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January 26, 2010

The economic crisis has resulted in reduced state and local tax collections by state and local governments. Therefore, state and local governments are seeking ways to increase revenue. Many states have already increased sales tax rates, have eliminated exemptions and are seeking additional collections through amnesty programs. However, several states are increasing audit coverage by hiring additional auditors. Most states audit less than 1 per cent of their taxpayers, and so adding auditors can increase the number of taxpayers audited, which can result in increased revenue.

State auditors are also becoming more aggressive, using techniques that are often difficult to defend. For example, state auditors are taking aggressive tax positions and assessing tax on issues that are typically supported with minimal documentation. In addition, states are less willing to waive penalties related to assessment for companies undergoing first-time audits. These techniques result in increased revenue for the states. For companies, they result in added costs for tax, penalties, interest due and resources to defend these assessments. Clearly, managing the audit process is extremely important. To minimize these audit costs, there are several factors to consider before the audit, during the audit and after the auditor's fieldwork.

Before the Audit

Once the company has received a notice of an audit review (or perhaps before a notice is received), a company representative should consider analyzing the company’s level of compliance related to the particular tax type and jurisdiction that is scheduled for the audit. The company representative should have a good understanding of potential underpayments and overpayments of tax. This knowledge will enable the company to make more informed decisions related to the audit. For example, the company may consider requesting a managed audit if the state offers such a program. Managed audit programs typically require that the audit fieldwork be performed by a company representative and/or outside contractor instead of the state representative. In return, the state authority will waive all or part of any penalties or interest due as a result of the tax assessment.

In preparation for the audit, the company representative should gather documentation that the auditor will most likely request in order to perform the audit. For example, the company should verify that resale and/or exemption certificates are on file. If an electronic file will need to be provided to the auditor, the company representative should consider what information will be available electronically to provide and test the accuracy of the data. If records are stored offsite, perhaps a request should be initiated to request these records.

The company should identify a point of contact (POC) to be responsible for all communication with the auditor. The auditor should contact the POC for all information requests, questions, etc. The POC should maintain a log of the auditor’s fieldwork activities, including a list of all information provided to the auditor and a timeline of the fieldwork activity. This log will be beneficial if the POC leaves the company. In addition, if the company requests a penalty or interest waiver at the end of the audit, this log may be used to support a full or partial waiver of penalty or interest related to any undue delay caused by the auditor.

The POC should inform the company that the auditor will be working onsite so other employees are careful to limit discussions of confidential company information. The POC should consider where to place the auditor to perform fieldwork. It is best to place the auditor in a work space with limited traffic flow to minimize interaction with other company employees.

At the auditor entrance conference, the POC should:

  1. Verify the audit scope with the state auditor — The POC should verify the specific legal entity selected for audit, the tax type and the audit period. The POC should only provide data for the specific audit scope, to the extent possible. The POC should only provide data necessary for the auditor to perform the audit.
  2. Set office guidelines with the auditor — The POC should communicate with the auditor the company office guidelines and rules such as office hours and dress code. The auditor may be expected to sign in and out each day to better track when the auditor is actually working at the company facilities.
  3. Verify audit methodology with the auditor — The POC should discuss the auditor’s plan for the audit, such as records to be reviewed, availability of records, audit timeline and sampling methodologies.

The POC should include in the audit log all significant discussions, such as the entrance conference.

During the Audit

Once the auditor has begun the audit fieldwork, the POC should communicate on a frequent basis with the auditor to ensure the POC is aware of the status of the fieldwork. This will minimize the chance of the auditor spending a significant amount of time on an issue or issues that may not be relevant.

Once the POC is aware of a potential issue, the POC should address the issue with the auditor, to the extent possible, to minimize the number of issues becoming part of the preliminary audit assessment schedule.

If the auditor plans to perform a sample, the POC should have a good understanding of the sample design and planned projection of the sample. To the extent possible, the POC should be involved in the sample selection process to verify that the sample is randomly selected. The POC should request from the auditor a copy of the auditor’s sampling workpapers which may include the sample design, selection process and initial evaluation. These workpapers should be reviewed and approved prior to allowing the auditor to continue the fieldwork.

Once the POC is aware of a potential assessment, the POC should request copies of the auditor’s workpapers so the POC may begin gathering documentation and information necessary to defend the preliminary assessment.

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. Often 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.

The POC should review each adjustment included in the auditor’s preliminary schedules to verify that the adjustment is appropriate. Outside of verifying that the issue is in fact taxable, the POC should consider other means that could support removing the adjustment from the audit. The POC should consider verifying that:

  1. The vendor or customer has not already paid the taxes due through a self-assessment, an audit of the vendor or customer, or a voluntary disclosure agreement or amnesty program.
  2. The assessment amount is correct.
  3. The tax rate being assessed is correct.
  4. The assessment transaction date relates to a period included in the audit period.
  5. There is no additional documentation to support that the item is not taxable.
  6. The company didn’t self-assess the tax.
  7. The taxes were not paid to the vendor or customer on the original invoice and overlooked by the auditor.
  8. The taxes weren’t included in a lump sum billing from the vendor.
  9. The transaction was taxable based on the applicable law at the time of the transaction (in case the statute may have been different than currently stated).

The POC should also review the assessment to verify that the items scheduled as part of a sample are properly projected. To the extent an item is extraordinary in nature, it may be best to remove the assessment item from the sample and project the transaction in detail.

The POC should communicate the status of the audit and the audit assessment to the appropriate company representatives. To the extent there is a significant assessment, an accrual may be required to properly reflect the financial statements.

After the Audit

Once the audit fieldwork is complete, and assuming the company has been issued an assessment, the POC should verify that the auditor’s final schedules have been reviewed in detail. The POC should verify that the auditor has properly removed any items that the auditor has agreed to remove from the assessment.

To the extent the POC 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 state representative or other party. If the company is forced to request a more formal litigation 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 related to the periods after the audit period — the post-audit period. Participation in a voluntary disclosure arrangement of the state may be beneficial.

The POC should communicate the audit results to company representatives and consider training appropriate personnel to ensure the errors do not reoccur.

Alvarez & Marsal Taxand Says:

With state and local governments looking for means to increase revenue, companies should be prepared for an increase in audit activity and aggressive techniques from state and local government representatives. Companies should be prepared and plan ahead. Companies should consider using techniques outlined above to best manage the audit process from start to finish and ultimately minimize the costs associated with the audit.

Author

Carolyn Campbell Shantz
Managing Director, Houston
713-221-3919
|

For More Information on this Topic, Contact:

Craig Beaty
Managing Director, Houston
713-221-3933
|

Lisa Barnick
Senior Director, Houston
713-221-3931

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As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.

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 advisors. 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 advisors before determining if any information contained herein remains applicable to their facts and circumstances.

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