Every New York business should be concerned about a potential sales tax audit. The result could be expensive and time consuming, and could also expose the owners of the business to personal financial responsibility. This article will discuss some of the various ways businesses can be selected for audit, and the areas where auditors are likely to focus. Knowing these factors may assist CPAs in limiting audits and liability for their clients.

New York Embraces Technology

Beginning in 2003, the New York State Department of Taxation and Finance (DTF) began to use predictive intelligence to dynamically determine when to process an income tax refund request and when to set it aside for further analysis. The system came to be known as the Case Identification Selection System (CISS). In recent years CISS has been extended to sales and use tax. The use of technology can indicate possible noncompliance in the following ways:

• Sales on corporate tax returns versus sales on sales tax returns. Though the periods reported do not overlap (the sales tax periods are not calendar quarters), looking at a 12, 24 or 36 month comparison should indicate some correlation between sales reported for both taxes.
• Consistent taxable percentages. A business that has a combination of taxable and nontaxable sales would not be expected to have the same ratio of taxable to total sales on each quarterly or monthly return. This could indicate that the books and records are not accurate and an estimate is being used.
• Only credit card sales are being reported. An auditor can quickly determine if cash sales are not being reported by comparing sales tax returns to credit card deposits.
• Information provided by third parties. DTF has access to information provided by banks, insurance companies, franchisers, liquor wholesalers, and utilities. Each of these can be used to determine the business activity of a taxpayer.

DTF has other methods of selecting audit candidates, such as a tip from a disgruntled former employee or customer, or information learned by performing audits of other taxpayers.

Your Client Has Been Selected for a Sales and Use Tax Audit. Now What? 

Generally, a sales and use tax audit entails the auditor looking at three areas: sales tax collected on sales, tax paid on purchases, and tax paid (or not paid) on capital additions. Let’s look at each of these.

Sales Tax Collections:

Most sales tax practitioners would agree that this is the area where there may be the most exposure for the taxpayer. At its most basic level, the auditor will try to determine that sales tax has been collected on all taxable sales, reported on the sales tax return, and remitted to the State. The taxpayer must maintain adequate business records so that the auditor can complete the audit. However, even where the taxpayer has adequate records, costly errors may occur. For instance, the taxpayer may not be collecting sales tax from its customers because they believe the sales are not subject to tax. Or, they make sales to customers who are tax exempt but have not received the proper exemption certificate. Another potential error is where the taxpayer has sales among various New York jurisdictions but is not using the correct sales tax rate or applying the law properly for a particular jurisdiction. For instance, sales of clothing under $110 are not subject to sales tax in New York City, but may be subject to sales tax in neighboring localities.

Once a taxpayer is under audit and it appears there will be an assessment for the undercollection of tax, the taxpayer’s representative needs to determine if the sales are indeed taxable, and, if so, how can the assessment be reduced. Are there sales to exempt customers, and can the proper documentation (exemption forms) be obtained to the auditor’s satisfaction? The customer may hold a direct payment permit allowing the customer to self-assess the tax, so the customer may have already paid the tax. Lastly, the taxpayer can go back to the customer and request the tax that should have originally been billed. That certainly isn’t something that they would want to do, but some larger customers may be understanding of the situation.

Sales and Use Tax on Purchases:

Depending on the type of business, many purchases may be exempt from tax. Most common examples are items purchased for resale (inventory), items exempt because they are used in the production process, or items which qualify for some other exemption. The taxpayer should be prepared to document why these purchases are exempt. 

Use tax describes the tax due when the purchaser does not pay sales tax to the vendor on a taxable sale, but self-assesses the tax and pays it to the State. This can occur when there is a purchase from an out-of-state vendor not required to collect New York sales tax. Auditors will review purchases to determine if tax is due on such purchases. Purchases of certain items, such as for software, can be significant. Even businesses that do not collect sales tax, such as law firms or medical practices, may have use tax liability and not be aware of it.

Sales Tax on Capital Additions:

The auditor will generally review the taxpayer’s purchases of fixed assets for the entire audit period, though if there is a significant amount of transactions, a test period may be selected. Capital improvements are not normally subject to sales tax, so the auditor may want to determine that the improvements meet the qualifications of an exempt capital improvement. For instance, an expensive conference room table may be properly recorded as a fixed asset for accounting purposes and depreciated, but as tangible personal property, would not qualify as an exempt capital improvement. Likewise, leasehold improvements would not qualify if the property had to be returned to its former condition at the end of the lease, as the improvements would not be permanent.

What to Do Before Your Client Is Audited: 

CPAs should be proactive dealing with sales and use tax as far as their clients are concerned. A review of the client’s records should indicate if there are adequate records to perform a sales tax audit, exemption forms are available, use tax has been paid where required, and proper billing practices are in place. If the client has added new products or services or has begun doing business in new jurisdictions since the last audit, a review may be needed. This could also be an opportunity to determine if there have been overpayments and a refund application may be in order. At a minimum, the client will appreciate the CPA looking out for their interests. 

Alfred T. Grillo, CPA, managed the sales and use tax function at Consolidated Edison, Inc. until his retirement in 2017. He remains active in the profession, providing sales and use tax services to accounting professionals and businesses. Mr. Grillo has been an active member of the New York State Society of CPAs and served as chairman of the New York State, Local and Multistate Committee. He has spoken on sales and use tax issues at numerous tax conferences.