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America’s sales tax system is broken! Sales tax collection is spread across more than 17,000 individual sales tax jurisdictions in this country, yet the rules aren’t uniform from one county to the next. It’s a complete pass-through for businesses, but it represents a huge cost to be compliant, with painful consequences for not following the rules.

Value-added countries such as those in the European Union have a single national tax, but the United States is a toxic landscape filled with sales tax land mines that make it hard to do business. How companies cope with collecting and paying their sales taxes when state and local governments are increasing their scrutiny of sales tax payments may determine if the company will sink or swim.

Budget Shortfalls

Nationwide, sales tax makes up the single largest source of income for state and local governments. However, sales tax collections have been decreasing annually due to the recession and continued high unemployment. The U.S. Census Bureau reported in March that state sales tax collections decreased by $14.3 billion to $704.6 billion in fiscal year 2010. This follows a down year in 2009, when sales tax collections decreased by $65.8 billion compared to FY 2008.

More and more services have been passed from cash-starved state governments down to local jurisdictions in the form of unfunded mandates. Local governments feel the pinch when trying to fund their pension obligations or school systems. As a result, many state and local governments are seeking to collect more of the sales taxes owed by businesses through sales tax audits, rather than raise taxes. This is bad news for businesses that are operating without a proper sales tax audit defense solution.

Highly populated states with big budget shortfalls such as California, Texas, New York and Pennsylvania have become particularly aggressive in their pursuit of unpaid sales taxes. Results from a survey taken by a tax management services company show that as many as 70 percent of all businesses polled were audited at least once every three years, resulting in an average tax bill due of $37,000.

Impacts of a Negative Audit

For a small to medium-sized business (SMB), this kind of unexpected hit can make or break the company. SMBs are more likely to be seriously harmed by a sales tax audit because they are more likely to have a simple tax portfolio. A large business is less likely to be as severely impacted. For example, a large business may have overpaid in another state and is due a refund, helping to offset the taxes and penalties resulting from an audit in another state.

Another downside of an audit that reveals a SMB owes taxes is credit worthiness. Because SMBs rely more on credit lines to operate, a disastrous audit can restrict their lifeline with the bank and severely crimp the company’s cash flow. A large business is more likely to have the cash on hand to weather the storm. And audits tend to be cumulative – once auditors determine a business doesn’t have a handle on paying its sales tax, they’ll return time and time again.

A final negative impact of a sales tax audit is its potential to sour the business’ customers. When customers realize they haven’t been charged sales tax accurately or that the company isn’t paying the government the taxes it collects, they may stop doing business with that company.

Avoiding Audits

No matter how well a company collects and documents its sales tax liability, an audit may still happen. In fact, manufacturing companies are typically on a regular audit schedule. State and local auditors have developed closely-guarded models and formulas to identify which companies to audit. These models incorporate many variables, including the type of industry, the age of the business and flags to identify sales tax reporting that is out of the norm.

For example, auditors are more likely to investigate industries with more complex sales tax rules as well as to look into younger, less experienced companies because they’re more likely to find problems. When an auditor finds a company that reports that 80 percent of its transactions are tax-exempt in a sector that averages just 30 percent, alarms go off. Auditors also go by intuition and what they hear from other auditors about how well a company is managing its income tax collection and payment.

Manufacturing is a high-risk industry closely monitored by auditors. The industry has a lot of statutory exemptions and complex taxability rules, such as different rates, taxability rules which depend on usage, tax thresholds and caps. Manufacturers also typically purchase expensive equipment—items that are exempt as long as the manufacturer has documentation that the equipment was used consistent with the manufacturing exemption.

Auditors will look at large purchases they see in invoices, public notices in newspapers, or in documentation from other audits. Auditors will also look for operational changes at manufacturer—e.g., a new fulfillment company or a change in the manufacturing process since the last audit.

Coping with an Audit

Auditors don’t swoop in on companies at five minutes to closing time and announce an audit. Businesses receive notices and have an opportunity to negotiate the scope and methodology of the audit. Smart businesses will use this to their advantage to limit their pain from the outset. But the best way to undergo an audit and live to tell the tale is to be prepared long before the audit notice arrives.

A common mistake that businesses make is simply not charging the right am­ount of sales tax, or not properly and fully documenting exemption certificates of tax-exempt customers. Auditors want to see that companies have made an honest effort to correctly assess and document sales tax, even if they’ve made mistakes. Accordingly, an automated sales tax collection system is a plus, because it provides a consistent method and treatment of calculating and reporting sales taxes and limits mistakes from judgment errors. Auditors like to see this kind of consistency, even if it’s not always 100 percent accurate.

Tips for Audit Success

The best audit defense will have a proactive, high level of accuracy, demonstrate a predictable process and be focused on thorough documentation. Businesses should consider these tips:

• Understand that sales tax is a complete pass-through obligation. It’s collected from the customer and passed on to state and local governments. Unlike other taxes, sales tax doesn’t go away if the business isn’t profitable that year.
• Employ a centralized sales tax collection and payment architecture. If the business has made recent acquisitions, it may be utilizing multiple systems collecting and documenting taxes in different ways. It’s essential to bring all branches of the company under one roof when it comes to handling sales tax.
• Bring the people responsible for documenting and paying the company’s sales taxes into the fold, and make sure they’re an integral part of the company’s operations.

Remember sales tax is more than just calculation and collection – it involves proper calculation for each product or service, collection, reporting, filing returns and remitting payment to the governing body. Within each step there are complex rules that need to be followed to ensure full compliance.

Clearly document all customers who are tax-exempt. One key indicator that alerts an auditor to perform an audit is the lack of tax exemption certificate information. Tax exemption certificates should be easily accessible and properly verified in order to present to an auditor at any time.

Be consistent. If your website says that the company has offices in two states, but you are claiming to pay taxes in only one—that is a clear indicator to an auditor that there might be an issue.

In order to ensure sales tax compliance and reduce audit vulnerability, businesses have an option to outsource their sales tax calculation, reporting and remittance to a trusted business partner. The most effective solution includes a web-based option that handles day-to-day administration, maintains tax rules and regulations, provides product taxability information and ensures timely delivery of the sales tax obligation to each municipality.

Diminishing Returns

Most businesses are not “in business” to calculate, collect, report and remit sales tax. Yet, it is important for businesses to be accurate in tax reporting and efficient in how they allocate resources to perform this function. Although most businesses do very well managing their resources, it could take a full department of individuals to monitor, maintain and deliver accurate sales tax calculations, create and complete returns and remit payment of tax liability on a daily, weekly or monthly basis. And even then, there could still be a costly audit.

Trying to follow the letter of the law when it comes to the incredibly complex world of sales tax management is not only difficult: it is a fool’s game. Com­panies attempting to gamble on manual sales tax processes while trying to beat auditors are playing a game that will cost them more than they can afford. The added expense of poorly managed sales tax compliance can diminish the value of a company, deplete its resources and damage its reputation.