It is frustrating to tell a taxpayer that there is no reasonable way to effectively fight a crippling tax deficiency. The truth is that a tax deficiency happens BEFORE an audit. If an auditor identifies a legitimate area of noncompliance, there is very little that can be done to ameliorate the situation. The following are a few examples of bad situations endured by taxpayers.
- DIVERGENT USE
There are companies that buy equipment tax-free because they issue a resale certificate. A resale certificate states that the purchase of an otherwise taxable item is not taxed because the item is being resold. The sale may come in the form of a transfer of ownership or a rental. When purchasing equipment tax-free, a company may not use the equipment to service clients without paying tax on the fair market rental value for the “normal” term of a rental to third parties.
It is not uncommon for companies to buy equipment, issue the resale certificate, use the equipment to service their clients, and not pay tax. When an auditor identifies this situation, the law is crystal-clear. Divergent use has occurred and sales/use tax is due. Taxpayers have tried to argue that tax is not due because there was no “sale” etc. Those arguments have not prevailed.
Unless there is another issue, time and money would be better spent on trying to make a deal with the taxing authority or executing a payment plan rather than spending gobs of money arguing a case that is doomed to fail. Be honest with yourself about what has occurred. If there is an issue of fact or law, pursue it. If not, don’t pretend that there is. The pretense is more expensive than facing reality.
Make sure invoices completely and accurately (1) describe what products or services are being purchased and (2) memorialize the transaction in a manner that dictates the tax treatment planned by the buyer and seller. There is absolutely nothing worse than a taxpayer stating that they provided a nontaxable service and noting that all the invoices clearly name the taxable component of the service with no mention of the nontaxable components. This is problematic for several reasons:
- On its face, the transaction is taxable. The presumption is that the invoice correctly states the product and/or service being purchased in real time. It is hard to convince an auditor that the invoice is incorrect and the correction of the invoice means that the transaction is no longer taxable. The presumption may be overcome in some instances but it may be difficult. Can you imagine if taxpayers could restate invoices during an audit and change transactions from taxable to nontaxable with little corroborating proof?
- Even if the transaction is not taxable and it can be proven, sometimes quantifying the taxable component of a nontaxable transaction results in the taxation of the quantified taxable portion of the transaction.
It is imperative that invoices (and all other documentation) support the tax treatment of the transaction. If an auditor states that a transaction is taxable due to inaccurate information on an invoice, it costs the taxpayer unnecessarily to prove the auditor incorrect. Audit findings are presumed to be correct. Taxpayers typically pay internal staff and third parties when proving audit findings are not accurate. It is a money drain that can be avoided by accurately and consistently documenting transactions.
Take the time to review contract terms, pay applications, invoices and all other documentation of the transaction to ensure proper taxation. It is a good practice to have large dollar items and large volumes of small dollar transactions reviewed. Interim reviews or project reviews are imperative until your accounting team is confident about applicable sales and use tax.
- VAGUE CONTRACT LANGUAGE
Auditors look to contracts to determine the scope of work performed. The contract should draw a clear picture of what is being purchased and payment terms. If contract terms are vague, an auditor has the discretion to look at all circumstances and make a determination based on the evidence presented. If you want the auditor to reach a certain conclusion, document the transaction in such a way that the desired conclusion is the only reasonable one available. It boils down to documentation. Make sure the documentation is clear and brief. If documents are made a part of the contract, ensure all of those documents paint the same picture as the main contract. Documents, such as invoices, pay applications, plans, change orders, etc. can be made part of contracts. If these items are part of the contract, each item will directly impact the tax treatment.
Don’t rely on an auditor to reason that the transaction is not taxable if all documents do not support that conclusion. The auditor may not reach that conclusion. And, again, the taxpayer may have the burden of proving the audit is incorrect. It is an expensive, time-consuming proposition.
- INCOMPLETE TAX KNOWLEDGE
Sometimes tax is due on part of a transaction that is not anticipated by the taxpayer. There are two common errors that taxpayers make that can result in the legitimate levy of tax:
- Taxable purchases. A red flag is the failure to report taxable purchases. When that space is blank you are telling the Comptroller that (1) no purchases were made from out-of-state companies that did not collect Texas sales tax and (2) no purchases were made from unpermitted vendors with a Texas presence. It is getting more and more rare that taxpayers do not buy items via the internet with sellers who are not registered to collect Texas sales tax. There are also instances in which it may be unreasonable to assume that all taxable products or services were purchased from permitted sellers. It is not unusual to see rather large deficiencies attributed to the purchase of cleaning and lawn care services. Both services are taxable in Texas.
- Software modification. It is common for taxpayers to assume that software is taxable but modification services are not taxable. The assumption is based on the perceived absence of software modification in the listing of taxable services. Software modification is taxable if the software is being modified by the party that sold the software. Software modification is not taxable if it is performed by a party that did not sell the software.
- Freight. Freight is taxable if the item being sold or purchased is taxable in Texas. Auditors commonly look at the charges for freight to determine if tax was charged appropriately. The tax on this item can become material over time. Remember, in Texas, sales or use tax is the liability of the purchaser but can be collected from the purchaser or the seller.
- BUSINESS EXPANSION
When deciding to enter another jurisdiction or expand service offerings, it is imperative that a taxpayer understand their “new” tax responsibilities. If a taxpayer doesn’t charge or pay tax based on (1) the rules of a jurisdiction in which the transaction did not occur or (2) the assumption that all services or products offered by the taxpayer are treated the same, there is nothing anyone can do to ameliorate the mistake during the audit. The time to research the matter is before entering the jurisdiction or shortly thereafter, i.e. before the mistake is material and is discovered by the taxing authority.
Each state, and sometimes cities and other jurisdictions within a state, have their own distinct tax rules. It is your responsibility to know and comply with the rules that apply to your transaction in the appropriate jurisdiction. Of course, the analysis is a lot easier if you don’t have nexus, i.e. enough contact in the jurisdiction to trigger tax collection and remittance responsibilities.
- NO CERTIFICATE OF TAX DUE
Taxpayers who buy companies are audited during periods where the acquired company was not part of the current entity. If the purchaser did not have the seller secure a certificate of no tax due, the purchaser is liable for sales or use tax assessed during the audit period, without regard to who owned the entity during the audit period.
Some attorneys build potential sales and use tax deficiencies into escrow. That works if enough money is allocated and the audit is over before the funds revert back to the seller. In other instances, a sale occurs and there is no set aside for sales and use tax deficiencies. It is disheartening to tell a taxpayer that without the paperwork for the audit period, the auditor is entitled to estimate a deficiency. Estimates are typically no favor to the taxpayer. If an estimate is made due to the lack of documentation, the taxpayer is in a very bad position for two reasons. First, it is the responsibility of the taxpayer to retain the documentation necessary to complete an audit. Second, the taxpayer has the mechanism to avoid the situation, i.e. secure a certificate of no tax due.
- CHANGE OF ACCOUNTING STAFF
When accounting staff changes it is not uncommon for the manner in which transactions are documented to change. The advisability of change depends on whether the invoices actually supported the desired tax treatment of transactions before the change. If perfectly good procedures are changed for the sake of change, you could be looking at a nasty tax bill. If invoices dictate that tax was due and tax was not charged, the tax is owed.
A common example occurs when a company sells a service or products that have both taxable and nontaxable components. If the invoice lists all components, tax is charged on the taxable components only. If the invoice charges one lump sum for both taxable and nontaxable components of the transaction, the entire charge is taxable.
Another example is changing invoices to quantify the taxable and nontaxable charges associated with the provision of nontaxable services. If the invoice lists one price for the provision of nontaxable services, no sales tax is charged. If the invoices differentiate taxable and nontaxable charges, tax is due on the taxable portions of the job.
The manner in which transactions are documented matters! The manner in which items are coded, i.e. as expenses or asset capitalizations, matters. The Comptroller has policy whereby the manner in which items are coded can affect taxability. Splitting the transaction in a manner that shows the provision of a taxable service and not mentioning the provision of the nontaxable service is not advisable.
- NO CHANGE TO TAX COMPLIANCE SYSTEM AFTER AN AUDIT DEFICIENCY
As a rule of thumb, if you have an accounting system that works, barring any change to the services or products offered, do not change the invoicing system. It is not uncommon to have a “good” audit result under one accounting regime and have a sizeable tax deficiency due to a change in the accounting system.
If errors are documented as the result of an audit, change the identified area of noncompliance. The taxing authority will probably be back to audit prospective compliance. It is standard practice to scrutinize areas of historic noncompliance. If the error is not corrected, it will be easy to identify. Upon the discovery of a previously discovered error, the taxpayer can expect the levy of the tax, interest, and penalty. It is less likely that penalty will be waived if a taxpayer fails to correct a previously identified error.
While a previous audit may be the catalyst for the correction of tax treatment, the taxpayer is cautioned that an audit is not assurance that all errors were identified. Taxpayers are responsible for compliance with the law even when an audit fails to identify all areas of noncompliance. While there is no guarantee that an audit uncovered all areas of noncompliance, it is imperative that compliance is achieved in areas that were identified.
- UNREALISTIC EXPECTATIONS OF ACCOUNTANTS, CONSULTANTS, LAWYERS AFTER THE AUDIT
When some taxpayers receive notices of audit deficiency, they hire consultants to challenge audit findings. In some instances the use of third party consultants is advantageous because there is a legitimate error in fact, audit methodology, or application of the law. However, there are other instances in which the taxpayer really has no basis on which to mount a challenge. It is the unique responsibility of the taxpayer to define their goals upon receipt of audit findings.
Some taxpayers want to minimize expenses associated with the audit. Other taxpayers want to prevail through the successful challenge of Comptroller policy or the facts determined by the auditor even though the payment of the assessment may represent a lower current investment of time and money than mounting a challenge. Taxpayers must identify their goals, communicate them clearly to service providers, and listen to the feedback given by the professionals engaged. Listen to, understand, and question how your service provider is going to achieve your goals. Ask yourself:
- Do the arguments being advanced on your behalf make sense?
- Have you engaged someone because they told you what you want to hear?
- Do fully understand your probability of success?
- If you were sitting on the other side of the table listening to your case, would you prevail?
- Are you prepared to pursue matter through the administrative process and through the Third District Court, appellate court, and perhaps the Texas Supreme Court?
- Can you afford to pay deficiency and third party advocates as you fight the assessment?
If you weigh all the pros and cons and wish to proceed, the challenge is appropriate. If you do not understand the process, the costs, and potential success, don’t proceed until you do. Advocates are not miracle workers. If there is nothing on which a successful challenge can be mounted, you probably will not prevail. It is a nightmare for all parties when a taxpayer has unrealistic expectations because the taxpayer is usually dissatisfied even if their advocate has performed well.
- FAILURE TO LISTEN, UNDERSTAND YOUR POWER, FOLLOW AN AGREED-UPON PLAN OF ACTION, AND BE FLEXIBLE
Advocates typically share the plan of action for addressing audits. We engage with clients as much as the client allows. As the taxpayer it is your right to ask questions, understand your matter, and be involved in decisions that will directly impact your company and/or your job. Ask how your advocate is going to approach the situation. Understand the basis of any challenge. Ask how your position will be proven.
Every taxpayer has the power to determine the cost of an audit. The taxpayer determines the documentation to be presented during a challenge before the audit. After the audit, the taxpayer determines if they wish to pay the deficiency or challenge audit findings. The taxpayer determines how far in the administrative process the challenge will precede. The best course of action is to determine a course of action with your advocate and stick to the plan. The plan should be fluid and may change. Be aware of how you define “victory” and go for that. Be prepared to compromise. Listen to your advocate, have them present legal precedent and lay out the case for your edification, and communicate with them freely. Listen to your gut. When your instinct (or advocate) tells you that you probably won’t get a better result, really listen.
Sometimes David does slay Goliath. But remember David employed a plan, practiced his craft, and employed his plan against a mightier (but unprepared, overconfident) opponent.