2016-Issue 2 – We have been dealing with a lot of aggressive auditors lately — not just aggressive from the standpoint of inflexibility on audit assessments, but aggressive in seeking to dictate the terms of how the audit is going to be managed from their point of view only (or for their convenience). A number of years ago, we wrote an article on managing a state department of revenue auditor and the audit process. We thought a refresher was necessary, given that we are finding that, more often than not, a “fair” auditor or audit may be becoming more the exception versus the rule. This edition of Tax Advisor Weekly focuses on ways a company can manage audit execution without allowing the auditor to manage the company.
Over the past few years, many states have sought to expand audit coverage by hiring additional auditors. Some states have even increased their use of contract auditors (Louisiana, as a recent example) to supplement their audit staff. Historically, most states audit less than 1 percent of all taxpayers in their state, so you can see that adding auditors could potentially increase the number of taxpayers audited, possibly resulting in increased tax revenue for the state.
While all states have some form of auditor training programs to educate the new auditors (or provide continuing education to existing auditors) regarding the state tax laws along with auditing policies and procedures, it seems that states may have lessened their focus on training their auditors in proper taxpayer etiquette. Today’s auditors do not seem to take into account the fact that taxpayers are trying to run a business and have responsibilities outside of gathering documentation and defending unreasonable audit assessments. This problem is compounded by auditors using techniques that are often difficult to defend. For example, we see state auditors take arbitrary tax positions or assess tax on issues supported with minimal documentation on the part of the auditor. In the past, it seemed the auditors would do more research of a company’s business operations and the nature and taxability of a transaction before making an assessment. Is it laziness or merely the result of trying to do more with less?
Our recent experience with some auditors has not been favorable. We have experienced auditors dictating the timing of response on audit requests when they have dragged their feet throughout the audit fieldwork. We have experienced auditors with no knowledge of the operations of the business they are auditing and not trying to gain an understanding. Other auditors have limited experience auditing a Fortune 500-size company or limited understanding of accounting policies and procedures. Still others focus unnecessarily on immaterial issues or show a lack of judgment and decision-making capabilities and lack of appreciation for the taxpayer’s most precious resource — time.
These techniques result in increased revenue for the states and increased costs and burden to the taxpayers. Costs related to tax, penalties and interest due as well as costs to supply additional resources to defend these assessments are increasing. Audits can no longer take a back seat; companies must take control in the beginning to ensure that the audit review will be completed in a timely and efficient manner. Managing the whole audit process is extremely important.
Managing the Audit – Before the Audit Begins
Once the company has received a notice of an audit review (or perhaps before a notice is received), a company representative should consider performing an analysis to determine the company’s level of compliance related to the particular tax type and jurisdiction scheduled for audit. This could provide the company representative with a better understanding of potential underpayments and overpayments of tax, as well as provide the company with the ability to make more informed decisions related to the audit.
Given that several states now offer a managed audit program, this is an option that should be considered. Managed audit programs require that the audit fieldwork be performed by a company representative and/or outside contractor as opposed to the state representative. In return, the state authority typically waives all or part of any penalties and/or interest due as a result of the tax assessment. Since some states require that the taxpayer initiate the request for a managed audit within a specified period of time, the company must move quickly in determining whether or not a managed audit would be possible and beneficial. Some of the points that should be evaluated include whether the entity under audit is in an underpayment or overpayment situation, whether it has resources to dedicate to completing the required tasks in a timely manner and whether the records necessary to perform the audit are available and complete.
In preparation for the audit, the company representative should begin gathering anticipated supporting documentation such as resale / exemption certificates, tax returns and return workpapers, electronic data, etc. If the supporting documentation is maintained in hard copy, verifying the location of the records and requesting records stored offsite can expedite the audit process. For electronic data, it is important to identify company personnel who can help extract the data. In addition, preparing an electronic download for a test month can be used as a “proof of concept” prior to extracting data for the entire audit period.
Managing the Auditor – During the Audit Fieldwork
If possible, the company should designate a point of contact (POC) for the auditor. This individual should be responsible for all communication with the auditor. The auditor should contact the POC for all information, document requests, questions, etc. It is important that the POC maintain a log documenting the auditor’s fieldwork activities, a listing of all information provided to the auditor and a timeline of the fieldwork activity (including auditor calls and office visits). This log could be beneficial in the event the POC leaves the company, is promoted or changes departments. In addition, this log can be referenced as support for request of penalty and/or interest waiver due to any undue delay caused by the auditor. (It might also be useful when proposing an audit settlement.)
The POC should consider placing the auditor in a workspace that has limited traffic flow to minimize interaction with other company employees, but in a location where the auditor can be monitored. The POC should also make a point to inform other company personnel when the auditor will be working onsite so other employees are careful to limit discussing confidential company information.
The auditor will typically begin their fieldwork by conducting an “entrance conference.” The purpose of the entrance conference is for the auditor to gain knowledge about the business operations of the company, determine whether any system changes have occurred during the audit period, discuss large capital expenditures made during the audit period and discuss the overall audit review methodology and timing. This is also a good time to make the auditor aware of office guidelines and rules that should be adhered to (i.e., office hours, dress code, etc.) while the auditor is onsite.
It is important to establish the audit scope with the state auditor as soon as possible. This includes verifying the legal entity selected for audit, the tax type and the audit period. Once the audit scope has been established, the POC should have a more in-depth discussion with the auditor about the audit timeline, along with anticipated deadlines, availability of records and the auditor’s approach to sample design and projection. It is in the company’s best interest to let the auditor know if there are upcoming internal deadlines due to monthly compliance processes or company projects. The auditor should be willing to plan and work around those deadlines if notified in advance.
If the auditor plans to perform a sample, the POC should make sure the sample design is representative of the company’s business operations during the period under audit. The purpose of the sample is to review a limited number of recurring transactions and project the findings of the review across a much larger population. It is important to take in to account events that would have impacted tax compliance during the audit period, as well as events that may require segregation of transactions from the population to be sampled. Involvement in the sample design phase is necessary to ensure that the sample is representative of the company’s business operations and that extraordinary items are not projected across periods to which they are not applicable. To the extent possible, the POC should be involved in the sample selection process to verify the sample is randomly selected by the auditor. The POC should request from the auditor a copy of the auditor’s sampling work papers, which should include the sample design, selection process and initial evaluation. These work papers should be reviewed and approved prior to providing supporting documentation and allowing the auditor to start fieldwork.
Once the audit fieldwork has begun, the POC should communicate regularly with the auditor. Regular communication helps minimize the auditor spending significant amounts of time on issues that may not be relevant and improves overall audit efficiencies. If the POC feels the auditor is heading down an incorrect path, it is important to take control of the situation and steer the auditor in the right direction. It may be a situation where the auditor does not have a clear understanding of a transaction. The POC should request copies of the auditor’s work papers so the POC can begin gathering documentation and information necessary to defend the preliminary assessment. Discussing taxability during the fieldwork and preventing the assessment of questionable transactions can significantly reduce the number of hours spent at the end documenting and defending a position.
The POC should review each adjustment included in the auditor’s preliminary schedules to verify the adjustment is appropriate. Outside of verifying that the issue is in fact taxable, the POC should consider other measures that could support removing the adjustment from the audit. Verification of the assessment should include, but not be limited to, the following considerations:
- The vendor or customer has not already paid the taxes due either by self-assessment, by audit assessment or under a voluntary disclosure agreement or amnesty program;
- The amount subject to tax is accurate;
- The applied tax rate is correct;
- The transaction dates for all assessments are within the audit period;
- No additional documentation can be provided to support the non-taxable nature of the transaction;
- The company did not self-assess the tax;
- The auditor did not overlook taxes paid to the vendor or charged to the customer on the original invoice;
- The taxes were not included in a lump sum billing from the vendor; and
- The transaction was taxable based on the applicable law at the time of the transaction (in case the statute has changed).
The POC should also review the assessment to verify that the items scheduled as part of a sample are properly projected. To the extent that an item is extraordinary in nature, it may be best to remove the assessment item from the sample projection and treat the item as a detailed transaction.
If the POC is aware of any refunds that may be available to the company, the POC should consider the most appropriate time to present the refunds to the auditor. Sometimes it is best to wait until the auditor has completed a substantial portion of the audit fieldwork before presenting the refund schedules to the auditor. This prevents the auditor from looking for additional assessments to “offset” the overpayments of tax.
If the auditor is not completing fieldwork at a satisfactory pace or is conducting the audit fieldwork in a manner with which the company does not agree, the company should contact the auditor’s immediate supervisor to discuss the points of contention. It is during these times that the audit log proves to be valuable. Be prepared to pursue any course of action, including contacting the head of the audit division, if necessary.
Managing the Results of the Audit
Once the audit fieldwork is complete — and the company has been issued an assessment — the POC should review the auditor’s final schedules in detail. The POC should verify that the auditor has properly removed any items that the auditor has previously agreed to remove from the assessment.
To the extent the company is not in agreement with any portion of the audit assessment, the POC should determine what options are available to the company to defend the assessment. Most states offer a mediation review with the auditor’s supervisor, another department representative or another objective party. If the company is forced to request a more formal litigation and/or appeal process, this process could delay closure of the audit and often results in additional costs related to outside consulting and legal fees. Therefore, the mediation review may enable the company to get closure to the audit and minimize additional costs.
Once the audit is complete, the POC should consider improving compliance (if assessments were found) related to the periods after the audit period (“post-audit period”), filing amended returns and participating in a voluntary disclosure agreement or state amnesty, if available.
The POC should communicate the audit results to company representatives and consider training appropriate personnel to ensure the errors do not reoccur in the future.
Alvarez & Marsal Taxand Says:
As state and local governments continue to seek ways to increase revenue, companies should be prepared when encountering an auditor who uses aggressive audit techniques. Consider using the techniques outlined above to best manage the audit process from start to finish and ultimately minimize the costs associated with the audit. Don’t let the auditor manage your time, your resources or your office space.
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The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisers. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisers before determining if any information contained herein remains applicable to their facts and circumstances.
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