include:
- In what states does the business now have economic nexus sales and use tax obligations?
- What are the “start collection” dates under economic nexus in each of these states?
- How does economic nexus affect local jurisdiction collections?
- What constitutes a “sale”, “revenue” and “transaction” under the minimum threshold economic nexus? Of particular interest to construction companies are nontaxable or exempt sales included for this test?
- Do increases in registration in these “new” states lead to increases in risk of prior-year audits?
- What are the new rules for managing exemption certificate in these states?
Construction process itself leads to complex sales and use tax rules.
Construction companies face even more challenges than most businesses in applying sales and use tax rules in the post-Wayfair world. There are at least three basic reasons for this increased complexity:
- The construction process itself is complex with many twists and turns and moving parts
- Each of these moving parts is subject to different sales and use tax rules and
- The rules for each of these parts must be tracked separately in more and more states, as well as the local jurisdictions of these states
Construction process is complex
Sales and use tax compliance and planning is particularly challenging for construction companies. This is so because the construction process itself has many moving parts—from bids, cost estimates and contracts to materials purchasing, subcontractors, inspections, progress billings (cash flow), change orders, retention and completion. Different sales and use tax rates and rules may apply not only to each of these moving parts, but to each state in which the business operates. And the rates and rules of these moving parts lead to more complex sales and use rules that differ in each state, as well more recordkeeping to track all of it.
What are some of the key “moving parts” that determine sales and use tax obligations for contractors in each state?
- Is it new construction or Repair/Remodeling/Restoration?
- Is it residential or nonresidential construction?
- What is the contract type—lump sum or separate/cost plus?
- Is the contractor a general contractor or a subcontractor?
- Is it considered a purchase of tangible property, e.g., materials, consumable, equipment/machinery, or a service (labor)?
- Are any materials resold (outside of the projects)?
- Does the contractor maintain a standing inventory of materials?
- Are the customers tax exempt or governmental entities?
What must construction companies do immediately?
Construction companies need to take these two steps to ensure that they will stay compliant and productive with respect to sales and use taxes:
- Understand their nexus profile — where do they have a sales and use tax obligation based on evolving standards? A nexus study would provide this.
- Assess their capability to accurately, consistently and efficiently meet their obligations—sales and use tax competency.
Protection — How much risk are you willing to take? Once the above company competencies are understood and assessed, construction companies must then weigh the risks and rewards, as well as the costs and benefits of implementing a solution that reflects best practices in the face of these challenges:
- Contractors will find themselves with state sales and use tax obligations in new states.
- Contractors will have to deal with separate sets of rates and rules for states, especially in states without administrative infrastructure and rules yet in place
- Contractors will face increased risk of audits for noncompliance
- Contractors in these audits will face even more aggressive tax authorities
- Contractors will find with respect to purchases of materials and equipment that more of their suppliers under the new economic nexus rules will include sales tax on invoices
- Contractors will have to manage exemption certificates in many more states, each with its own requirements
- Contractors may require changes in their accounting systems and staffing to handle sales and use tax in multiple states, with special attention to cash flow, as well accrual adjustments for accounts receivable, accounts payable, and machinery and equipment accounts
Productivity — Improved efficiency, cost reduction and improved cash flows. For example, a business makes a purchase and receives an invoice from a vendor that includes sales tax.
Keep in mind that the burden of proving that a purchase qualifies for exemption from sales tax rests with the purchaser. It is the responsibility of the purchaser to:
- Understand all qualifications before claiming any exemption;
- Provide the appropriate exemption certificates to suppliers; and
- Keep complete and adequate records in case of audit
If time is not taken by the purchaser to properly research that invoice, the invoice might simply be paid without proper attention given to whether the sales tax was computed correctly or even whether the tax should have been charged by the vendor in the first place. Lower sales and use tax rates and exemptions may have been missed. The more invoices that are processed in this way, the greater will be the overpayment of tax and therefore, the more material will be such overpayments to the bottom line. The problem is often exacerbated because the accounts payable folks do not always talk to the sales and use tax folks as regularly as needed.
The Bottom Line — Compliance Readiness
The sales and use tax end game for complex business operations like construction companies has dramatically changed because of major changes in state laws governing nexus, taxability, rates, exemptions, documentation and return compliance. It is no longer “business as usual”; a whole new set of issues must be tracked and answered. Why, especially for construction companies? Not only are there different rules in each of the states in which construction companies may operates, but even within each state, different sales and use tax rules may apply to separate component of its operations. The stakes are high in getting it right because the dollars potentially lost from both the underpaying and overpaying of sales and use tax can change the bottom line in a material way. These companies can no longer afford to postpone a review of their operations with sales and use tax compliance in mind.