How to Leverage a Reverse Audit to Uncover Tax Refunds, Identify Areas of Exposure and Improve Compliance Systems

Businesses routinely submit to audits by state and local taxing jurisdictions aimed at identifying and collecting underpayments of sales and use taxes or gross receipts taxes. However, a more proactive approach is necessary to identify overpayments of tax or when tax is being paid on one or more exempt or excluded items. These types of errors can be uncovered by performing a reverse audit. The result is often the discovery of refund opportunities, which can generate income and create positive cash flow. There are numerous reasons that contribute to companies overpaying sales and use and gross receipts taxes. Below is a discussion of how a reverse audit can assist companies in finding refunds and improving their compliance systems.

Common Causes of Overpaid Sales and Use Tax and Gross Receipts Tax

Taxpayers commonly overpay sales and use tax on purchases of goods and services that are used in their daily business operations. Overpayments frequently occur due to:

• Paying sales or use tax on exempt or excluded items, either to their supplier or to the state, where a legal exemption or exclusion is available;
• Remitting tax in error as a result of incorrect or inefficient internal use tax accrual processes;
• Missing and not adjusting tax compliance systems for the frequent legislative changes to exemptions and other aspects of each jurisdiction’s sales and use tax laws;
• Deferring to vendors for certain tax decisions, which can lead to an overpayment of sales and use tax; and
• Refraining from incurring some of the internal administrative cost associated with making a correct tax payment, which can be prohibitive.

Companies can recover overpaid sales and use taxes by reviewing their purchases and identifying potential refunds; however, for an in-house tax department, analyzing the voluminous transaction records to uncover overpayments and system errors is a time consuming and labor-intensive process. The time and effort required to perform this analysis in-house is one of the key deterrents for a company.

Industry Specific Benefits and Considerations

In addition to overpayments resulting from the above common issues, particular industries tend to especially benefit from the reverse audit process. These include:

• Manufacturing and/or Research and Development - Taxpayers with significant capital investment in manufacturing and/or research and development (R&D) operations should consider reviewing their production-related purchases to ensure they are not overpaying sales or use taxes and seek refunds for any overpaid tax on historical purchases. Potential areas of opportunity include identifying potential tax exclusions or exemptions for:

- Ingredients/component parts of a product or service sold;

- Equipment, replacement parts and supplies used in the production process;

- Pollution control equipment and supplies; and

- Safety equipment and protective clothing.

• Retail Industry/Marketplace Facilitators - Taxpayers in the retail industry with a significant footprint in the U.S. and/or other countries should review potential sales and use tax exemptions. Taxpayers with retail operations in many states have an opportunity to take advantage of potential exemptions, resulting in significant refunds. Potential areas of opportunity include:

- Packaging exemption;

- Promotional items and advertising; and

- Warehousing exemption.

• Software/Cloud Computing - Taxpayers whose corporate software purchasing function occurs in a state that offers a Multiple Points of Use (MPU) exemption, and where the taxpayer’s employees are located in multiple states should consider the sourcing of software purchases (examples of states offering a MPU exemption include New York, Massachusetts, Texas, Utah and Washington). Many states allow for sales and use tax on software purchases to be sourced based on where the software is used (MPU exemption). By properly sourcing the use of taxable software to locations outside of a company’s home state, the home state sales or use tax liability can be reduced.
• Gross Receipts Tax - Many states and local governments impose gross receipts taxes without allowing deductions for the companies’ expenses. Taxpayers located in a state/city with gross receipts tax and whose customers have a national and/or international market presence may benefit from the sourcing of receipts. The Ohio Commercial Activity Tax, Nevada Commerce Tax, San Francisco Gross Receipts Tax, and Washington Business and Occupation Tax are examples of gross receipts taxes. By properly determining a reasonable and consistent method of apportioning the receipts, taxpayers may be able to reduce their taxable base and thus reduce their past and future tax liability.

Benefits of a Reverse Audit

A reverse audit conducted by a trusted SALT professional can assist companies in finding refunds and improving their compliance systems without the unwanted additional stress placed upon an in-house tax department function.

A reverse audit can uncover refund opportunities and set the stage for:

• Offsetting potential state and local tax assessments if under audit;
• Obtaining cash that was erroneously paid without burdening internal resources; and
• Establishing proper internal sales and use tax/gross receipt tax filing methodology for the future benefit.

The Reverse Audit Process

SALT professionals with experience in reverse audits understand each state and local jurisdiction’s procedures for recovering tax overpayments and can help design a process to implement corrections or enhancements to the client’s tax compliance system. The process includes:

• Meeting with key personnel to gain an understanding of the company's business operations as well as its sales and use tax/gross receipt tax compliance system;
• Reviewing sales and use/gross receipt tax returns, related workpapers and past audit history;
• Analyzing accounting records and source documents to identify opportunities for refunds and credits;
• Determining whether significant sales or use tax/gross receipt tax audit exposure exists;
• Preparing the refund claim, including schedules, documentation, and evidence to support the refund claim; and
• Following up with taxing authorities on a frequent basis to expedite claims processing.

After performing a detailed analysis, the Company should be provided with a detailed report setting forth potential refund opportunities and identifying possible areas of exposure.

The Takeaway

A reverse audit can help to uncover overpayments of tax as well as taxes mistakenly paid on exempt or excluded items. The process can also identify areas of possible tax exposure and lay the groundwork for implementing improvements to a company’s compliance process.

Contact an Andersen State and local tax (SALT) professional to learn how a reverse audit can help your business.