The Audit Process
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 sit down with Sabrina Hidalgo, STM’s Head of Audits and VDA department.
Here’s a glimpse of what you’ll learn:
What are some of the reasons why someone would be audited?
Are there discovery units for companies that are already registered?
Why did some tremendous refunds result in audits for businesses who received them? Is there a lack of documentation when it comes to companies supporting their refunds?
Are auditors generally wanting to see source documents as well as internal documentation When a company is looking at internal controls what are they actually look at or for?
Use Tax Horror Stories
How lack of exemption certificates or invalid certificates would play a role in what an auditor would be look at.
Connect with Michael
Episode Transcript - Audio Version
[00:00:00] Welcome to Sales Tax and More, your go to resource for all things state tax related. Now, here is your host, Michael Fleming.
Mike Fleming: Hello, everyone. Mike Fleming here, founder of Sales Tax More and today's co host of the Sales Tax More Podcast, where we talk about everybody's favorite topic, which is of course, sales tax. And today we're going to talk about sales tax audits. And we've got the, the head of our audit and VDA department with us, Sabrina Hidalgo.
Sabrina is a former Mississippi state auditor and she's always, always got some great insights whenever I talk to her. So with audit activity increasing, and we're [00:01:00] seeing more and more audits at this time, I figured now was a great time to speak with her. So that's what this episode is going to be about.
I think it's going to be a really good one, but before we get started, let me introduce you to my cohost, Ellie Moffat.
Ellie Moffat: Hey, everyone. Great to be here. And I'm also excited for this episode and to speak to Sabrina. Mike has some really great questions for her. I know she has some great, great, hopefully she has some great responses in there too.
I guess well time will tell. But I'm going to do a quick introduction for Sales Tax and More. So we are a full service consulting and solutions firm. We have a really great team here of experienced tax professionals, including Sabrina, 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, audit defense, exemption certificate management, and like our name states more. So, with that, Mike, I'm going to turn it over to you, and let's get started.
Mike Fleming: [00:02:00] Okay, well thanks very much. You know, I mentioned we're seeing audits increase, and one of the reasons why is when states see a decrease in revenue, and there's a number of reasons why states are seeing this.
I mean, inflation, cutting in, to people's discretionary spending, people spending less, means less sales tax, companies make less money, there's less income tax. So the states have to make up for this revenue loss, and one of the ways they do it is by increasing compliance efforts. So, Sabrina, you know, with that as our backdrop, what are some of the reasons why someone would be audited?
Sabrina Hidalgo: Yeah, of course. So a lot of people, they are audited through discovery units, which the state has set aside just to send out letters to find out more about their business, figure out things they're doing, if they should be paying sales tax. They go through a list [00:03:00] if, if they should be paying more or less based on your company's normal, business activities.
There's also refund claims that they will audit you based off of because obviously the states doesn't like giving back money that you've already paid them. There's internal databases that they can sort and filter if, for instance, there was a new change in law or something that they've seen an error in the past with past businesses.
They can go through and sort that particular business activity and pull those and then randomly pick you. My favorite part of being picked is from having an internal list from a previous audit. So, at one point I was doing an audit and you have to go through different receipts from other businesses that you have contacts with.
And I pulled an audit just [00:04:00] by a receipt. So you go on an internal list that nobody knows of. It's just luck of the draw and they can pick you from a simple receipt of doing business with another business that's being audited. Those are my favorite.
Mike Fleming: Yeah. And that's one of the things we talk about quite often, Sabrina, is that when an auditor is looking at your records, they're not just looking at, you know, your sales, making sure that you have collected the right amount of tax and you've remitted all of the tax that you've collected.
They're also looking at your purchases to see if you've paid tax and who should have been collecting that tax. So I, I think that's what you're, you're talking about there. Finding companies through the auditor of another company. So that's, thank you for sharing that. That just proves what, what, what we've been saying for many, many years now.
Now you mentioned discovery units, and discovery units, you know, often lead to audits, but [00:05:00] that's for companies that generally are not registered. And that's the way that I see it. Am I correct there? Or are there discovery units, for the companies that are already registered also?
Sabrina Hidalgo: The discovery units are majorly for the people who are not already registered because they're trying to discover if you should be registered or not. I guess more on the internal database they have that they have, that they pull directly from, but those discovery units, they will also send a list to our audit managers. And then the audit managers will send us a list out and say, Hey, you need to go do this. Another way we, we were, tested on was if you see a business out with a truck that has their name on the side of their truck plumbing services, you should write the name of the company down, bring it back to your desk and Google to see if they.
What [00:06:00] they do first of all, which if it says plumbing, you know what they're doing, if the services are, should be taxable, then you go into the system to see if they're registered and that's how you discover them. So we've been trained to actually just take simple truck riding down the street. If you pass a business and you think that they're not registered, write it down and bring it back to the office and they can find them so many different ways.
Mike Fleming: So personal observation and experience, you know, auditors are people too. I, I always knew that auditors did this. I didn't realize that it was actually being trained into them. I just figured it was something that they picked up on their own. So, interesting to, to, to know that. Now you mentioned refund claims.
We have some clients, who had some tremendous refunds and I know that this actually did result in some, some audits. You want to explain, [00:07:00] about that a little bit more?
Sabrina Hidalgo: Yeah, of course. So the refund claims, obviously, states like to receive money. They don't like to give money back too often.
So If you have paid them money and you request a refund to get that money back now, they're like, okay well, why did you pay this to us in the first place? And why are you requesting it back? So now they're going to go through your books to try to find any in every way to not give this money back to you, so even if for whatever reason your refund claim is valid. They're going to find another instance in your books to make that money go towards what you should have paid somewhere else.
So just for that refund claim, you may or may not be in, even though you're entitled to it, they're going to open an audit and say, okay, well now you owe that money. And we're [00:08:00] going to put it towards this part of your business that you should have been paying on already. So they just, they're not I'm not going to say they're not going to give it to you, but they're going to make it hard to get that refund.
Mike Fleming: Yeah. And we're not talking about, you know, small refunds or, you know, run of the mill refunds. We're generally talking about large refunds, you know, Not always worth, you know, states are busy. It's not always worth their time and effort and energy to go after, you know, $100 refunds. We're talking, you know, thousands and thousands or tens of thousands or millions of dollars worth of refunds.
The larger the refund, the more likely the state is going to going to come after you. So, the problems that companies run into, I would assume, in my experience, it's been documentation, documentation, documentation. Companies are just not keeping or not getting or not providing, enough documentation [00:09:00] to support, their refunds. Is
this, what you see out there with us and as, when you were on the other side, when you were on the side of darkness, before we turned you to the side of goodness and light, were you experiencing that there also? Was it a lack of documentation or?
Sabrina Hidalgo: Yeah. There's, I feel like a lot of companies don't realize, like just because you say, this is how it should be done.
It's not how states do it. There's, it's a little more delicate. There's more work behind it. The auditors try to do a good job of making it make sense, but you also have to provide a reason and the documentation supporting documentation and correct supporting documentation to support those claims.
Even if it's true and accurate, you still have to have documentation
Mike Fleming: And sometimes it's not enough to have any old documentation. A lot of times, some [00:10:00] people will try to provide us internal documentation. A lot of times the states or jurisdictions, they want to see the source documents, you know, what everything stems from, you know, what the customer is seeing.
You know, details of the transaction as reported by perhaps credit card receipts or the actual invoices, not journal entries, you know, is, is that generally the case? Or it could be important to journal entries could explain the source documents. But in my experience, we're, the states are still want to see those source documents.
Sabrina Hidalgo: And that's correct. So, like I said, sometimes what you think is enough supporting documentation, it's not exactly the what the state would call the correct supporting documentation. So like the documentation, like you stated needs to be a source document. A journal [00:11:00] entry is just too broad. Like that something that you just put in there.
And even though it's correct and very well, it probably is correct. You still have to have that documentation. So if you're doing a refund claim back three years ago, you would need that supporting documentation from three years ago and not just your word if it's correct and the reason.
Mike Fleming: Great , good to know that.
Thank you for that information. Now, I want to move on here. I want to talk about some parts of the audit process and, maybe we'll have you back and really go through the process from start to finish. But right now, I want to, you know, cherry pick some different parts. Some of the parts that have been, giving us problems, lately, when we're defending our clients in audits, like internal controls.
Can you talk about, you know, that I know that Canada is real big on it. We've got an issue with Canada right now. But when a company's looking at internal [00:12:00] controls, what are they actually looking at or for?
Sabrina Hidalgo: Yeah. So they're looking and testing to make sure that you're doing what you're supposed to be doing.
That there's steps to it and not one person doing every single thing. You know, that could go back to someone either stealing or not doing it the correct way. So they really like to have a proxy, a process of how everything's done, who's touching it, who's doing what. So they can really test if those internal controls and how things are being placed inside the books are being done correctly.
When they test those internal controls, they do request a lot of information, a lot of information, and sometimes this takes the client, you know, they gasp a little bit and they're like well they don't need that to know how much sales tax we're collecting but the thing is is that when you start a beginning at the beginning of an audit, they need to test those internal [00:13:00] controls so that they can go to the next step. If you they don't have an accurate picture of if your internal controls are being done correctly, then how can they trust that you're doing your sales tax returns correctly?
Mike Fleming: And that's, that's an important point. I mean, if, I've seen audits where the auditor said there's a lack of internal controls here and the audits usually go downhill from there. You know, it's, it's hard to defend someone when the auditor believes, they're not doing things the way that things should be getting done, that there's not a system of checks and balances that, you can't just take the company at its word.
So, internal controls, in my opinion, is you know, not all auditors do it, unless some states, you know, if it's a regular run of the mill audit, don't make it a big issue, but, you know, we talked about refund claims earlier, and, you know, exemption certificates, another area, there are certain types of [00:14:00] audits and certain auditors that this is gonna be real big sticking issues, so, you we've got to make sure that, each company that we're working with does have internal controls and is, does keep the correct documentation and follow their own process.
So it's important that in order to be able to follow along.
Sabrina Hidalgo: Yeah, exactly. The important thing is that you can make the auditor follow your books, in a line and not say something like, well, we don't have that, or we can't get that, or well, that's not how we do it so you can't have that documentation. Those are not very good lines to be saying to an auditor. You need to figure out a way to do it or a work around because there's always a way to get something or there's an option to do it another way to make the auditor [00:15:00] understand how your books are ran and that it's being done correctly
Mike Fleming: Absolutely, and we we always say here you need to have a good working relationship with the auditor because the auditors believe it or not, they have a lot of power in in the audit, they can push for things to be waived.
They can work with you. They, you know, if there's a gray area, you give on something, they'll give on something. I mean, it's got to be a good working relationship as you're going through this audit. And if the auditor believes, you know, that you've got these good internal controls that you're doing in things, doing things correctly, the auditor is going to be in a more favorable position to, to work with you than if you start off butting heads and they believe that you, you don't have these good internal controls.
All right. So, we always hear these stories, you know, someone was in Michigan and they, they wanted to run the auditor off. So they put them [00:16:00] in January in a block house storeroom with no heat. And they were there for 10 minutes. And I always say that that's absolutely all auditors are human.
And if you make their life miserable, they're going to get the last laugh. Do you have any stories like that? What, what have people tried to do to you?
Sabrina Hidalgo: Yeah, definitely. They, they always. I have had that happen. They tried to put me in, it was a back warehouse in the right outside of the cooler. It obviously didn't have any heating.
So, and it was in wintertime. I remember being so cold and shivering. They did offer me a, a small space heater for my feet. It was still so cold in there though. I've also had people say they have no electronic records and bring me in boxes and boxes and boxes. Five, six boxes of like [00:17:00] huge boxes for me to go through.
And obviously I have to type all this in piece by piece into a spreadsheet to be able to really go through it. And yes, we do have the last laugh. I like how you worried worded that because if you make my life harder, I'm probably gonna look harder for ways to make you pay more instead of just letting it slide.
Mike Fleming: Yeah, absolutely. Now, Mississippi, not quite as, cold as Michigan, but, everyone has different tolerances. So, I've heard the exact opposite too. I've heard, you know, someone in Austin and they put them out in a trailer with no air conditioning in the middle of August. And it's 110 degrees.
So, if you, if you make an auditor's life miserable, they're, they're kind of find a way to make your life miserable. It doesn't end there. And just because you chase them out, a lot of times the auditor may be there for 10 minutes. They're going to go [00:18:00] back. And when they get back to their office, they're still going to be working on your audit.
And they're going to be less inclined to work with you now and pretty much make you prove that you've done everything correctly, rather than give you the benefit of the doubt sometimes, along the way so yeah, thanks. Thanks for sharing that. I always like hearing these horror stories. All right, let's let's talk about another topic.
Use tax. You know, I always, tell a story about the auditor who told me, that, this woman was buying, short paying the toilet paper invoices. Because she was a manufacturer and he joked, he said, Mike, yes, toilet paper is used and consumed, but it's not used and consumed in the manufacturing process.
So imagine having to go back to your boss and telling him, Hey, I thought I was saving the company some money. I sure paid all the taxes on this. Now we got to pay the taxes anyway. That had probably been spent somewhere else. Plus we [00:19:00] got the added insult to penalty and interest all because of toilet paper.
Yeah. You have any stories along those lines or any horror stories when it comes to use tax companies didn't realize they needed to be paying the consumer use tax?
Sabrina Hidalgo: So I think this goes back to another reason of why you would be audited because we were also trained on if you saw a big business opening up and you know, they're getting in new printers, they're getting, especially doctor's offices or dentist offices, because they don't have sales tax, but they do have use tax.
So we would open a whole use tax audit just on the assumption that they've just bought printers and got them shipped in new chairs, new paper, pencils. All of these and we would go through and pinpoint all the use tax that they would owe. And before they were really catching [00:20:00] on what we were doing, we had high amounts of use tax audits and they were training us to go out and do these businesses just solely on use tax.
Another thing is, is that in this audit process, again, like I stated before, they asked for so much information. In audits, one of those things are assets and a lot of people are like well why do they need to have my asset ledger? What does that have to do with me paying sales tax? And they don't understand or don't realize that a use tax audit goes is automatically approved with a sales tax audit.
So as soon as you get a sales tax, they are going to open up a use tax and usually say either there's no use tax or there's going to be a lot of use tax. So they use those documents to say, okay, well you purchased this asset on this date, provide that payable invoice just to see if you've paid the sales tax on it.
Mike Fleming: Yeah, and just because someone [00:21:00] doesn't charge you sales tax doesn't mean it's tax free. I mean, if maybe they didn't have nexus. So they didn't charge you a sales tax, but like, like we said, that's doesn't make it tax free. You're supposed to self assess that, and remit it directly to the state as a consumer use tax.
So, yeah, that's, either the number one or number two biggest area, that we see large assessments coming from. So, use tax, very, very important. You know, and like you said, great tip there. If you're opening up a new office, a new location, they're out looking for you because you're making a whole lot of purchases.
Whenever there's a lot of purchases going on, states are looking, to make sure that you, have paid all the taxes on everything that you're going to use in your business. So just because you're a manufacturer doesn't mean everything you buy is going to, fit the manufacturing exemption.
If you're a doctor, if you're using it in your, [00:22:00] practice, you know, like all of the furniture and everything, that's usually going to all be taxable. So you got to make sure that, if your vendor is not collecting the tax that you're self assessing and remitting that tax directly to the state. Before we, we wrap up here, let's talk about the other big problem area.
And for companies that, have a responsibility to collect exemption certificates, this is one area. And that I, you know, even when companies tell me, Oh, Mike, yeah, we got our hands down on this. And then I'll do some sort of, exposure review. And they're usually 80 percent or more non compliant for what an auditor would be looking at.
So in the audits you defended here, you want to just share some of the, the examples of how, lack of, exemption certificates or, invalid exemption certificates would play a role.
Sabrina Hidalgo: Yeah, so even just recently, there was a client that thought [00:23:00] they had collected all their certificates correctly.
This is before we were involved, and they inputted an exemption certificate into their system as a full time use instead of a one time use. This resulted from their audit going from twenty thousand dollars to over three hundred thousand dollars. This is for one exemption certificate that was input wrongly into their system.
It's heartbreaking, but, you know, it just goes to show that sometimes clients doesn't understand exactly how either a one time use certificate is being applied. Or if there should be something in additional to that certificate. Some states request or require additional documentation in addition to just the exemption certificate or just a one time use certificate.
They also ask for [00:24:00] other documentation to provide that it's valid. The other thing is, is that they should be collecting it on time when at the time of purchase, sometimes we can get auditors to accept that, in an audit, and we can go back and grab those, but it's very, very useful if you collect those at the time of purchase and collect the correct documentation.
That's the key word is the correct documentation to make that a valid exemption.
Mike Fleming: Yeah, and you mentioned there, this one missing certificate took the audit from twenty thousand up to over three hundred thousand. And I've got a number of different examples like that also. But, the reason why is that audits are usually done on a sample basis.
So, you know, you're not just looking at the tax that should have been on the one invoice that should have been collected. You're looking at the error percentage. And, you know, when you extrapolate that [00:25:00] out over the population, what impact does that have? So it's not just the tax for that one invoice.
You got to apply it to the whole sample, which is why missing or invalid certificates have such an oversized impact on large assessments. And that's why it's so important that you're, you're making sure that not only are you collecting a certificate, But someone's validating it. We do a lot of validation in our exemption certificate management, services that we offer here.
And the reason why is it's like we said, it's not just enough to get the certificate. Someone's got to be making sure whether it be you, or whether you hire someone like us to do it, they got to make sure it's going to survive an audit, that an auditor is not going to be kicking it and you're getting, you know, Unfortunately, a $300, 000 audit instead of a $20, 000 audit.
So Sabrina, I, you know, I greatly enjoyed our conversation today. I'd [00:26:00] love to have you back, but, anything else you want to share today?
Sabrina Hidalgo: I think we've touched on a lot of different things. And I think it was a lot of useful information for everyone out there and I hope they've really enjoyed everything that I had to say in instances that I've provided.
Hopefully it gives them insight to go check their books and make sure it's all correct so that if they're audited, they can have everything in line.
Mike Fleming: Yeah. And I'm going to give you a shameless plug on our free webinar. So not too much of a plug there, but our free webinars right now, we're doing a series called the seven pillars of a successful sales tax strategy.
And you know, if you follow these pillars, you're not going to be able to prevent an audit. You can't prevent audits. I mean, a lot of audits are done based upon a lottery. You just chosen randomly. But if you are audited and you're following these seven pillars, the amount of assessments are going to be kept to, to be very minimal or, [00:27:00] no assessment whatsoever.
So, you know, what Sabrina I think was saying here is don't wait till you're audited to see if you have problems. You want to make sure beforehand that all your ducks are in a row and that you have time to fix things before an auditor walks in the door. We could talk to Sabrina, you know, all week long.
I mean, I've had conversations with her that have lasted for hours and hours, but we've got 20, 30 minutes today. So, we, like I said, Sabrina, are you, you want to come back and talk with us another time? We'll get into a little bit more detail.
Sabrina Hidalgo: Yeah, of course. I'd be happy to come back and tell more about my knowledge of being an auditor and all the things that can go wrong.
Mike Fleming: Alright, well we appreciate that. And, we greatly appreciate you joining us today and, we hope to, to see you on the, next episode of the Sales Tax and More Podcast. And Ellie, I'm going to kick it back to you to, to do some wrap up here.
Ellie Moffat: [00:28:00] Yeah, absolutely. And you know, if you're listening to this podcast episode, months later, years later, however amount of time we do have that entire series on a paid portion of our website that you can access.
We also cycle through our live free webinars all the time. They all offer CPE credit. They're all a great resource. And like Mike mentioned, you know, if you, if you watch every episode of the pillars to successful sales tax strategy. It doesn't prevent an audit, just like you said to reemphasize, but it can, it can help you be prepared.
And, you know, we also offer a lot of solutions and services. You can reach out to me directly. If you have questions about them, my email is E Moffat, that's E M O F F A T at sales tax and more. com. You can also go over to our website, sales tax and more. com and reach out to us via contact information there.
That's where you can find all of the resources free and not free on our website. And, thank you so much, [00:29:00] Sabrina. This has been, there's been a lot of really great information here and I really, we are going to have you have you back if I have anything to say about it. And thank you so much.
Mike Fleming: Thank you everyone. Bye bye.