Reverse Sales and Use Tax Audits: Mitigate Risks and Uncover Potential Savings

Companies looking for ways to reduce the risk of tax overpayments and/or identify systemic issues that could prevent future overpayments should consider conducting a reverse sales audit. Sales and Use Tax can be complex. As a result, a Reverse Sales & Use Tax Audit will help businesses to identify overpayments, as well as underpayments, of sales and use tax. 

These audits seek to uncover industry-specific credits and exemptions that may have been overlooked. 

Sales and Use Tax

Sales tax is imposed at the U.S. state and local level and is, generally, imposed on retail sales to end consumers. Sales made to parties other than the end consumer (i.e., resellers) are generally not taxable. Sales tax is generally imposed on sales of tangible personal property, but, depending on the state, may also include certain services. The sale of intangibles and real property are generally not taxable. The consumer, generally, bears the burden of the sales tax, but the tax is collected and remitted by sellers which have nexus (i.e., enough connection) to the state. Sellers may be required to remit tax to the state on a monthly, quarterly, or annual basis. If a seller does not collect tax, the purchaser owes use tax which is complementary to the sales tax.

The use tax is imposed in a situation where no sales tax was collected by the vendor and paid by the purchaser. Use tax is generally imposed on the use (consumption, etc.) of tangible personal property or certain services in the state, where no sales tax was paid. The use tax imposes a tax equal in amount to the sales tax that would have been imposed on the sale of the property or services if the sale had occurred within the state’s taxing jurisdiction. The purchaser, generally, bears the burden of the use tax.

Reverse Sales and Use Tax Audit

A reverse sales and use tax audit is the process of reviewing previous years of purchase data for a company to find purchases that the vendor charged incorrect sales tax, or that the purchaser paid incorrect use tax.  Generally, these erroneous sales or use tax charges are due to a misapplication of the rules by the seller or overlooking of an exemption provided by the state or locality.

The statute of limitations varies from state to state.  For instance, Pennsylvania has a three-year lookback and New Jersey has a four-year lookback period.  If a company has an on-going audit, any period that the taxing authority has open under audit is also open for a reverse sales and use tax audit.

Unlike a traditional audit, which is conducted by tax authorities and aimed at identifying tax underpayments, a reverse audit is a proactive audit conducted to identify instances when a company has inadvertently overpaid on its sale tax obligations and is entitled to a refund. It is not unusual for a reverse audit to uncover significant amounts of overpaid taxes. 

In a reverse audit, part of the process is to uncover overlooked credits, exemptions, or overpayments, so a key to success is working with a highly experienced practitioner that is familiar with the applicable tax laws in jurisdictions where the company operates.

A reverse audit typically applies to sales taxes paid by the business or use taxes remitted, meaning that a reverse audit addresses the tax paid on purchases the company has made, not products or services it has sold. Correction of taxes overcharged to customers is handled a bit differently. In those cases, generally, the overtaxed amount must be returned to the customer before the tax authority will issue a refund.  

Why would a company overpay taxes?

There are many reasons why a company might unknowingly overpay sales or use tax, including: 

• Paying taxes on items that qualify for an exemption
• Being unaware of rule changes in jurisdictions where the company operates
• Not validating the amount of sales tax charged by vendors on items purchased
• Failing to update tax and compliance systems to account for rule changes in applicable authorities
• Overlooking industry-specific credits
• Sourcing rules: oftentimes vendors incorrectly tax based on where they ship to, rather than destination for use.

Reviewing data for overpayments

Reverse audits usually begin by targeting the areas where an overpayment is most likely. One of the most common sources of overpayments is relying too heavily on vendors to determine the proper tax. 

Vendors may overlook rule changes that impact the taxability of the items they supply, so they may be inadvertently applying the incorrect tax.  

A beneficial area of exploration for a reverse audit may be industry-specific credits and exemptions that the company is either unaware of, is not securing, or misapplying.  

For example, many industries have sales and use tax exemptions, including but not limited to manufacturing, transportation, agriculture, digital products, research, and heath care providers—but identifying exemptions frequently requires analysis of facts and circumstances.  

In manufacturing, for example, exemptions for equipment used directly in the in the manufacturing process are common, but you must determine where the manufacturing process begins and ends, so identifying what equipment is eligible for exemption may require some interpretation and a deep analysis of the rules.

Manufacturers and many other types of businesses are also often eligible for resale exemptions which includes items that become a component part of a product sold. 

Claiming a refund for a sales tax reverse audit

The process to be followed, data to be provided, and length of time to be considered depends on the specific tax authority as well as on the size of the credit being requested. If state authorities agree with the company’s refund claim, the authorities may issue the refund in cash or extend a future credit. 

Refunds can be used to offset audit assessments.  In addition to reducing the liability imposed, the offset lowers the amount on which penalties and interest are imposed, resulting in a significantly lower assessment.  In some cases, the refund amount is larger than the audit liability amount resulting in a net refund for the company.

After the audit / Making changes

As a best practice, companies that conduct a successful reverse audit should then take steps to ensure that the correct tax is being applied to all future transactions. 

If the reoccurring purchases from a vendor are deemed to be “exempt” then an exemption certificate can be furnished to the vendor for future transactions. 

Herbein is ready to help

A reverse sales tax audit is an efficient means of uncovering overlooked savings and exposures, as well as the optimization of compliance. 

To explore how a reverse sales tax audit can help your business, please contact Lou Palladino at lapalladino@herbein.com. Our team of professionals is ready to discuss an efficient reverse audit process to address your company’s needs and potential opportunities to uncover benefits and enhance compliance.

Article Contributed by Lou Palladino