Exemption Certificate Management Documentation
Michael J. Fleming is the founder and president of Sales Tax and More, a full-service consulting and solutions firm with a passion for state tax. He is one of the country's leading authorities on sales tax issues such as consulting and research, registrations, returns, nexus, drop-shipping, eCommerce, and service providers.
Michael is a renowned writer and speaker, and he regularly presents on webinars. He is also the host of the Sales Tax and More Podcast, where he shares his wisdom and learnings with his audience in order to help them navigate the tricky world of taxes.
In this episode…
Mike Fleming and Ellie Moffat delve into the complexities of exemption certificate management (ECM) and the repercussions of missing or invalid documentation on sales tax audits. Mike traces the historical shift in state tax enforcement during the Great Recession, highlighting the increased scrutiny on exemption certificates. They discuss the impact of missing certificates on audit assessments and emphasize the importance of validating certificates for compliance. Offering insights into managing ECM effectively, they stress the significance of collecting, validating, and matching certificates to transactions.
Here’s a glimpse of what you’ll learn:
Understand how the Great Recession changed state tax enforcement
Learn how missing certificates can lead to hefty financial penalties during audits.
Essential steps for validating exemption certificates and ensuring compliance with regulations.
Learn how proper certificate management can minimize audit risks and ensure tax compliance.
Connect with Michael
Episode Transcript - Audio Version
[00:00:00] Intro: Welcome to Sales Tax and More, your go-to resource for all things state tax-related. Now, here's your host, Michael Fleming.
[00:00:20] Mike: Hi, Mike Fleming here. Founder of Sales Tax and More. And today's co-host of the Sales Tax and More podcast, where we talk about everyone's favorite topic, which is, of course, sales tax. And today, we're going to talk about exemption, certificate management, ECM, and missing documentation or invalid documentation, which is a great follow-up to our previous podcast, which we talked about missing documentation in general. We highly recommend that you listen to both of these. But first, before we get started here, let me introduce you to my co-host, Ellie Moffitt.
[00:00:57] Ellie: Hi everyone, and don't look it up, but according to Spotify, according to Apple podcast, sales tax is indeed everyone's favorite topic. Again, don't look that one up. Just trust me, blanket trust. So great to be here for those who don't know. Sales Tax and More. I'll do a quick introduction. We are a full-service consulting and solutions firm. We have a really great team here of experienced tax professionals who are very dedicated to fulfilling your state tax and related needs. So we do a lot of sales tax returns, sales tax registrations, consultations, research, exemption certificate management, audit defense, and, like our name states, more. If you ever have questions about our services or right away you'd like to work with us based off of our stellar jokes here, please reach out. We'd love to hear from you. Okay, so Mike, we say right on our website that the leading cause of large audit assessments can be due to missing or incomplete or invalid exemption certificates. Can you ignore all my cheesy jokes and speak on that?
[00:02:08] Mike: Yeah, I think I have to clarify myself now when I was saying it's everyone's favorite topic, I was being a little bit sarcastic. So sorry if I set us up for a couple of bad jokes there, but yeah, let's, as we're getting into why certificates are such a big issue and why there's such a problem in audits, let's go back a little bit. Let's do a little bit of the history review. Most of sales tax is based on substance over form. In other words, what's really going on here? Look through the way that something is set up and what's actually happening. Historically… exemption certificates were the same way. If an auditor could tell that something was a sale for resale or some other type of exempt sale, then they gave you a whole lot of latitude. And, states didn't even audit a lot of companies that had like wholesalers and distributors who most of their sales were going to be sales for resale. So the state figured, why should we spend our time and our energy here if there's not going to be any money to find? That all started to change, though, back during the Great Recession in 2007, 2008, 2009, 2010, in that area there, the states were really hurting for cash.
[00:03:52] They needed more revenue. They figured that they couldn't raise their rates. So they started looking at some of the laws they have on the books and weren't really enforcing. And exemption certificates came across their radar. And they said we haven't really been enforcing any of this. So, let's just start doing that. And they did, and they caught so many companies unaware because these companies weren't keeping the documentation of these exempt sales the way they should because they were never getting checked up on. And the states made a whole bunch of money. They've raised a whole bunch of money. And, as the economy got better, you would think that states would go back to doing it the way they do everything else as a matter of substance over form. And they didn't; what they did back during the recession is they went to form over substance. In other words, if every I wasn't dotted, if every T wasn't crossed, that was a reason for a certificate to get kicked during an audit. So that's form over substance. And if anything, since that time, it's accelerated. You would think that the states might back off, but once the states start, seeing money very rarely do they back off. So that's one of the reasons we've had a big shift in the way that states look at this.
[00:05:05] Now, the second reason is because most audits are done on a sample basis. So we do a lot of exemption certificate management here. And a lot of times, the owner of a company or somebody is going to try to override one of our recommendations. If we say, don't accept this certificate, oh, it's our best customer. The salesperson's giving em a really hard time. And they think it just has to do with the tax on that one certificate, one invoice if they get caught in an audit, but it's not. Because everything's done on a sample basis, each missing certificate goes into the error percentage. And then that is extrapolated out over the entire population. So, it has an outsized impact. I'll give you an example. I was working on an audit one time, and there was one missing certificate. And if it's just one certificate, sometimes it can be detailed. Just look at that. It can be excluded from the sample, but we had used up all our favors in this audit. We took it from three and a half million down to about 17,000, except for this one certificate, and it was an 8,000 tax on the invoice. And that's bad enough, but when it was extrapolated out over the population, it had over a 270,000 impact. Now, for most invoices, you're not going to have 8,000 worth of tax, but most of the time, you're going to have more than one missing or invalid certificate, so they add up.And they're always going to have, because to the sample, if they're done in a sample basis, they're always going to have an oversized impact on the assessment. Does that make sense, Ellie?
[00:06:48] Ellie: Yeah. Thanks so much, Mike, for covering that. So we talked about what happens when you don't have documentation of your sales during an audit, and we touched base on ECM issues during our first documentation podcast; what have you heard of when people don't have their exemption certificates in order during the audit?
[00:07:11] We've not only heard this we have lots of stories we hear, but also we do a lot of audit defense. So we're seeing this. And if you cannot if you don't have the documentation for an exempt sale, the state is generally not going to recognize it as an exempt sale. Now, most states will let you go back and try to perfect the certificates at that point, either go out and get a certificate some states, like California, will let you contact your customer directly, or have them send what's called an XYZ letter back to the actual auditor. So there are ways. To if you don't have that documentation at the time of the audit for you to go back and get it. However, when you're accepting a certificate, you're accepting it in good faith. In other words, you have, if you have no reason to believe, and we're going to talk about this in a little bit here, but if you have no reason to believe that the certificates shouldn't be accepted, then the state will generally go after the person who issues the certificate, and there it's actually a crime for the improper use of the certificate that the state will go after them. If you accept the certificate in good faith now. If it's not available at the time that the auditor wants to review it, then it's not accepted in good faith. And at this point, an auditor can put on their detective's hat. You never want an auditor with a detective's hat on. They can start digging into this, even if they get you a certificate, and it looks great. They may not have been registered at the time of the transaction. If the certificates on file, they're not going to put on their detective's hat. They're not going to start digging into this. But when you have a missing or invalid or incomplete certificate, that just gives permission for the auditor to put on that detective's hat and really start digging into this. Looking for reasons to exclude it or set it up in the audit as a taxable sale.
[00:09:31] Ellie: So Mike, how does someone manage their certificates? What are they looking for? How do they do this?
[00:09:39] Well, Ellie, the first thing you got to do is ask for it. Someone's got to ask for it. Different companies have different departments doing it in some companies, it's the sales department in some companies. It's the credit department. Sometimes, it's whoever's setting new customers up or the accounting department. So we've seen all sorts of, departments within companies that are asking for the certificates. So that's the first step. Someone's got to be collecting them, but that's not enough. Just because you have something on file doesn't mean the auditor is going to accept it. It has to be validated. And when we talk about validation, it just means checking that certificate for the most common reasons why a certificate would be kicked out by an auditor during an audit. Number one, is the exception valid? That's something that you need to know in order to accept something in good faith. Someone's telling you, hey, we're, an agricultural exemption, and I'm buying we're going to use an agriculture exemption, and I'm buying a piece of heavy earth moving equipment. You have to know if a piece of heavy earth-moving equipment can be purchased with an agricultural exemption. So that's the first thing is the exemption actually valid. And we talked about good faith earlier. So, let's expand on that a little bit for something to be accepted in good faith. It's got to be on the correct form. It's got to be completely filled out. It's got to be signed. It's got to be dated, and here's a good one.
[00:11:17] It's got to make common sense. For example, if you're selling to a company and they give you a certificate, and let's say that you're selling desks and this company gives you a certificate, they're buying one desk and they're saying that their line of business. Is computer software development. Now, common sense comes in here. Does it make sense that someone's buying one desk for resale when they're in the business of developing software? And the answer to that is no. So that's a reason why an auditor can kick that. It just doesn't make common sense. And you, at the very least, have to question your customer and why are you buying one desk? Is this not going to be used in your business? It's not going to be resold. So you have to at least question them. And in most instances, you're going to actually have to charge them a tax. There is no God-given right to an exemption. Most of the time, the seller is going to be on the hook for this. So they have to make a determination on whether or not they're going to accept the certificate. And if it doesn't make sense, they're going to be on the hook. And oh, by the way, we talked about the improper use of a certificate and how it can be a criminal offense. Sometimes, if you're coaching your customer on how to fill things out and they're not eligible for these actual certificates, that cuts both ways.
[00:12:55] A big case out of New York, Sotheby's the big auction house, they were coaching art buyers on how not to pay tax. And it was like a 30 million dollar fine. So can be big money that's involved here. Now, again, not everyone's going to have something that large, but I think that you get the point I'm trying to make here. We don't want to be coaching people on how to fill out forms or what exemptions they are eligible for. They need to come to you. They need to be able to tell you what exemption they are eligible for. Then, you have to make sure that it is actually a valid exemption. And that all of the things we talked about here, correct form, completely filled out, signed, dated, makes common sense. Those are all of the things that will make up whether or not you accepted this in good faith. And that good faith acceptance is so important because You want the state going after the issuer of the certificate, not after you.
[00:14:08] One more thing: this has just become a major issue with a couple of our clients. The name on the certificate should generally there's always an exception to every rule, but the name on the certificate should generally match the name on the invoice, the contract, or whatever you have here. Too many times, we see companies or a family of companies trying to use one certificate when perhaps they should all be having their own certificates. We even saw one company. The franchisor they were using the exemption certificate for them. These are two separate companies. The franchisee should not be using the franchisor's certificate, even if they have similar names. So you want to make sure that not only are you collecting these certificates, but the certificate is going to survive the audit. And we call that validation. Simple things are the reasons why certificates get kicked during an audit. So if you're doing this yourself, just make sure that someone there is. Looking at the certificates and going over those things that we talked about. If this is a big deal and you're collecting a lot of certificates, maybe you want to outsource it. As I mentioned earlier, we do a lot of exemption certificate management. If you want to talk about this in more detail, please give us a call, and we'll be happy to go over what you, for your specific business, should actually be looking at.
[00:15:43] Ellie: Yeah, and you know what? Our exemption team is phenomenal. They do a great job. Not only will they make sure it's the correct form, but I've heard you say that we've seen some wild stuff, birth certificates, all kinds of certificates that are definitely not correct. Yeah. The correct form, like you mentioned.
[00:16:00] Mike: So I may have been being a little bit sarcastic there. I've said that if it's got the word certificate in it, we've seen it. I was fibbing a little bit there, but it's amazing what we do see: letters from the IRS will not work in most instances, and sales tax permits will not work in most instances. A letter from Horshack's mother will not work in most instances. So it's, I'm dating myself there, huh? Welcome back, Cotter. It's something that You know, someone's got to be paying attention to because it's, it is the number one reason for large assessments in companies that have a responsibility to collect certificates.
[00:16:44] Ellie: Yes. Thank you so much for this great information, Mike. And just to reiterate to everyone, if you do have sales tax needs, if you need help with your exemption certificate management, we offer many solutions and services here. And you can reach out to me directly at emoffat@salestaxandmore.com. You can also visit our website directly, salestaxandmore.com. In addition to our services, we have an entire series of free webinars that provide CPE credit. We have paid resources on our websites. We have free policy updates, free state tax charts, and agency. A lot to offer for general education as well. So, thank you so much for joining us today. And thank you, Mike.
[00:17:34] Mike: Thank you everyone. We hope to see you on the next episode of the Sales Tax and More podcast. Bye bye.
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