One byproduct of the recent economic downturn is that state and local governments are scrambling to bridge the gap between budgeted and actual collections. One tool of the trade, of course, is the compliance examination, or audit. Audits have long been used to spot check tax compliance, but in years past, we have found these audits to be somewhat rare. Now it seems we are spending more and more time managing state and local compliance audits on behalf of our clients. Several audit trends have emerged:

Multi-Jurisdictional Examinations
Many of the larger urban municipalities and counties conduct their own audits. However, many suburban and rural taxing authorities have contracted with third party agents to conduct these examinations on their behalf. This relationship presents a unique challenge for taxpayers. Business is often conducted with customers across a multitude of jurisdictional boundaries, and the rules governing whether a business has a taxable presence in a particular area is anything but clear. When a business has been selected for examination by a third party auditing firm, the effect is that the business will be audited by every taxing authority that auditing firm has under contract. Even the most well-intentioned taxpayer will find it difficult to escape such a broad examination scope with no additional tax assessed.

Multi-Tax Examinations
Last year one of our clients was selected for examination by the City of Birmingham. The scope of the examination included sales tax, use tax, lease tax, occupational tax, and business license tax. Nearly all of these taxes have a three-year lookback provision; however, the occupational tax has a five-year lookback period. Again, the broad nature of the examination, both in taxes and years covered, makes a zero tax assessment nearly impossible.

Documentation Standards
In a sales and use tax audit, source documents evidencing taxes paid is generally required to avoid an additional tax assessment. Yes, retention of three years of purchase invoices is onerous, especially when much of our purchase activity is conducted with a corporate credit card and/or over the Internet. However, our experience has been that auditors are unwavering in their request for source documents and will generally not accept any other form of documentation as evidence that the appropriate tax was remitted.

We are painting a picture that a successful defense to a revenue examination is next to impossible. While the deck may be stacked against an across the board “win” if your business is selected for examination, there are actions that you can take to maximize your compliance:

Assess the various revenue streams of your business and determine whether you have an obligation to collect and remit sales tax on any sources of revenue. The Alabama sales and use tax administrative rules set forth guidelines that govern various industries and transactions. Don’t wait until you have been selected for examination to find out where your business stands in relation to these rules.

Regarding purchases (especially Internet purchases), be sure you know what sales taxes, if any, have been collected and remitted on your behalf. If your business is located in an incorporated municipality, you generally have three levels of tax (state, county, and city); if your vendor has failed to collect any or all of these taxes, the burden generally falls on you to remit use tax on those purchases. Again, remember that source documentation wins the day, so a well-organized vendor file that goes back three years will serve you well when you receive the dreaded notice of examination!

Keep plugged in with contemporaries in your industry. The third party auditing firms are effective at identifying non-compliance on unique transactions and applying that knowledge across all known businesses in that industry. Learning from the mistakes of other businesses in your industry will allow you to take appropriate compliance action in advance of an audit.

Seek professional representation. Yes, it is probably not a surprise that the accountant suggests that when you receive a notice of examination that you should contact your tax advisor. However, this is an area where it is easy to be penny wise and pound foolish. Included with the notice of examination is a document request list that is quite broad, and many of the requested documents are not applicable to the scope of the audit. A tax advisor representing the business can communicate with the auditor, determine the audit scope, and serve as the content filter. Additionally, we prefer for revenue agents to conduct their audits from our office so as to minimize the intrusion on our clients’ businesses and also so we can closely monitor the progress of the examination. In addition to managing the audit process, your tax advisor can advise you regarding potential remedies beyond the audit and preliminary assessment phases.

At the very least, you should be aware that taxing authorities are more aggressive now than at any time in recent history. Taking measures to assess your compliance before the taxman knocks on your door will help you to achieve the best possible outcome.