Armanino Blog

Reverse Audits Ensure Appropriate Sales & Use Tax Exemptions

by Scott Copeland
September 22, 2011

In an economy where there’s no room for unnecessary expenditures or costly mistakes, many manufacturers are turning to the reverse audit to make sure they haven’t overpaid sales and use taxes.

Why You May be Overpaying
In most states, manufacturers are exempt from sales tax on equipment used in manufacturing or recycling, and many states don’t require them to pay taxes on the utilities and chemicals they use, either. In some states, custom software, computers and peripherals are exempt if they’re used for research and development projects.

With most state sales taxes now between 4% and 7%, it’s worthwhile to be sure you’re receiving all the exemptions to which you’re entitled. And unless you’re diligent about claiming exemptions, you’re probably missing out on some.

Most manufacturers have sales and use tax compliance systems to guard against paying too much, but if you haven’t reviewed yours recently, it may be functioning improperly. Employee turnover, business expansion or downsizing, and simple mistakes all can take their toll on sales and use tax compliance policies, and you may be paying more than you should.

Reverse Audits Can Go Way Back
A reverse audit should include an examination of your tax compliance systems as well as your purchasing records. For example, your accounts payable department may be tasked with spotting exemptions that purchasing hasn’t requested, but are they doing it?

The audit should extend across your business, going back as far as the statute of limitations on state tax reviews. If your state sales tax auditors can review all records for the four years preceding the audit, for example, your reverse audit should encompass the same timeframe.

Timing is Everything
A good time to consider a reverse audit is when state tax laws change. Sales and use tax exemptions typically don’t apply to local taxes, and changes in state regulations may be easy for your staff to overlook at first. If a state in which you do business has revamped its tax laws, use a reverse audit to be sure you’re not missing additional opportunities for tax savings. Your tax advisor can help you stay up to date on tax law changes.

In the current economy, you may not be undertaking any major capital projects, such as adding manufacturing space. But, when you do, it will be an excellent time to conduct a reverse sales and use tax audit. Even if you can’t justify a full, companywide audit because of time or staffing constraints, you can audit transactions associated with the project. During a capital project is when you’ll be buying equipment and supplies that are most likely to qualify for tax exemptions. If you can spot overpayments during the process, you can act to resolve them promptly.

Overpayments Can Happen Anywhere
What types of payments should be reviewed? You may have made sales tax overpayments on components of your manufactured products as well as on the equipment you use to make the products. Other areas where overpayments may occur, depending on state laws, include warehouse equipment, software licenses, safety equipment, maintenance fees and so forth.

When considering whether you may have overpaid taxes in these and other areas, a clear understanding of your operations is key. You must know where your manufacturing process begins and ends, for example, if you want to ensure you’re receiving maximum benefit from industrial processing exemptions.

Also remember that, if you have plants or sales offices in more than one city or state, your sales tax records may be decentralized. Don’t overlook any sites.

Database Software Can Help
Thanks to advances in technology, database software is available to help identify where overpayment is most likely to occur. Select random samples of invoices for review and use the results to project total overpayments.

In some states, such statistical sampling is an accepted method for projecting overpayments. In others, you’ll be required to complete a detailed review of all purchases. So before beginning a reverse audit, it’s important to understand sampling requirements and tax exemptions for every state in which you do business.

Findings Pinpoint Weaknesses
Your external sales tax auditor generally will provide you with a written report when the audit is completed. In addition to helping save you tax dollars right away, the findings can be used to pinpoint weaknesses in your compliance system for future tax savings.

September 22, 2011

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Scott Copeland - Partner-in-Charge, Audit - San Francisco CA | Armanino
Partner-In-Charge of Audit
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