The Profile of a Tax Audit: Who’s next?

Do you follow the law because that is your nature, or do you follow the law because you are afraid of the consequences of not following the law? The answer is very simple for a state auditor: you follow the law because you are afraid of being audited. Some believe that if they didn’t audit, taxes would never be paid.

If the threat of an audit is the only reason why businesses pay their taxes, what is the likelihood that you will be audited and what will lead to an audit?

The statistical likelihood of being audited is difficult to determine because very few states publically report the number of audits they perform. Two states that do publish audit information are South Dakota and Wyoming.  In 2012, South Dakota audited 1,669 businesses, or 2% of their total 80,130 licensed businesses. The same year Wyoming audited 437 businesses, or 1.6% of their total 27,964 licensed businesses. Wyoming also reported that their auditors returned $5.02 in audit assessments for every dollar spent conducting their audits.

In other words, audits work.

The data auditors use to target businesses

The auditing process has become more scientific in recent years, as auditors attempt to understand where best to devote their resources. Ideally, audits target businesses that are not complying with tax laws; audits helps keep retailers honest. It’s a nice perk that they also generate revenue for the state.

Determining sales tax compliance is complicated by the lack of outside data from which to verify the accuracy of retailers’ tax returns. Historically, the only outside data available was Federal income tax return data from the IRS. That data came with some accuracy issues and was only as good as a state’s ability to automatically compare sales reported on a business income tax return with sales reported on a sales tax return. If a state could not automate that comparison, the data was only useful to auditors during audits; it could not be used to decide whom to audit.

Over the last few years, the private sector has created vast “warehouses” of publically available business data. These warehouses come with software that allows a state to quickly compare the data on a sales tax return with the same data on returns from like businesses both in and outside the state.

The following quote from one state’s annual report reveals a good deal of enthusiasm for these tools. In this particular state, audit accounts receivable increased 25% in 2012, the year after implementing their data warehouse:

January 2012 saw the first use of the new tax compliance data warehouse which has allowed for the modernization of some personal income tax adjustments and assessments. Warehouse modules include detecting and preventing refund fraud; identifying and assessing non-filers and under reporters; streamlining the collections process; and improving the quality and efficiency of audits. A number of previous tax periods were reviewed using the new process which generated an increase in accounts receivable. As the Department’s use of this tool matures, it should further improve collection results.

States use data from these warehouses to reduce the “randomness” from the audit selection process. Random selection often produces random results which is not the goal of any audit manager. Otherwise the audit selection process has not changed much in 70 years.

Other reasons your business may be a target

The following are common reasons why a business will go on the “maybe” audit list:

• Failing to file a return;
• Failing to report sales;
• Taking excessive credits or exclusions on a return;
• Filing returns with errors;
• Having return information that is different from outside information;
• Having made mistakes found in a prior audit;
• Having been found to have misused exemption certificates;
• Not reporting use tax; and
• Industries which historically have high error rates either on returns or in audits.

It’s in a state’s best interest to audit businesses that will owe money. That said, there is no guarantee you won’t be audited if you file all your returns correctly and on time, report use tax, use exemption certificates properly, and are not a “high-error” industry.

How would your business stand up to an audit?

photo credit: Rob Ellis' via photopin cc