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Use Tax: The Cost of Unintentionally Saving a Few Dollars

by: Raymond Chang, CPA

Is your company a distributor or manufacturer in the U.S.? If yes, then how thorough is your use tax compliance? From a sales and use tax perspective, companies like yours typically have the collection and remittance of sales tax on goods and services sold to customers down to a science. But when it comes to identifying and accruing use tax on your purchases of merchandise and equipment for internal use, that’s where things may get a bit interesting.

As companies seek out the lowest prices for non-inventory items, companies may increase their number of purchases from vendors that don’t charge sales tax, especially internet-based vendors with limited nexus for sales tax. This may inadvertently result in the company not self-accruing use tax on a broad range of business purchases –furniture, computer equipment, you name it.

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The reasons are understandable – as companies look for new ways to cut costs, they increasingly choose low-cost vendors. Many of these new low-cost vendors operate online and may not have sales tax nexus in the company’s state. Therefore, they may not be required nor permitted to charge sales tax on purchases.

As companies increasingly replace legacy vendors that did charge sales tax on purchases with internet vendors that are not required nor permitted to charge sales tax on such purchases, companies are more likely to miss potential use tax.

Prior to the explosion of internet-based retailers, vendors historically shared sales tax nexus with their customers and typically charged sales tax. As a result, most companies were not as focused on self-accrual of use tax or use tax compliance with respect to their own expenditures because most purchases were made from vendors that charged sales tax.

Small Oversights Become Large Exposures

These days, state tax audits, in particular sales and use tax exams, are on the rise. As states realize that companies are doing an excellent job of properly charging (or not charging) sales tax on the items or services they sell to their customers, states are turning to use tax compliance.

Businesses that find themselves in the midst of a state tax audit are typically in for a comprehensive and lengthy experience. A typical state tax audit will cover an “audit cycle,” the entire period open under the respective state’s tax statute of limitations. For sales and use tax that’s usually 36 or 48 months.

In addition, if the state discovers a particular procedural or technical shortcoming in one audit cycle, the state may either expand the years under exam to the current period or return to audit subsequent years. For example, if the state found an error or shortcoming in the 2013-2015 audit cycle, the state may expand its audit through 2017 or return for the subsequent years after it has completed its audit of the initial audit cycle.

And here’s the kicker: As the standard audit will be for a 36- or 48-month period, the state may choose a 2, 3, or 4-month test period. Or the state may choose a particular year, say 2015, as the year it wants to “test.” If the state then tests a company’s records for the agreed upon “test period” and identifies shortfalls in its use tax self-accrual, i.e., if the company didn’t pay sales tax on one or more purchases during the test period, the state will usually extrapolate that error onto the remaining period in the audit cycle. A missed self-accrual of use tax during the test period may result in a proposed assessment based on an extrapolation of the error onto the remaining untested months of the audit cycle.

Here’s what that means: Let’s assume that the state has an 8 percent use tax rate and the state’s exam of the test month for one particular category of expenses determined that there is a 4 percent error ratio resulting from an omission of $400 of use tax ($5,000 of purchases without sales tax at 8 percent) in the test month.

That 4 percent error ratio ($5,000 of purchases without sales tax divided by total purchases of $125,000 for the test month) may be applied to that expense category for the remaining untested months of the audit cycle. If the amount of that expense category was consistent over a 48-month audit cycle ‒ $125,000 per month ‒ that $400 use tax omission in the test month could result in a $19,200 use tax assessment for that expense category for the audit cycle.

Imagine how much worse the extrapolated assessment would be if the purchases for the tested expense category on average were higher than in the test month. Worse yet, the state will also charge your company monthly interest based on the extrapolation and perhaps a penalty, leaving you with a bill far more than the use tax you inadvertently failed to pay in the first place.

Back to Square One: How Use Tax Oversight Occurs

The omission to self-accrue use tax is often unintentional or the result of numerous random transactions or transactions with new vendors, thereby making identification of such omissions challenging.

In other cases, confusion may occur through a transaction from a vendor where your company generally purchases products for resale, such as inventory, as well as products that your company uses internally. Say you usually buy inventory from a particular vendor for items that you plan on reselling, but your company also purchases similar products from the same vendor for its own use. As the vendor has a resale certificate from your company, unless the vendor is informed that one or more purchase orders are not for resale, the vendor will apply a blanket resale certificate to all purchases – thereby not charging sales tax on those purchases for your company’s own use.

In yet another scenario, one of your employees may pay for an item out of pocket, and get reimbursed by the company at a later date. A problem can ensue if the employee either purchased the item without paying sales tax or fails to provide documentation that they paid sales tax. Fair or not, when documentation is lacking, even if the reasons may stem from a limited reasonable omission, the state will proceed as if the expenses in question did not have sales taxes paid at the time of purchase.

Self-Correct by Establishing Controls and Procedures

The solution begins with education within your own accounting department, ideally before you ever get to the point of responding to a state sales or use tax exam notice and engaging an outside accounting firm to assist with the exam.

While there’s nothing new about use tax, changes in technology and business practices are still designed around old ways of purchasing merchandise. Whereas in the past a person would have to go to a store to buy something, now they can simply place an order over the phone or internet. The same holds true for any employee, past or present, who’s expensed items back to your business, or taken an item off your inventory rack for company use.

In all these cases, no one told the accounting department what was going on, and that’s precisely how negligence in use tax compliance occurs.

So here’s a good rule of thumb: When expenses come through your accounting department, there should be some review process to make sure sales tax is always charged. And if sales tax is not charged, there should be some procedure in place to document why it should not have been charged.

In addition, if a business ever buys something from a vendor for which they don’t typically get charged sales tax, or if a business ever takes stock from its own inventory for company use, the accounting department should be notified of all these circumstances.

By establishing controls and procedures like these at the outset, your accounting department will know what to look for, and help ensure your business solidifies its sales and use tax compliance. Such measures will also ensure that if or when state auditors come knocking on your door, your business will be at the ready with proper documentation so you can quickly move on to more important things – like building your business.