25 Stories About Work – The Sales and Use Tax Audit

During a recent conversation I was reminded of our fabulous “25 Stories About Work” series here on the blog and thought I would share one with you. This post is going to be fairly boring to most, although it will be interesting to those who like to hear about what small business owners go through on the daily, and who may also be interested in what happens if you are presented with a sales and use tax audit. The rest is below the fold.

In the Summer of 2018 I received a letter from a state sales and use tax auditor. This letter said that my business was being audited for sales and use tax for a period of four years. For those who aren’t in the know, sales tax is just that – the money that we collect for sales tax and forward to the state government, who keeps their share, and then parcels out to the counties or whatever other agencies, their shares. Use tax is for things we, well, use on site or hand out – such as printing, safety supplies, etc.

I called the listed agent to verify the letter and indeed, I was going to have to go through this process. And it is a process.

The first thing I did was call my accountant, who gave me an exasperated tone on the phone and said to me “hold on, you are in for an interesting ride”. Fortunately, my accounting firm has an audit division and they assigned me to an extremely intelligent guy, who actually was a state sales and use tax auditor in his past life. More on this later.

To begin, the state demanded the following:

1) Sales invoices for the entire four year period – this wasn’t as easy as you may think, as we had gone through a computer software change in the middle of the audit date and I had to hire an outside company to help extract the older invoices from my previous server. I was able to get them, and I sent all quarter million of them to the auditor.
2) Sales tax exemption certificates – more on this in a bit
3) Purchase invoices for the audit period – after a bit of negotiation, and categorization, we were able to whittle this down to a reasonable amount and format
4) Sales/Use tax returns along with supporting schedules for the audit period – this was the accountants job
5) Depreciation and fixed asset schedules for the audit period – accountant work
6) Credit card statements for the audit period – thank god we went with AMEX – these bills (yes, 48 of them) were available online and I sent them to the auditor

After the auditor got all of this information, the hard work began. My work was divided into three major areas:

1) The auditor chose several hundred random cash invoices that didn’t have sales tax on them and I had to prove why they were sent out as non-taxable.
2) The auditor chose several hundred customers that we didn’t charge sales tax to. We had to provide sales tax exemption certificates for all of these.
3) The auditor made up a gigantic spreadsheet, approximately 500 lines long, that had on it credit card purchases and other purchasing invoices. If the invoice had no sales or use tax paid, I had to prove why we didn’t pay them. If tax was paid on the invoice, I could just provide a copy and cross it off the list.

Part one proved to be very easy, after a bit of back and forth. The vast majority of these invoices were for municipalities, government agencies, and the like or we had tax resale certificates on file for them. We scored a 100% in this category.

Part two was harder. We had tax exemption certificates for the vast majority of these customers, but there were a lot of holes. I started calling places and got almost all of them, but there were a few that I just couldn’t get, as the companies either were out of business, or simply wouldn’t return my calls. I had to try as hard as I could in this category because they took a ratio of the certs you were short and applied this across your enterprise. In other words, if you had 96% of the certificates, they would take the missing 4%, and apply that across all of your sales to come up with the tax you owed. We had to repay the state some sales tax in this category, but it wasn’t much.

Part three was the majority of the work. I had to go back in time and get invoices either to prove that we paid sales tax on the transactions, or come up with a reason why we didn’t (i.e. “postage”). The auditor concentrated a lot of the work on printed material, advertising, and Amazon purchases. This was made more difficult as I wasn’t president of the company during the whole audit period and some of the people who were running the place just weren’t available for comment.

So, on the spreadsheet – it was my job to come up with a copy of the invoice and put a comment in there stating a reason why this shouldn’t be taxable. All of this is guilty until proven innocent, by the way. He was assuming that we didn’t pay the use tax and that he was going to collect it – it was my job to show him that either we paid the tax, or didn’t have to.

Around four or five months later, my aunt died. I was sitting in the airport in Akron, Ohio and will never forget the email I got. It was from the accountant. Before I go to this email, a little about the accountant.

As I mentioned, our accountant has an audit department and I was assigned a person who was a state auditor in his previous life. I never spoke with the auditor after I gave our accountant our power of attorney, and this was an excellent move in hindsight. Basically, the accountant was my go-between to the auditor. There were a few times I was furious about the process and it was extremely beneficial that I had a go-between to lean on in certain situations.

Back to the email I received in the airport. I had spent four or five months painstakingly putting together reams of information from two different computer systems, checking everything, and making copies and had a final product to send to the auditor. When I got the email in the airport, it was immediately evident that the auditor had not read my work- he hadn’t even looked at the spreadsheet and all of my proof that I had supplied. He just came up with a “lower number” and asked if we would pay it. I was livid. The answer to that email was a firm NO.

After some strong words to the accountant, the auditor had to look at my work and finally had to cave. I had to supply hard copies of all of the proof and did so.

In the end, we had to pay about two thousand dollars in back sales and use taxes and penalties, and about six thousand dollars to the accountant (remember, this is for a four year audit period). All of our errors were honest – our biggest one was advertising stuff. We used an out of state printer and an out of state vendor for swag and never paid use tax on those materials. As previously mentioned, we were short some tax resale certificates. For a few invoices on the use side, we just couldn’t find anything and had to give up. A deeper dig could have been done, but at a certain level you reach the point of diminishing returns and frankly, I wanted my life back.

This audit was exhausting and exhaustive. The good news is that my accountant told me that the auditing agency usually scores an audit as to if they will bother you again, and it is highly unlikely as my work was extremely detailed and organized. As Bill Murray said in Caddyshack – “so I got that going for me…which is nice”.

14 thoughts on “25 Stories About Work – The Sales and Use Tax Audit”

  1. Sounds like California.

    One time, on a trip to Turkey, I bought a nice “Oriental” rug. It looked Persian but was made in eastern Turkey. It was around $4,000 and it took about a month to be delivered to customs. I went down and paid around $400 import duty and took it home.

    About three years later, I got a use tax bill from California. I tried to use the argument that it was unconstitutional to charge what is in effect import duty by the state. The guy I talked to agreed with me but said they wanted the money anyway. If I wanted to argue, I could hire a tax lawyer. I paid.

    About two months ago I got a tax bill from California for income tax for the year after I moved to Arizona. I bought my Tucson home in December 2016 and moved over the New Year weekend. I filed an Arizona tax return for 2017. My accountant submitted a rebuttal. I have not heard back so far.

  2. Think about how many man-hours are being wasted across the country because of what happened to you also happening to many others, Dan!

    And congratulations, by the way, on having kept such excellent records.

    My own tale of woe began with an e-mailed question from a County auditor, to which I promptly e-mailed back a complete response. I heard no more for several months, and then received a threatening registered letter because I had not replied to the e-mail — scofflaw that I was. It turned out my e-mail response had been trapped in the auditors spam filter. Fortunately, the County auditor was a reasonable man, and could see the humorous side of this situation. He even advised me that I had overpaid State taxes for the matter under review, and explained how to reclaim that overpayment.

    Dealing with tax authorities reminds me of stories of English slave-owners in the Caribbean sugar plantations who would make the slave cut down the switch which the Englishman would use to beat him. We taxpayers pay the auditor’s salary, for Goodness sake!

    Another impact of our overly-complicated tax system is the opportunities you lost while you were painstakingly going through that 500 line spreadsheet — the business inefficiencies you did not have time to correct, the sales prospects you did not have time to pursue.

    Maybe governments should be required to pay business owners for their work as tax collectors? After all, demanding unpaid work makes governments uncomfortably close to slave drivers.

  3. “Another impact of our overly-complicated tax system is the opportunities you lost while you were painstakingly going through that 500 line spreadsheet — the business inefficiencies you did not have time to correct, the sales prospects you did not have time to pursue.” It goes without saying that I wasn’t getting paid for any of this work, and also lost the opportunity costs, this is true. But like you said, happens over and over all day long.

  4. “Another impact of our overly-complicated tax system is the opportunities you lost while you were painstakingly going through that 500 line spreadsheet —

    When I was still in practice, we did not accept Medicaid (MediCal in California) because of the low payment and maxed out bureaucrat factor. When I first started, I was still a bit idealistic but my office staff pointed out that some MediCal procedures (like injecting varicose veins) cost us more than the reimbursement. We lost a few dollars on every case and no, we couldn’t make it up on volume.

    The Trauma Center, however, put us back in the MediCal business for a few high dollar cases. So, I was back to wrestling with the state bureaucracy. One favorite trick was to refuse payment because the bill had “not been submitted within the time limit.” We had submitted the bill in time but they denied it. So, my staff began submitting the bills by registered mail, with a receipt requested to verify delivery date,

    The state simply refused to accept registered mail. And so it goes.

  5. Similar to how speed traps target drivers in middle class neighborhoods going less than 10 mph over the speed limit because they probably won’t protest or contest a ticket, tax revenue departments target small businesses hoping they will just settle to avoid spending even more money fighting it.

  6. Sales and use taxes are presented as simple to collect. And they are, compared to things like VAT and income tax. Any time you have to document a large number of transactions the effort is going to be non-trivial.

    You would think that the tax agency would know who had an exemption. You would probably be wrong if you assumed that the auditor had a way to see it. It also provides a profitable gotcha for the inevitable certificates that would disappear from files.

  7. MCS – “You would think that the tax agency would know who had an exemption.” I asked this exact question – why isn’t there a searchable database of these to assist in audits? Crickets.

    Grurray – your point is well taken. Way easier to hassle the law-abiders than the guy on the side of the road selling bonsai trees or shrimp for cash. Or bust up popular farmers markets, where it is all pretty much cash transactions as well, and I assume mostly under the tax radars.

  8. In 2009, the IRS sent me a notice stating my daughters tuition deduction was not allowed as i made too much money, or is was claimed on somebody else’s taxes as a dependent,… etc etc.
    None of which was true, so i sent them a letter explaining why all the reasons they stated for denying my deduction were simply not true. 4 months later they send me a form letter saying i owned nothing, with no explanation. I am guessing someone was using my ssoc as a deduction.

    Two years later,,,,,

    State of North Carolina sends me a FINAL NOTICE, saying i owe them for the same issue and in 30 days they are taking the money from my checking account. The post office had changed our zip code during this time, so i never got any notifications until the FINAL, which the PO was kind enough to forward. The PO never bothered to forward the earlier notices.

    The feds dont update NC when they make a mistake (they actually told me that) so NC still thought I owed them. So I had to get a formal transcript from the feds, as the letter the FEDS send is not sufficient proof.

    Armed with the additional IRS transcript documentation, I went to the NC
    Dept of Revenue. They looked at it and gave me a statement in writing saying I owed NC nothing.

    With the right forms, clerks will do anything.

  9. tax revenue departments target small businesses hoping they will just settle to avoid spending even more money fighting it.

    Of course. This is why gun control always targets the law abiding. There was a workplace shooting in Illinois a couple of years ago and the shooter was a felon. He bought a gun legally because the state police had not updated the background files.

    That doesn’t even address the illegal sales. The NYC “Stop and Frisk” law was just to detect these illegal guns.

    Not allowed.

  10. why isn’t there a searchable database of these to assist in audits?

    Because no one gives a shit. That’s public-choice economics in six words. Things like searchable databases won’t exist without the right incentives. The default incentives are for the bureaucrats to churn as much revenue out of the taxpayer cash-cows as possible.

  11. At a past employer we underwent three year sales and use tax examinations repeatedly. The State assessed six-figure taxes due plus penalties, mostly for some direct mail advertising costs that were properly exempted under the sales tax code.

    The audit team said this is your assessment, you must appeal if you disagree. First level of appeal was to a Department of Revenue board which never ruled in the taxpayer’s favor, even when assessments were clearly in error, even for obvious arithmetic errors.

    Next level of appeal was to a multi-agency appeal board with rigid procedures, the taxpayer had to be represented by an attorney meeting that Board’s certification standards. The Board included a member from the Attorney General’s office, and all papers submitted to their appeal had to be in a specific format and size, submitted in a narrow time window, and taxpayer’s attorney had to make a live presentation only a few minutes in length. This Board would then adjourn with a decision to be rendered later.

    Soon thereafter the Attorney General’s office would approach the taxpayer’s attorney to suggest a negotiated settlement. That would typically be the taxpayer agreeing to pay all the undisputed claims in the assessment (simple errors and omissions they had located) and a negotiated percentage of the disputed items. Because we pretty clearly had the law on our side on the bulk of the assessment, being the advertising portion, they proposed that we pay only a minor percentage of those charges, as little as three to five percent. If the Board ruled against us on the total, we would incur large expenses appealing to the State courts of jurisdiction, so it was just as easy to accept their lowball offer and end up paying low five figures instead of the original six figures, plus penalties and interest. Without the court appeal, we could get back to work for our customers.

    The only problem with accepting the negotiated settlement was that it established the monetary amount only, and left the legal issues unresolved. They never acknowledged that they had no legal basis for disallowing our direct mail advertising exemptions.

    So three years later the audit teams would be back, slapping a huge and unwarranted assessment for the direct mail advertising costs, and the team would repeat the same aggravating and time consuming process to once again pay only a small fraction of the total assessment. Each cycle they found fewer errors as our processes improved, so the direct mail advertising became the only real target. I’m not sure why they persisted, as after the first audit their pickings got very slim.

  12. Dan D: “I’m not sure why they persisted, as after the first audit their pickings got very slim.”

    Easy question to answer! Of course the bureaucrats persisted, because they are being paid to audit. They have to audit someone. If the bureaucrats reported to their superiors that there was no-one who required to be audited, it would raise the question of whether the auditors should be transferred to the Corrections Department, which is always chronically short of guards.

    I have often wondered about the 5th Amendment guarantee that “nor shall private property be taken for public use, without just compensation”. My time & my work is my property. If that private property of mine is taken by a government for public use (acting as a tax collector for the government), then surely I am entitled to “just compensation” for my lost time?

    And what about the 13th Amendment prohibition of “involuntary servitude” — which seems to describe the hours of unpaid work which go into collecting taxes for governments?

  13. If the bureaucrats reported to their superiors that there was no-one who required to be audited, it would raise the question of whether the auditors should be transferred to the Corrections Department, which is always chronically short of guards.

    In the military, where of course everybody is getting paid by Uncle Sam, this is an old game. The inspector always has to find something or be out of a job. So minor errors are always produced.

    My last medical malpractice lawsuit was just before I retired. A podiatrist came to me because he had painful hemorrhoids. I told him I always required a patient over 50 to have a colonoscopy before hemorrhoid surgery. I wrote a letter to his referring doctor pointing this out and asking if he wanted to arrange it himself. I always scheduled the colonoscopy for the morning of the surgery so there was no need for two bowel preps. The patient told us a week before the surgery that he was going to decline the colonoscopy. I agreed to do a rigid sigmoidoscopy at the time of surgery since he had refused the other. I did not do colonoscopies for a couple of reasons. It was an expensive instrument and required involved cleaning plus I would be competing with my referring doctors.

    Anyway, I scoped him at the time and at about 25 centimeters, the limit of the rigid scope, there were some suspicious looking polyps. After the surgery, I told him he really should have a colonoscopy now because those polyps (even though benign) were suspicious for something above, beyond the scope. He refused again because his bottom was sore. I wrote another letter to his GP about my recommendation.

    A month later I had my back surgery and retired. The young man who took over my practice finally got him scoped 3 or 4 months later and, of course, he had a cancer of the colon. He sued me. I sent copies of the letters to his lawyer and the lawsuit went away. Then he complained to the state Medical Board. He was a medical professional and I had known him casually for 20 years. He just could not accept that this was his own fault. I even found that his son was a gastroenterologist in San Diego. I called him and he agreed with me. Why didn’t the son intercede with his father ?

    Anyway, two officious little Vietnamese doctors showed up and went through all my records. Finally, we all agreed that my discharge instructions (in a printed pamphlet I had used for years) needed to be more complete and they went away.

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