Reverse sales tax audits

It's your money -- get it back!

by Muthu Periakaruppan, CPA, principal, CliftonLarsonAllen LLP | May 2017 Footnote

As companies work to identify opportunities to increase cash flow, a reverse sales tax audit (reverse audit) can help by recovering overpaid sales tax. All states, including Minnesota, audit taxpayers to identify underpayments of sales/use tax. While a state audit tries to identify any underpayments of sales/use tax, a reverse audit does the opposite.

Causes of overpayments of sales tax

Typically, vendors should collect sales taxes on taxable sales they make to their purchasers when the vendors are registered in the state where the item was purchased. If the vendor doesn't collect the tax, the purchaser must accrue and remit the corresponding use tax. Most states impose sales tax on the sale of tangible personal property and certain services. Only Alaska, Delaware, Montana, New Hampshire and Oregon do not impose any sales tax.

For all other states, sales of tangible personal property are subject to sales tax unless the item qualifies for an exemption. In Minnesota, the most well-known exemptions are for clothing and groceries. However, Minn. Stat. § 297A.68 also provides several exemptions that apply to business purchases.

Sales tax exemptions for business purchases

Most states provide an exemption for purchases related to manufacturing. Minnesota provides the "capital equipment" exemption (Minn. Stat. § 297A.68.Subd.5), which applies to purchases of equipment and replacement parts used in the integrated production process to manufacture a product that's ultimately sold at retail. This exemption also covers purchases used in research and development, and in testing and quality control, even though these processes may be located outside the production line.

Prior to July 1, 2015, Minnesota sales/use tax was required to be paid upfront on capital equipment purchases before a full claim for refund could be filed. This exemption recently became an upfront exemption; however, items used and consumed in production were always exempt upfront as part of the "industrial production" exemption. The industrial production exemption includes purchases of chemicals, lubricants, packaging materials and tools that touch the product and have a useful life of fewer than 12 months, such as blades and drill bits.

The capital equipment exemption does not necessarily only apply to a manufacturing plant or factory; it may also apply to the development of a canned software product, or to a lab that tests products produced by other manufacturers. For example, equipment used by a contractor to crush gravel may be exempt if more than 50 percent of the gravel is sold to retail customers and not used by the contractor to perform contracts to improve real property, i.e., laying roads.

While purchases of clothing and groceries are statutorily exempt in Minnesota and don't require an exemption certificate, purchases of capital equipment are subject to tax unless the purchaser provides a valid exemption certificate (Form ST-3 in Minnesota). Thus, sales tax could be paid on a purchase that could have been exempt if the exemption certificate had been provided.

Reverse audits can also be performed to identify overpayments for nonmanufacturers. In Minnesota, examples of applicable exemptions include purchases of certain types of computer software, materials used in providing certain taxable services, medical supplies purchased by a licensed health care facility and advertising materials sent out of state. If a business incurs significant spend in these areas, a reverse audit may make sense.

Overpayments of sales/use tax may also occur when a vendor mistakenly collects tax on statutorily exempt items, or when an available exemption certificate was not provided by the purchaser.

Many businesses use software to accrue use tax on taxable purchases. The software may rely on programmed logic using commodity codes to make the taxing decision, or the accounts payable processor may be responsible for making the taxing decision. When dealing with large transaction volumes, errors may result in over accruals of use tax, and a reverse audit can identify and recover these amounts, too.

The process for a reverse sales tax audit

Phase one

The first phase is a feasibility study to identify and estimate the potential sales/use tax refund opportunities. Depending on the size of the company, this usually requires up to two days of review. The documentation reviewed during this phase is typically a fixed asset listing, chart of accounts, accounts payable detail for selected accounts for a sample period and access to the invoices and, if available, an electronic download of all accounts payable activity and invoices. This phase may only cover a certain time period, where the results are projected over all periods within the statute of limitations to estimate the potential refund. In Minnesota, the refund limitations period ends three and a half years from the date the tax was paid. Based on the results of the feasibility phase, a decision will be made regarding what steps will be taken in phase two, the validation phase.  

Phase two

If tax exposure has been identified, phase two will consist of identifying the reason for the underpayment of tax and determining potential steps to mitigate the past exposure. Once a plan is developed, the company would most likely move on to phase three, the implementation phase where the company implements new processes and training to limit future exposure.

If an overpayment is identified in the feasibility phase, the primary focus of the validation phase is to compile the documentation required to prepare and submit the claim for refund. This often involves meeting with the company personnel most familiar with the items purchased, i.e., plant supervisors or buyers, to help provide descriptions for the items being claimed. Summary explanations may also be required if the reason for the exemption would not be obvious to the state's claim reviewer. In the final step of phase two, the entire refund claim package is presented to the company for review and approval.

Phase three

Once submitted to the state, the state representative may have questions and request copies of invoices. Thus, phase three includes responding to the state's requests and working to ensure the refund is issued and received by the company. Similar to the final step when mitigating an exposure, it is important to provide training to company personnel and make sure a process is in place to capture the exemptions that resulted in the refunds prospectively.

The best time to perform a reverse audit is when a business is undergoing a sales/use tax audit by the state. However, because sales/use tax refund claims are common, filing a refund claim does not automatically trigger a state audit.
It should be noted that a reverse audit can be performed in any state that imposes sales and use tax, following a process similar to the one described above for Minnesota.

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