It is a safe bet that the State Revenue Department will let you know if you have not paid enough sales and use taxes, but what are the odds that you will be notified if you have paid too much? The chances are slim, so slim that many manufacturers use reverse audits to find overpayments and seek reimbursements on their own.
With most state sales taxes now between 4% and 7%, it is worth it to be sure you are receiving all the exemptions you are entitled to and unless you are diligent about claiming exemptions, you are probably missing some.
In many states, manufacturers are exempt from sales tax on equipment used in manufacturing or recycling. Certain states do not require manufacturers to pay taxes on the utilities and chemicals they use. In some states, custom software, computers and peripherals are exempt if they are used for research and development projects.
Most manufacturers have sales and use tax compliance systems to guard against paying too much, but if you have not reviewed yours recently, it may not be functioning properly. Employee turnover, business expansion or downsizing, and simple mistakes all can take their toll on sales and use tax compliance policies. Therefore, you may be paying more than you should.
Take a long view
A reverse audit should include an examination of your tax compliance systems as well as your purchasing records. Your accounts payable department could be tasked with spotting exemptions that purchasing has not 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. For example, if your state auditors can review all records for the four years preceding the audit, your reverse audit should encompass the same timeframe.
What types of payments should be reviewed?
You may have made 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:
- Pollution control equipment and supplies,
- Safety equipment,
- Warehouse equipment,
- Software licenses,
- Maintenance fees,
- Protective clothing, and
- Service transactions
When considering whether you may have overpaid taxes in these and other areas, a clear understanding of your operations is crucial. You must know where your manufacturing process begins and ends, if you want to ensure you are receiving maximum benefit for industrial processing exemptions.
It is also important to remember that, if you have plants or sales offices in more than one city or state, your records may be decentralized. So do not overlook any sites.
Consider statistical sampling
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 will be required to complete a detailed review of all purchases. Therefore, before beginning a reverse audit, it is important to understand sampling requirements and tax exemptions for every state in which you do business.
Do not give more than your due
Reverse audits can be time consuming and complicated, but a little pain can bring significant gain. Use your reverse audit not only to reap tax refund rewards now but also to update your compliance systems to help ensure you do not overpay taxes in the future.
Rules and regulations surrounding state sales and use tax refunds are complicated. Work with your tax professional to understand them and ensure your refund claims are properly prepared before you submit them.
When is a good time to conduct a reverse audit?
If you are doing a major capital project such as adding manufacturing space, a reverse sales and use tax audit may be the last thing you want to add to your schedule. Nevertheless, it may be the best time. Even if you cannot justify the effort a full, companywide audit would require, you could audit transactions associated with the project. Now is when you will 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.
Another good time to consider a reverse audit is when state tax laws change. Sales and use tax exemptions typically do not 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 are not missing additional opportunities for tax savings.
Your tax advisor can help you stay up to date on tax law changes.
Byron Largen, CPA
Tax Partner
