Reverse sales and use tax audits.

The reverse sales and use tax audit is identical in many respects to the sales and use tax audits conducted by state auditors, except the reverse auditor looks for overpayment of tax.

Several factors may cause sales and use tax overpayments. In many states, the field auditors have become very aggressive in assessing taxes, penalties and interest. This environment has caused retailers to be aggressive in charging tax, because of the fear of a state audit deficiency. Often, tax is charged even when the sale would be exempt.

In many cases, suppliers and distributors are aggressive in charging sales tax on every sale, even when the sale may be exempt. Usually, their motivation is to avoid the responsibility for tax, because most state laws will hold the seller responsible for the tax if not paid. Other times, they will inappropriately charge the tax because there is no (or an invalid) exemption claim. Either way, the purchaser may pay tax not due.

Finally, an inadequate sales and use tax compliance system may allow tax to be paid in error. Normally, it is the responsibility of the purchasing function to make a claim for exemption (industrial processing or agricultural production). If this is not done (either through miscommunication or negligence), the supplier will normally charge the tax. A second line of defense is the accounts payable function. If an invoice that includes tax is presented for payment, the accounts payable department should omit the tax if the purchase is exempt. Inadequate compliance in the purchasing and accounts payable areas can cause the overpayment of tax.

Performing a Reverse Audit

The first step in a reverse audit is to perform a complete study of the taxpayer's business activities. It is important to identify what line of business the taxpayer is in and how it is taxed. More important is the determination of which exemptions may apply. In the case of manufacturing or industrial processing, it is important to identify when the exemption starts and ends.

The second step is a complete study and evaluation of the sales and use tax compliance system. The acquisition of property is traced from the purchasing function through the payment and accounting for the acquisition. Particular attention should be paid to the sales tax and use tax compliance function. Reverse auditors look for weaknesses in the system that would allow for the overpayment of tax. Often, a sample review of invoices will be made to identify adherence to company policy.

After completion of the business and compliance system reviews, an audit program is prepared. The audit program will almost always require a review of all capital acquisitions and other large dollar amount purchases made by the taxpayer during the audit period. The audit program will require the review of some other purchase invoices based on the compliance review if the auditor believes there is a high probability for the overpayment of tax.

State-of-the-art computer database analysis software can be used to assist in analyzing purchases to identify those in which tax was paid in error. When combined with statistical sampling, these programs can substantially reduce the time required to complete a reverse audit. The database software (ACL or Monarch) can analyze the accounts payable data files to identify purchases in which an overpayment of tax would most likely occur. The software can also stratify a population of purchase items for review and scientifically select a random sample of invoices for review. The reverse auditor can then review the selected invoices and identify those containing an overpayment of tax. Mean estimation can then be used to scientifically project the tax overpayment to the entire population. The scientific tools give the reverse auditor a method to quantify the precision and reliability of the scientific projection.

When the review is completed, the information is assembled and claims for refunds can be made to the vendors or the state. The auditor must check with each state involved to determine if it will refund overpaid tax directly to the consumer taxpayer or whether it will be refunded only to the retailer taxpayer.

Final Report and Recommendations

After completion of the reverse audit, a written report is given to the taxpayer. The report identifies the audit procedures completed and the findings. To the extent the auditors believe improvements can be made to the system of compliance for sales and use tax, specific recommendations will be made and will become a part of the written report.

FROM EDWARD S. KISSCORNI, CPA, GRAND RAPIDS, MI