Chapter 5 - Audit Procedures
- Representation/Nexus in Texas
- Reporting Categories
- Audit Process Flowchart
- Analysis of Reporting Method
- Common Sales Tax Reporting Methods
- Internal Control Overview
- Total Sales (Gross Sales)
- Examination of Records
- Sales Tax Verification
- Sales Tax Verification, Example
- Fixed Asset Sales
- Resale Certificates
- Resale Certificate Form (01-339)
- Exemption Certificates
- Exemption Certificate Form (01-339, back)
- Direct Payment Exemption Certificate
- Direct Payment Exemption Certificate Form
- Alcoholic Beverage Exemption Certificate
- Alcoholic Beverage Exemption Certificate Form
- Consular Tax Exemption Cards
- Prior Contract Exemption Certificate
- Prior Contract Exemption Certificate Form
- Divergent Use
- Sixty-Day Letter
- Sixty-Day Letter, Example
- Letter of Assignment
- Letter of Assignment - Example
- Sales to Destinations Outside of Texas
- Cash Discounts
- Cash Discounts, Examples
- Returned Merchandise
- Credit for Tax Paid
- Multistate Tax Credit
- Bad Debts
- Tax Erroneously Collected
- Taxable Purchases
- Internal Control Questions to be Analyzed and Evaluated for Taxable Purchases
- Audit Procedures for Taxable Purchases
- Multi State Tax Credit, Examples
- Alternative Auditing Methods
- Account Information Card
- Audit Lead - Form 00-828
- Insolvent Taxpayers
- Successor Liability - Liability Incurred by Purchase of a Business
The primary purpose of the sales tax audit is to confirm that the taxpayer has reported the correct amount of tax. Reported amounts from the sales tax history must be analyzed when examining the taxpayer's records.
Representation/Nexus in Texas
Nexus is the establishment of representation in the State of Texas, making a taxpayer responsible for collecting sales or use tax. The due process clause of the United States Constitution requires some definite link, some minimum connection between the state and the person, property, or transaction it seeks to tax. This link, referred to as representation, is determined to be sufficient by an analysis of the benefit derived. The analysis indicates whether the taxpayer has received some economic gain or advantage from his association with the state.
According to Section 151.107 Texas Limited Sales, Excise, and Use Tax Act and Sales and Use Tax Rule 3.286, Seller's and Purchaser's Responsibilities, a retailer has representation or is engaged in business in Texas if the retailer:
- Maintains, occupies, or uses in Texas permanently, temporarily, directly or indirectly or through a subsidiary or an agent, a physical facility, including an office, place of distribution, sales or sample room, warehouse or storage place, or other place of business;
- Has a representative, agent, salesman, canvasser, or solicitor operating in the state under the authority of the retailer for the purpose of selling, delivering, or taking orders for a taxable item. This includes salespersons, agents, canvassers, solicitors, repairmen, installers, inspectors, etc.;
- Utilizes independent salespersons in direct sales of taxable items;
- Operates a delivery vehicle in this state;
- Derives receipts from a lease of tangible personal property located in this state;
- Promotes a flea market, trade day, or other event involving the sales of taxable items;
- Allows a franchisee or licensee to operate under its trade name if the franchisee or licensee is required to collect Texas sales or use tax;
- Conducts business in this state through employees, agents, or independent contractors.
These types of documentation may support the claim of nexus:
- Shipping documents
- Vehicle logs
- Sales invoices
- Gasoline tickets
- Territorial assignment sheets
- Documentation of a place of operation by the taxpayer
- A written statement from the taxpayer
- Delivery directions
- Travel notes
- Expense vouchers
- Itinerary sheets or logs
Once representation/nexus has been established, an out-of-state seller continues to be legally required to collect tax on sales made into Texas for a period of 12 months after the seller ceases to be engaged in business in Texas.
Reporting categories are broken out as follows on the sales tax return:
- Total Sales
- Taxable Sales
- Taxable Purchases
- Amount Subject to State Tax
- Amount Subject to Local Tax
- Amount Subject to City Tax
- Amount Subject to Transit (MTA/CTD Tax)
- Amount Subject to County/SPD Tax
Even though the category "Deductions" does not appear on the sales tax return, this amount is calculated by the computer and appears on the Audit History.Total Sales - Taxable Sales = Deductions
Audit procedures used in each audit situation will be adapted to the individual taxpayer's system of accounting and recordkeeping. Since different reporting methods are used by taxpayers to complete sales tax returns, it is important that the auditor understand the method utilized by the taxpayer. The auditor should complete an analysis of the accounting system and devise specific audit procedures applicable to the audit. Certain procedures must be performed on each and every audit:
- Sales tax reconciliation,
- Gross Sales (Total Sales) reconciliation,
- Examination of purchases, etc.
Audit Process Flowchart
View alternate text for Audit Process Flowchart.
Analysis of Reporting Method
During the entrance conference, the taxpayer or the taxpayer's representative should explain the reporting method utilized. Ask open-ended questions to obtain an overview of the entire operation of the business and also identify probable problem areas of tax liability or credit. Consider the following areas:
- The step-by-step process by which the information is obtained and summarized to prepare the return - includes the records used to prepare the return
- Any work papers used to prepare the return
- General ledger accounts that have been used by the taxpayer in reporting. Check for related accounts when the Chart of Accounts is reviewed.
- Changes in personnel who prepared the return. Obtain the name and position of anyone who prepares a specific portion of the return.
- The possibility of using computer audit assistance should be considered if any areas of the return or recordkeeping are computerized. Examine the computer section of the Audit Questionnaire.
- Availability of resale/exemption/direct payment exemption certificates for tax-free sales.
- Checking to see what items are being claimed as Deductions.
- Are Deductions being reported or are they "netted"?
- Are Taxable Purchases being reported? If so, what items are being included?
- Unusual areas - changes in reporting method, fluctuations in reported amounts, etc.
- Testing one or two reports to verify that the procedures as explained are used to prepare the return.
- Checking to see if the reporting method has been changed. If so, check the different methods used and document the changes on the Audit Plan.
Common Sales Tax Reporting Methods
Two common methods frequently used by taxpayers for reporting sales tax are:
- Netting non-taxed sales with Gross Sales
- Backing into Taxable Sales
The taxpayer's records indicate the following monthly amounts:
|Gross Sales (Nontaxable & Taxable)||$5,000,000|
|Sales Tax Accrued (@ 8%)||240,000|
The corresponding amounts would be reported on the monthly sales tax return using the "netting method" are:
When this method is utilized by the taxpayer, Gross Sales reported will usually be incorrect and should generally not be used for projections. If adjustments to reported Gross Sales and Deductions net to zero, the adjustments should not be made.
The corresponding amounts would be reported on the monthly sales tax return by "backing into" Taxable Sales are:
|Taxable Sales (240,000 ÷ .08)||$3,000,000|
When reported taxable sales are backed into, any differences between Taxable Sales on the books and reported Taxable Sales should be analyzed.
Internal Control Overview
The taxpayer's system of internal control must be analyzed and evaluated to determine the reliability of the records being examined. The depth of the audit examination is determined in great part by the reliability of the taxpayer's internal control system.
Characteristics of Good Internal Controls
Some characteristics of good internal control are listed below. Each system must be analyzed for specific strengths and weaknesses.
- A clearly defined responsibility for each function
- An adequate system of authorization
- Adequate supervision of duties
- Adequate documentation
- Adequate protective measures (i.e., locked rooms for inventory, etc.)
- Segregation of duties
- Internal verification
Total Sales (Gross Sales)
Total sales consist of all taxable and nontaxable sales during the reporting period for each outlet. Taxable and nontaxable sales include:
- All sales, leases, and rentals of tangible personal property. Sales of intangibles such as stocks and bonds would not be included.
- All labor and service charges.
- Sales tax collected should not be included in reported total sales.
Generally, verification of Gross Sales includes:
- Reviewing the chart of accounts for revenue accounts.
- Reviewing the taxpayer's method of reporting sales.
- Reconciling recorded and reported amounts.
- Determining which accounts make up Gross Sales.
- Determining how cash sales are handled.
- Determining how bad debts are handled.
Reconciliation of Recorded and Reported Sales
A reconciliation of sales should be performed by comparing reported sales, per the sales tax return, with audited sales, per books and records. This reconciliation may be completed by report period or by year.
Reported Gross Sales should also be compared to:
- Federal Income Tax returns
- Franchise Tax Gross Receipts - now part of the taxpayer's Audit History
- Financial Statements
Any differences found between reported and audited sales should be analyzed taking into consideration the taxpayer's reporting method. Determine if the differences result from taxable or nontaxable sales. Audit adjustments should be made for unreported taxable sales and included in an exam of "Adjustments to Gross Sales".
If the reconciliation does not result in any differences, then document this fact in the audit plan.
Preliminary Review (Short Testing)
Preliminary reviews (short tests) should be done before a thorough examination of records is performed. Short tests will provide the necessary information to determine whether to perform detail or sample audit procedures. Short tests highlight key areas that may need a more detailed examination. Before relying on taxpayer's records, perform short tests of the following:
- Trace postings in sales journals to general ledgers
- Trace recording of daily sales totals or invoices to sales journals
- Trace recording of sales invoice information to sales journals
- Verify sales journals footings (totals)
- Scan for unusual entries in journals and ledgers such as debits to the sales tax accrual account
- Verify recording accuracy and records flow
- Verify tax charged and rate of tax
- Verify that tax is being collected and allocated to the correct local jurisdictions
Document in the Audit Plan the steps and findings of the short tests. If short tests reveal that summary records accurately reflect the taxpayer's method of accounting, then use the taxpayer's summary records. If not, then an examination of the original source document may be necessary.
REMINDER: Short tests are not used to reconcile reported totals, only to reconcile the steps used to arrive at those totals.
Examination of Records
Examine general ledger accounts for debits and credits which may represent unreported taxable sales or services such as:
- Sales of merchandise at cost credited to purchase or inventory accounts
- Sales of by-products credited directly to profit and loss, surplus or expense accounts
- Sales of furniture, equipment or other capital assets credited to equipment, depreciation, gain or loss or other accounts
- Sales of taxable services such as:
- Amusement services
- Cable television services
- Laundry, cleaning and garment services (Personal Services)
- Motor vehicle parking and storage services
- Repair, remodeling, maintenance and restoration of tangible personal property except for:
- A ship, boat, or other vessel other than a taxable boat or boat motor
- The repair, maintenance, and restoration of a motor vehicle
- Repair, maintenance, creation, and restoration of a computer program, including its development and modification not sold by the person performing the repair, maintenance, creation, or restoration service
- Real property services
- Debt collection services
- Information services
- Data processing services
- Insurance services
- Telecommunication services
- Credit reporting services
- Real property repair and remodeling
- Security services
- Telephone answering services
- Internet access services
- Utility distribution
Examine the general journal and note entries which may indicate unreported taxable sales or services.
Consider all data pertaining to general journal entries in determining if an entry represents an unreported taxable sale or service. This data may include:
- Invoices and other documents.
Cash Receipts Journal
Examine the cash receipts records to determine whether receipts from cash sales have been credited to the proper sales or revenue accounts. Be careful not to duplicate taxable sales or services found in other records.
Accounts Receivable Ledger
Examine the accounts receivable from the owners, partners, officers or employees of a firm for evidence of taxable sales or services not otherwise recorded in the sales or revenue accounts. Examine partners' drawing accounts and employees' advance accounts.
Entries may be made in the purchase journal for sales at cost or returned merchandise. Inventory withdrawals which should have been reflected in the inventory accounts may also appear as credits in the purchase journal. Examine these postings for taxable sales or services.
Sales Invoices and Journals
Sales invoices are source documents and usually represent the original record of a transaction. It is a necessary part of audit procedure to examine a representative number of these invoices to determine:
- How the transactions are recorded on the invoices
- If tax was properly assessed
- How the invoices are filed - By invoice number? By customer's name? By days? By months?
NOTE: Many taxpayers have multiple sets of invoices. For example, one set of sales invoices may be filed in numerical while another set may be filed in customer folders.
Invoices are used to verify:
- Tax accruals
- Types of transactions
Tracing the postings of sales invoices is the first step in verifying the accuracy of the books of original entry. The sales invoice is traced directly to the sales or revenue journal for accuracy of posting relative to amount and classification. Trace source documents through to summary records and check for errors and omissions.
- They are consistent
- There is a posting from each source for each month or accounting cycle
- There are sources of postings that might reveal operations not disclosed in pre-audit research or discussions with the taxpayer
The tax assessed on the invoice is important because the tax accrual account is based on the tax rate times the taxable value. This is especially important on audits of taxpayers who derive total sales, taxable sales or deductions based on the amount of tax accrued.
Note what type of deductions the taxpayer is claiming because they may lead to a detail of certain accounts. Ensure that the taxpayer is in possession of all necessary resale, exemption, and direct payment exemption certificates.
Type of Transactions:
For the sale of tangible personal property or taxable services, examine invoices to determine if charges are consistently separated or billed as a lump sum. This information is also important to know when examining purchases.
If there is a lump sum charge which includes both taxable and nontaxable amounts, the entire charge is taxable. To be excluded from the taxable amount, the nontaxable items must be separately stated on the invoice or other billing document.
Federal Income Tax Returns
A comparison of sales reported for federal income tax purposes with state sales and use tax returns is a good audit practice. This may not be feasible if the taxpayer files a consolidated federal income tax return. However, the taxpayer should have working papers showing how these figures were obtained.
Reconcile the differences if a taxpayer has acceptable records but gross receipts recorded in the books and reported on sales and use tax returns do not agree with gross receipts on the federal income tax returns. Material differences should be analyzed. Determine if the difference is the result of taxable or nontaxable sales. Also review Schedule D of the federal income tax return for any fixed asset sales.
In making this reconciliation, differences may be due to:
- Accounting basis - reporting on cash basis for income tax purposes and using an accrual basis for sales and use tax purposes or vice versa
- Netting - Gross Sales shown on the sales tax returns may actually be the net of sales minus deductions
Sales Tax Verification
Sales tax collected versus sales tax reported should be reconciled in detail for every audit. Gross Sales should not include sales tax collected but:
If a taxpayer does not separate tax and selling price (Gross Sales figure includes tax), determine if:
- Total amounts, (including tax) of sales invoices are entered into the sales revenue account including exempt sales, and
- The sales price and tax rung up on the cash register is recorded in the sales revenue account.
Then determine Gross Sales by:
- Reducing the Gross Sales figures (tax included) by the amount of tax-exempt sales to arrive at total Taxable Sales (tax included).
- Dividing total Taxable Sales (tax included) by one plus the appropriate tax rate to arrive at total Taxable Sales (tax excluded).
Add total Taxable Sales (tax excluded) and tax-exempt sales to obtain a Gross Sales figure. See the following Example. Compare the Gross Sales figure to the amount reported on the tax return.
Analyze Sales Tax Accrual Accounts
Compare Tax Accrued to Tax Reported
Verify tax accrual account (also called sales tax payable account) by comparing tax accrued to tax reported for the audit period. If differences exist, determine the reason for the difference, and, if necessary, prepare a schedule and make an adjustment in the audit. Differences may occur due to:
- Other credits in the sales tax accrual account (i.e., discounts)
- Returned merchandise sales for which credit memos have not been recorded in the sales journal and/or tax accrual account
- Tax on taxable purchases being posted to the tax accrual account
Note: If the taxpayer does not maintain a tax accrual account, examine available summary records.
Analyze Debit Entries
Analyze debit entries to determine if:
- Excess tax is being written off to a miscellaneous income account
- Debit entries exist for bad debts, discounts, returned merchandise and refund claims - verify tax refund claims to determine if the customers have received them
- Debit entries are due to customers not remitting tax - verify that the taxpayer has valid resale/exemption certificates to support them
Credits and Refund Claims
During the course of an audit, a tax reconciliation is normally performed for the audit period. However, when refunds or credits have been allowed in an audit or refund period, the tax reconciliation must be expanded to include the most current report filed. This procedure is necessary in order to verify that the refund or credit has not been taken in subsequent report periods.
Fixed Asset Sales
Examine summary records for the sale of fixed assets:
- Review general ledger fixed asset accounts for credit entries
- Review Schedule D of the taxpayer's federal income tax return
- Examine gain or loss accounts in the general ledger
- Trace sales to journal entries, cash receipts, and source documents to determine if tax was collected and reported or if the sale was exempt
Verification of Deductions is an important area of an audit. Although not specifically reported by the taxpayer, Deductions are the difference between Gross Sales and Taxable Sales.
Items included in Deductions:
- Deductions supported by valid certificates (resale, exemption, direct payment exemption)
- Deductions based upon sales destination (items shipped out-of-state)
- Deductions for sales and services specifically exempt by sales tax law and rules
- Deductions for adjustments to sales when sales tax has been paid (returned items)
Normally, the review and reconciliation of Deductions is made at the same time as that for Gross Sales. Whenever feasible, adapt the audit procedure to the method used by the taxpayer to report Deductions. The scope of the examination of Deductions will depend on the conditions encountered. Deductions consist of the total nontaxable sales claimed by the taxpayer. Most claimed Deductions are supported by resale and exemption certificates and exemptions by law.
Conduct a detail examination if:
- Claimed Deductions consist of relatively few items
- All transactions can be examined in a reasonable amount of time
Consider a sample examination if:
- Gross Sales are numerous
- Gross Sales are of similar unit value
- Claimed Deductions are numerous
Consider a stratified sample if:
- There is a large variation of price for units sold
- There is only an occasional large sale
Deductions can be supported by various certificates which relieve the seller from liability for collecting the tax if the seller accepts the certificates in good faith. Among the first audit procedures should be the examination of the taxpayer's certificate file. Are the certificates updated and current?
Types of certificates include:
- Resale Certificate* (Rule 3.285)
- Exemption Certificate (Rule 3.287)
- Direct Payment Exemption Certificate* (Rule 3.288)
- Alcoholic Beverage Exemption Certificate* (Rule 3.289)
- Prior Contract Exemption Certificate (Rule 3.319)
*Valid taxpayer numbers are required on these certificates.
If a certificate is accepted by the seller at the time of sale, then the certificate should be considered as accepted in good faith unless there is something obviously wrong on the face of the certificate (not a valid 11-digit number on a resale certificate, for example). Account Information Cards should be submitted on the purchasers who have submitted questionable certificates.
When deciding if a certificate is sufficient in content and if a seller acted in "good faith" in accepting the certificate, these questions should be considered:
- Was the merchandise sold to a retailer who does not sell that particular type of merchandise?
- Did the seller have knowledge that the particular item sold was to be consumed rather than resold by the purchaser?
Any certificates received by the taxpayer after the audit entrance conference date are subject to verification by the auditor.
A resale certificate is a document which is presented to the seller at the time of purchase. A purchaser who is purchasing an item that he will sell, lease, or rent within the geographical limits of the U.S. may issue a resale certificate to his supplier in lieu of paying the sales and use taxes.
A purchaser who buys only items for resale from a seller may issue a "blanket" resale certificate to a seller. The certificate describes the general nature of the taxable items purchased for resale, and it is valid until revoked in writing by the purchaser.
Texas and out-of-state retailers may issue resale certificates. In addition Mexican retailers may also issue resale certificates. To be valid a resale certificate must contain:
- The name and address of the purchaser
- The purchaser's 11-digit Texas sales tax permit number. If the application is pending, the resale certificate is valid for only 60 days. After that date a new resale certificate should be issued which lists the permanent permit number
- An out-of-state permit number or the registration number assigned to the purchaser by the purchaser's home state
- Mexican retailers must show their Federal Taxpayers Registry (RFC) number on the certificate and also give a copy of their Mexican registration for to the seller
- A description of the item(s) to be purchased, leased, or rented
- The signature of the purchaser and the date
- A description of the items generally sold, leased, or rented by the purchaser in the regular course of business
- The seller's name and address
In addition, the following statements must be included as part of the resale certificate:
- I, the purchaser named above, claim the right to make a nontaxable purchase (for resale of the taxable items described below or on the attached order or invoice) from
- The taxable items described above, or on the attached order or invoice, will be resold, rented, or leased by me within the geographical limits of the United States of America, its territories and possessions, or within the geographical limits of the United Mexican States, in their present form or attached to other taxable items to be sold
- I understand that if I make any use of the items other than retention, demonstration or display while holding them for sale, lease or rental, I must pay sales tax on the items at the time of use based upon either the purchase price or the fair market rental value for the period of time use
- I understand that it is a criminal offense to give a resale certificate to the seller for taxable items that I know, at the time of purchase, are purchased for use rather than for the purpose of resale, lease, or rental and, depending on the amount of tax evaded, the offense may range from a Class C misdemeanor to a felony of the second degree
If a person from the United Mexican States issues a valid resale certificate or a Border States Uniform Sale for Resale Certificate, along with a copy of their Mexican Registration Form to the seller, export documentation is not needed.
All blanks on a resale certificate should be completely filled in. Pay particular attention to the description of the property being purchased to be resold. Compare the description on the resale certificates with the description on the sales invoice to determine if the certificate applies.
Miscellaneous Notes Regarding Resale Certificates:
- Copies of sales tax permits or taxpayer numbers alone do not qualify as resale certificates.
- FAX copies of signed resale certificates are acceptable, but the certificates must be dated at the time of the sale.
- If resale certificates are not obtained at the time of the sale, the seller has 60 days from the date written notice is received from the Comptroller to present them.
- A purchaser may issue a resale certificate when it is not known whether the item will be resold or used. Sales tax must be paid at the time of purchase when a purchaser knows an item is not purchased for resale.
- If a purchaser issues a resale certificate knowing at the time of issuance that the item would be used in a taxable manner, the certificate is invalid and sales tax is due on the purchase price of the item.
Resale Certificate Form - 01-339 (Rev.6-04/5)
NOTE: This is only a suggested format. Besides the above format, the "Border States Uniform Sale for Resale Certificate" which was adopted by the states of California, Arizona, New Mexico, and Texas is also acceptable.
An exemption certificate is a document similar to resale certificates, except that a taxpayer number is not required for it to be valid.
An exemption certificate may be issued to a supplier by:
- An organization that has qualified for exemption under Chapter 151, Sections 151.309 and 151.310 of the sales tax law - refer to Rule 3.222, Exempt Organizations
- A person purchasing an item which is exempt under the provisions of Chapter 151, Subchapter H of the sales tax law: for example, purchases that qualify for the agricultural exemption, materials consumed in manufacturing an item for sale, etc.
- A purchaser of a taxable item who donates the taxable item to an organization exempted under Section 151.309 or 151.310(a)(1) or (2) of this code - any use by the purchaser of the tangible personal property or taxable service other than retention, demonstration, or display shall be subject to tax
Exemptions from sales and use tax are provided under the following general categories. It should be noted that this is not a complete list. Each rule needs to be studied to determine whether a full or partial exemption exists.
- Agricultural items (Rule 3.296)
- Aircraft and qualifying flight simulators (Rule 3.297)
- Amusement services provided by government, various non-profit educational, religious, law enforcement or charitable organizations (Rule 3.298)
- Animals sold by nonprofit animal shelters (Section 151.343)
- Certain ships and vessels (Rule 3.297)
- Clothing and footwear during limited period – Sales Tax Holiday (Rule 3.365)
- Consular exemptions (Rule 3.322)
- Containers, packaging supplies and wrapping (Rule 3.314)
- Disaster-related repair labor (Rules 3.292, 3.310, and 3.357)
- Drugs, medicines, medical Equipment, and devices (Rule 3.284)
- Exportation (Rule 3.323)
- Food and meals (Rule 3.293)
- Food Stamp purchases (Rule 3.293)
- Gas and electricity (Rule 3.295)
- Gold, silver, and Sesquicentennial commemorative metals (Rule 3.336)
- Governmental entities (Rule 3.322)
- Gratuities (Rule 3.337)
- Information services and data processing services – 20% of the value (Rules 3.342 & 3.330 and Section 151.351)
- Internet access service – the first $25 of a monthly charge (Rule 3.366)
- Inter-corporate services (Section 151.346)
- Interstate commerce – vessels and aircraft (Rule 3.297)
- Items taxed by other laws (Section 151.308)
- Labor to restore, repair , or remodel historic sites (Rule 3.357 and Section 151.3501)
- Manufacturing items (Rule 3.300)
- Newspapers, magazines, publishers, sacred writings (Rule 3.299)
- Occasional sales (Rule 3.316)
- Official state coin (Section 151.340)
- Previously taxed items – tax already legally paid to another state (Section 151.303)
- Prior contract exemptions (Rules 3.319, 3.376 and 3.426)
- Property used in the production of motion pictures or video or audio recordings and broadcasts (Section 151.3185)
- Religious, educational, and public service organizations (Rule 3.322)
- Repair, remodeling, maintenance and restoration of a motor vehicle, airplane or commercial vessel (Rule 3.297 and 3.290)
- Repair, remodeling, maintenance and restoration of residential real property (Rules 3.291 and 3.357)
- Rolling stock, train fuel, and supplies (Rule 3.297)
- Sales by or to Indian tribes (Section 151.337)
- Services by employees of property management companies (Rules 3.356 and 3.364)
- Services performed on products being manufactured are exempt if they are for the purpose of "making the product more marketable" and are performed prior to the product's distribution for sale (Rule 3.300)
- Taxable items for use under a contract to improve realty of an exempt organization (Rule 3.291, 3.357, and 3.347)
- Timber items (Rule 3.367)
- Transfers of common interests in property (Rule 3.331)
- Water (Section 151.315)
An exemption certificate must contain:
- The name and address of the purchaser
- A description of the item to be purchased, leased, or rented
- The specific reason the purchase is exempt from tax
- The signature of the purchaser and the date
- The seller's name and address
- A statement that the purchaser will be liable for payment of the sales and use taxes which may become due for failure to comply with the provision of the Tax Code
An exemption certificate is not required if the purchase is:
- Made by the federal government
- The State of Texas and its agencies or political subdivisions
- Exempt by statute, such as sales of water
Miscellaneous Notes Regarding Exemption Certificates:
- Check for certificates which are qualified
- Certificate states that only certain purchases are exempt
- Certificate states that purchases are exempt with the exception of certain items
- Exemption certificate on file pertains only to a specific job number
- Out-of-state governmental agencies and foreign governments do not qualify for exemption from sales tax.
- An exemption certificate cannot be issued to support a tax-free sale/purchase of tangible personal property exported outside the United States.
- A multi-state exemption certificate can be issued to a provider of a taxable service when the purchaser of the service derives benefits from that service for locations both in Texas and out-of-state. The purchaser issuing the certificate assumes all responsibility for accruing tax for the appropriate jurisdictions and remitting the tax to the Comptroller.
- Sellers of auto parts, farm supplies, and similar items need only one exemption certificate from each farmer or rancher claiming the agricultural exemption. This certificate will satisfy the seller's responsibility for all sales made to those individuals. However, each invoice must indicate if the purchase is for a farm exemption.
- FAX copies of signed certificates are acceptable, but the certificates must be dated at the time of the sale.
- If certificates are not obtained at the time of the sale, the seller has 60 days from the date written notice is received from the Comptroller to present them.
- If the purchaser issued an exemption certificate knowing at the time of issuance that the item would be used in a taxable manner, the certificate is invalid and tax is due on the purchase price of the item.
An exempt organization search is available on the Windows on State Government Web site under Texas Taxes/Filing and Paying Taxes.
Exemption Certificate Form - 01-339 (back)
NOTE: This is only a suggested format.
Direct Payment Exemption Certificate
Direct payment exemption certificates are issued by authorized taxpayers who have obtained a direct payment permit and remit all taxes directly to the Comptroller. In order for a taxpayer to obtain a direct payment permit, the taxpayer must purchase at least $800,000 of taxable items annually for use by the entity and not for resale. The taxpayer must be able to show the Comptroller that the accounting methods used clearly distinguish between taxable and nontaxable purchases and between purchases for own use and purchases for resale.
Once the taxpayer receives a direct payment permit, he should use a direct payment exemption certificate for purchases for his own use and a resale certificate for purchases for resale. The direct payment permit holder must report his purchases monthly on the Direct Payment Return (Form 01-119). Purchases cannot be reported on the Sales and Use Tax Return because a timely filing discount is not allowed for direct payment permit holders. This is part of the Taxpayer's Agreement (Item 1 on the application) signed by the taxpayer.
A lump-sum contractor may not accept a direct payment exemption certificate, because the contractor is considered the ultimate consumer of the materials incorporated into the lump-sum job. However, a real property repairman/remodeler may accept a direct payment certificate for a lump-sum job for remodeling or repair of nonresidential real property. The direct payment permit holder would then be required to accrue and remit the taxes due on both the materials and labor.
Direct payment permit holders may not issue direct payment exemption certificates to persons providing nontaxable services. When a direct payment permit holder is doing business with a person who may be selling taxable items as well as nontaxable services, the direct payment exemption certificate must indicate that it does not cover any nontaxable services that may be provided.
When scheduling unsupported Deductions the auditor should:
- Review the list of direct payment permit holders
Note: A searchable database is available at Window on State Government/Texas Taxes/Sales & Use/List of Direct Payment Permit Holders
- Verify all direct payment exemption certificates received after the entrance conference date
- Determine if the Deductions are sales to direct payment permit holders
- Verify the effective date of the Direct Payment Permit by running CICS inquiry MTSUMM or XISUMM
The direct payment permit holder agrees to accrue and remit the applicable state and local taxes on all items used in Texas. If the items are for use in Texas, taxes are due upon first storage in Texas.
Normally, taxes are due based upon date of purchase. However, if a storage facility contains taxable items purchased under a direct payment certificate and at the time of storage it is not known whether the taxable items will be used in Texas or out-of-state, then the direct payment permit holder may elect to report the taxes when:
- The taxable items are first stored in Texas or
- When the taxable items are first removed from storage for use in Texas
The method of reporting the taxes must be consistent. Items taken outside Texas for use solely outside the state are exempt from tax.
If taxes are reported based on first storage and the items are later used out-of-state without any prior uses in Texas, credit may be taken by the direct payment permit holder.
Local taxes are based on the location where the taxable items are first used, stored, or consumed.
Direct payment holder with locations within Texas and out-of-state purchases taxable items from a supplier located in Chicago, Illinois and stores the items in a warehouse in Austin, Texas.
When to report: If purchased for use in Texas, tax is due when brought into Texas.
If at the time of purchase it has not been determined whether the items will be used in Texas or out-of-state, tax is due when first stored or when first removed from storage for use in Texas. Direct payment holder must select one method and use it consistently.
|Taxes Due (based on first storage):||State - Use
City - Austin Use
Transit - Austin MTA Use
If any of the items are later used out-of-state without any prior use in Texas, credit may be taken by the permit holder.
Direct payment holder, with locations within Texas and out-of-state, purchases taxable items from a supplier located in Houston, Texas and stores the items in a warehouse in Austin, Texas.
When to report: If purchased for use in Texas, tax is due based upon date of purchase.
If at the time it has not been determined whether the items will be used in Texas or out-of-state, tax is due when first stored or when first removed for use in Texas. Direct payment holder must select one method and use it consistently.
|Taxes Due (based on first storage):||State - Use
City - Austin Use
Transit - Austin MTA Use
If taxes are reported based on first storage and any items are later used out-of-state without any prior use in Texas, credit may be taken by the permit holder.
Sales to Direct Payment Permit Holders
Sales to direct payment permit holders require special treatment in the audit of the vendor as the direct payment permit holder is responsible for accruing and remitting the tax directly to the Comptroller rather than paying the tax to the seller. During the vendor's audit, the auditor must determine that the sale is to a direct payment permit holder and also verify the effective date of the permit to make sure it is applicable for all of the transactions being examines. The auditor should then follow these guidelines.
|If the seller…||then…|
|collected tax on a sale to a direct payment permit holder||verify that the tax has been remitted.|
|collected tax on a sale to a direct payment permit holder but never remitted the tax||assess the tax in the vendor's audit as tax collected not remitted.|
|has not charged tax and does not have a completed certificate on file||advise the vendor to get a certificate as soon as possible. Include the sale(s) in the vendor's audit.|
|collected state tax but not the appropriate local taxes||verify that the state tax has been remitted. Schedule the local tax in the vendor's audit.|
If the seller is a lump sum contractor, he cannot accept a Direct Payment Certificate from his customer in order to purchase materials for a job tax-free. The contractor must pay the tax on the materials because he is the ultimate consumer – the direct payment permit holders cannot authorize any other entity to use their permit. A seller may accept a Direct Payment Certificate for non-residential restoration, remodeling, and repair and for any sale of taxable services.
Optional Percentage-Based Reporting
Since October 1, 1999, the Comptroller may authorize direct payment permit holders, through a formal contract, to use a percentage-based reporting method. Once approved, the authorized percentage must be used for a three-year period unless the Comptroller revokes the authorization before that period. This percentage-based reporting is available on to direct payment permit holders and applies only to the purchases that the taxpayer is authorized to make under the Direct Payment Permit.
Qualifying taxpayers wishing to report Taxable Purchases utilizing the optional percentage-based reporting must make a written request to the Manager of Audit Division. Initially, the percentages to be reported will be computed through an Audit or Managed Audit of the taxpayer. Subsequent audits of the taxpayer will consist of verifying the reported percentages.
The preliminary meeting between the auditor and the taxpayer's representative(s) will consist of analyzing the various identifiable segments of the taxpayer and the various categories of purchases – assets, expenses, and other. A determination will be made which purchases will be detailed and which will be sampled. For purchases to be sampled, the various Accounts of Interest will be identified. Regardless of whether an Audit or a Managed Audit is being performed on the taxpayer, all sampling procedures must meet Comptroller guidelines. The appropriate transactions may be categorized by:
- Dollar amount
- Type of taxable item purchased
- Purpose for which taxable item will be used, or
- Other standards appropriate to the taxpayer's operations
After the above procedures are completed, a Formal Approval to proceed is granted by the Comptroller, and a Formal Contract between the Comptroller and the taxpayer is executed. An Audit Plan Summary, which includes the procedures to be applied to each identifiable business segment, is developed jointly with the taxpayer. The necessary fieldwork is then completed. If this is a Managed Audit and the taxpayer is performing the fieldwork, Comptroller approval, as outlined in the Audit Plan Summary, is required during the various steps of the fieldwork. All schedules submitted by the taxpayer must be in the format specified by the Comptroller.
The Comptroller reviews the fieldwork, finalizes the schedules, and provides preliminary results to the taxpayer. The Comptroller issues the Letter of Authorization by attaching Exhibit A to the Sales & Use Tax Compliance Agreement. Exhibit A would consist of the various Accounts of Interest and the percentages that will be reported as taxable.
For more information on Percentage-Based Reporting for Direct Payment Permit holders, please refer to Audit Memo AP 75. For more information on Managed Audit policy and procedures, please refer to Audit Memos AP 111 An exhibit of the Sales and Use Tax Compliance Agreement is shown below.
Sales and Use Tax Compliance Agreement
Optional Reporting Method: Percentage-Based
The State of Texas
Comptroller of Public Accounts
This Tax Compliance Agreement is made this ______ day of ________________, _____, between
____________________________________ and the Comptroller of Public Accounts of the State of Texas and will be effective from
___________________ and ending ______________________.
Whereas, Taxpayer is permitted under the Texas Tax Code, Chapter 151, with direct payment permit number ___________________ and
has use tax responsibilities to the Comptroller under that permit number during the period of this Agreement pursuant to the Texas Tax
Code, Subchapter I, Chapter 151, Section 151.419.
Whereas, Taxpayer has requested authorization to report their tax obligations under the Texas Tax Code, Chapter 151, using an optional
reporting method - percentage based, as authorized by the Texas Tax Code, Subchapter I, Chapter 151, Section 151.4171.
Whereas, Section 151.4171 defines "Optional Reporting Method: Percentage-Based" to mean a method by which a taxpayer categorizes
purchase transactions according to standards specified in the letter of authorization, reviews an agreed-on sample of invoices in that category
to determine the percentage of taxable transactions, and uses that percentage to calculate the amount of tax to be reported.
Whereas, Comptroller may, as authorized by Section 151.4171(b), permit the holder of a direct payment permit to use a percentage-based
reporting method under Section 151.4171.
PROCEDURES AND GENERAL PROVISIONS
Comptroller and Taxpayer hereby agree as follows:
1. Taxpayer currently is reporting all taxes imposed under Tax Code, Chapter 151, on purchases of taxable items for its own use under
direct payment permit taxpayer number ______________________. All terms and provisions found within this Agreement apply solely to
purchases Taxpayer is authorized by law to make under this direct payment permit, and no other. This Agreement constitutes an Addendum
to Taxpayer's Direct Payment Permit Agreement executed by Taxpayer pursuant to Section 151.419.
2. The Comptroller has audited Taxpayer for tax due on purchases for the period of _______________ through _________________,
using sampling procedures that both parties agree reflect as closely as possible the normal conditions of Taxpayer's business as required by
the Texas Tax Code, Subchapter A, Chapter 151,("Section 111.0042"). This sampling procedure was found to be appropriate because the
Taxpayer's records are so detailed, complex, or voluminous that an audit of all detailed records would be unreasonable or impractical. This
audit of the Taxpayer determined the correct amount of tax that should have been reported for the sample period based on the law and rules
in effect at the time the audit was performed. The sample procedures were applied to the Taxpayer's ________________________________
and to the total purchases related to each ____________________________________ based on general ledger accounts listed on Exhibit A,
exclusive of General Ledger Account(s) for__________________________________________.
3. Because the sampling procedures, as applied to the general ledger accounts listed in Exhibit A, used in the sample audit produced
reasonable results and indicated a stable and consistent percentage of taxable purchases compared to total purchases, the Comptroller and the
Taxpayer agree that the percentage of taxable purchases determined by the sample audit for (Identifiable Business Segment) listed on
Exhibit A will be appropriately applied to the periods covered by this Agreement, ________________ through _________________. This
Agreement only covers the general ledger accounts listed in Exhibit A and expressly excludes Taxpayer's General Ledger Account(s)
for_________________________________________________. Taxpayer's tax reporting and compliance responsibilities under this direct
payment permit will be met by Taxpayer reporting as taxable amounts on its periodic reports an amount equal to the total purchases for the
general ledger account multiplied by the appropriate taxable percentage listed on Exhibit A as determined by the sample audit. If the
Taxpayer changes its accounting system, business practices and/or operations, it must notify the Comptroller. Failure to notify the
Comptroller of such changes within forty-five (45) days will give the State the right to cancel this Agreement immediately upon written
notice to Taxpayer.
4. The Comptroller will audit Taxpayer's general Ledger Account Number(s) using any method that it finds to be appropriate under
the guidelines found within the Tax Code and rules.
5. If, as a result of a preliminary review of the Taxpayer's records, the State determines that the cost of a more detailed audit of the
Taxpayer's records will be unreasonable in relation to the benefits derived and the procedures described in this Agreement continue to
produce a reasonable result, the Comptroller and the Taxpayer agree that this Agreement may be extended so long as the percentages stated
on Exhibit A remain representative of the normal conditions of the Taxpayer's business and will be bound, subject to the exceptions noted
herein. If an extension of this Agreement is warranted, the percentages stated on Exhibit A will be utilized for reporting purposes, as
mutually agreed upon by both the State and the Taxpayer, and so noted by an addendum to this Agreement. The State retains the right to
audit the Taxpayer's records to determine if the business practices and operations of the Taxpayer have changed.
6. Although the parties intend to be bound to the percentages stated on Exhibit A for assessment and refund purposes, if the State
determines, in its reasonable discretion, that any individual transaction or account, due to extraordinary circumstances, is not representative
of the Taxpayer's business operation for the periods covered by this Agreement, the transaction or the account will be eliminated from the
Agreement upon written notice to Taxpayer and can be separately assessed in the audit by the State or can be subject to a refund to
Taxpayer, whichever is applicable. The terms of this Agreement, however, will remain in force for all other transactions and accounts not
eliminated as extraordinary.
7. The percentages stated on Exhibit A were determined to be correct in reporting Taxpayer's purchases based on the law and rules in
effect at the time the audit was performed. If the State, in its reasonable discretion, determines that there have been significant changes in
applicable law, including changes in interpretation of existing laws and rules, which render the percentages on Exhibit A no longer
representative of Taxpayer's taxable purchases, the State shall have the right to terminate this Agreement immediately upon written notice to
the Taxpayer. This Agreement does not relieve the Taxpayer of its responsibility to report in accordance with changes in law and
interpretations of law and rules.
8. Except as otherwise provided herein, this Agreement may be terminated by either party, provided a written notice of sixty (60) days
is given to the other party prior to the termination date. Upon termination under this paragraph, the Taxpayer and the State agree that a
representative sample of transactions will be mutually selected and examined to determine that the factors for tax reporting and compliance
for periods within the term of this Agreement were representative of Taxpayer's business activity. If this examination reveals that the factors
for tax reporting are not representative of Taxpayer's business operations, the State shall have the right to separately assess the Taxpayer, or
can be subject to a refund to the Taxpayer, whichever is applicable.
9. Taxpayer represents and warrants that it has not given, offered to give, and does not intend to give at any time hereafter, any
economic opportunity, future employment, gift, loan, gratuity, special discount, trip, favor or service to any public servant or state employee
in connection with this Agreement.
10. This Agreement may be amended only upon written agreement between Comptroller and Taxpayer, but in no case shall this
Agreement be amended or construed so that it conflicts with the laws of the State of Texas or rules or regulations adopted by Comptroller
under those laws.
11. This Agreement shall be governed by and construed in accordance with the laws of the State of Texas. The venue of any suit
brought for any breach of this Agreement is fixed in any court of competent jurisdiction of Travis County, Texas.
12. Any correspondence related to this Agreement directed to the Comptroller should be sent to the Manager of Audit Division. Any
correspondence related to this Agreement intended for Taxpayer should be directed to: _________________________________________.
13. Comptroller and the State of Texas shall not be liable for any damages or any other amounts to Taxpayer or any other entity or
person resulting from any termination or cancellation of this Agreement for any reason.
Authorized Signatures Comptroller of Public Accounts Taxpayer By:____________________________ By:____________________________ Martin Hubert Name:__________________________ Deputy Comptroller Title:_________________________ Date:__________________________ Date:__________________________
Direct Payment Exemption Certificate Form
State of Texas
Direct Payment Exemption Certificate
Limited Sales, Excise, and Use Tax
Direct payment authorization number: __12345678903______________________
The undersigned hereby claims exemption from the payment of state, city, county, MTA, and/or CTD sales and use
taxes upon its purchases of taxable items from:
Seller: ___ABC Services, Inc._____________________
Street address: __1212 Gibson Lane________________
City, state, zip code: ___Houston, Texas 77043_______
This certificate will remain in effect until the seller is otherwise notified.
Description of items purchased. If this space is left blank, this certificate covers everything on the attached order, invoice, or billing.
This certificate does not cover:
(1) Purchases of taxable items to be resold.
(2) Sales or rentals to any purchaser other than the permit holder.
(3) Sales or rentals of motor vehicles subject to the motor vehicle sales and use tax (Chapter 152) and interstate motor carrier sales and use tax (Chapter 157).
(4) Materials or supplies used, transferred, or consumed by a provider of a nontaxable service.
The permit holder agrees not to permit others (including its contractors and repairmen) to use the undersigned's direct payment authorization to purchase materials tax-free. This certificate is not valid for lump-sum new construction projects to improve real property.
The undersigned agrees to accrue and pay the tax to the Comptroller of Public Accounts as required by statute.
Permit holder: _XYC Corporation______________
Authorized signature: _Pablo Ximenez, Treasurer__
Date of purchase: ____June 22, 2006__________
NOTE: The above form is only a suggested format.
Alcoholic Beverage Exemption Certificate
A resale certificate is not required on the sale of liquor, wine, beer, or malt liquor from a licensed manufacturer, wholesaler, or distributor to a retailer licensed under the Texas Alcoholic Beverage Code (Rule 3.289). These sales are presumed to be for resale.
An Alcoholic Beverage Exemption Certificate may be issued to the supplier by a holder of a mixed beverage permit, late hour mixed beverage permit, or daily temporary mixed beverage permit issued by the Texas Alcoholic Beverage Commission. The holders of mixed beverage permits may not necessarily be permitted for sales tax.
The certificate may be issued to suppliers in lieu of sales tax on the purchase of alcoholic beverages, ice, mixes, and nonalcoholic beverages if the receipts from their resale of these items are taxable under Tax Code, Chapter 183 (Mixed Beverage Tax).
Alcoholic Beverage Exemption Certificate Form
I, the undersigned, hereby claim an exemption from payment of taxes under the Tax Code, sec. 151.308(8), (9), for the purchase
of the taxable items described below or on attached order or invoice to be purchased from ____________________
I claim this exemption because I hold _____________________(type of permit)_________________________________
_______________________________, _________________(number of permit)_______________________________
issued by the Texas Alcoholic Beverage Commission. I understand that I will be liable for payment of the limited sales and use
tax if I use the items covered by this certificate in any manner or for any reason other than in a sale which is subject to the gross
receipts tax as levied under Texas Tax Code, Chapter 183.
Executed this ___________ day of ____________________, 20___.
Business Address ___________________________________________________
Consular Tax Exemption Cards
The foreign diplomat should present his consular tax exemption card to the vendor when purchasing taxable merchandise.
A consular tax exemption card is issued by the U.S. Department of State, is not transferable, and may not be used by others, including spouses.
For audit purposes, check individual invoices for the signature of the consular official and the consular exemption number which appears on the back of the card.
Prior Contract Exemption Certificate
A contract that is legally binding and entered into prior to a law change or tax increase may be exempt due to a prior contract exemption. Prior Contract Exemption Certificates must be furnished by a contractor to the vendor for all purchases which qualify for the prior contract exemption.
Prior Contract Exemption applies to:
- Contracts for taxable items entered into prior to the date of a tax rate increase
- Contracts for taxable items entered into prior to a tax base increase
For example, the taxable items purchased, leased, or rented were not subject to sales tax prior to the contract signing date.
- Any contract entered into prior to the date the city, county, MTA/CTD tax takes effect in any city, county/SPD, MTA/CTD which may affect the contract, if the contract is not subject to change or modification by reason of the tax
- An obligation of a bid submitted prior to the date the city, county, MTA/CTD tax takes effect in any city, county/SPD, MTA/CTD which may affect the contract, if the bid may not be withdrawn, modified, or changed by reason of the tax
- Annexation of the job site into a city having city tax in effect
- A cancellation clause in a contract will not cause the loss of a prior contract exemption
Refer to Rule 3.319 - Prior Contracts - for more detailed information
- Any change orders that constitute additions to the original contract will not be included in the prior contract exemption
The original part of the contract may still retain its prior contract exemption if the change orders can be separately identified.
- Any renewal or exercise of an option to extend the terms of the contract will be considered a new contract, thus not qualifying for the prior contract exemption
- Also includes leases of tangible personal property that are entered into prior to a tax rate or tax base change. (Hearing #27,336)
The prior contract exemptions apply only if the Texas legislature has provided enabling legislation. The effective date and statute of limitations date on prior contracts will also be governed by the enabling legislation.
The prior contract exemption is only good for three years from the date the city, county, SPD, or MTA/CTD takes effect in any taxing jurisdiction.
Note: Currently, there is no enabling legislation which would allow for a prior contract exemption.
Prior Contract Exemption Certificate Form
State and local sales or use tax is due on the divergent use of a taxable item purchased under a valid resale or exemption certificate.
If a taxable item purchased under a valid resale or exemption certificate is used in a taxable manner, the purchaser is liable for tax on the fair market rental value of the tangible personal property or the fair market value of the taxable service for the period of time used or on the original purchase price of the item. The fair market rental value is the amount that a purchaser would pay on the open market to obtain that taxable item or taxable service.
At any time the person using the tangible personal property or the taxable service may stop paying tax on the fair market rental value and instead pay tax on the original purchase price. When the person elects to pay tax on the original purchase price, credit will not be allowed for taxes previously paid based on the fair market rental value.
An office supply retailer located inside the city limits of Houston, Texas withdraws a desk (cost of $1000, retail price of $1500) from a valid tax-free inventory for use in its office. The retailer adds the desk to its furniture and fixtures section of the general ledger and will depreciate the desk throughout the useful life. The desk was purchased from a wholesaler located in Dallas, Texas. The retailer owes tax on the cost ($1000) of the desk to the following taxing jurisdictions:
- State of Texas
- City of Houston
- Houston MTA
By law, properly executed resale or exemption certificates should be in the possession of the seller at the time of the nontaxable transaction. Auditors should allow the taxpayer a reasonable amount of time (depending on the circumstances of the audit) to obtain the missing certificates relating to unsupported tax-free sales before the audit is finalized.
If the taxpayer did not acquire all certificates needed within the time period allowed by the auditor, Texas Tax Code §151.0054(e) allow taxpayers sixty days to obtain the missing certificates from the date the Comptroller gives written notification requiring them. A sixty-day letter will be sent by the Audit Processing Section of Audit HQ in Austin. All certificates acquired during this time are subject to verification.
The Sixty-Day Letter does not apply to:
- The United States government (Sec. §151.309(1)(2)(3)
- The State of Texas and its political subdivisions (Sec. §151.309(4)(5)
- Sales which are exempt by statute; e.g., water
- Sales which by their nature qualify for a resale or other exemption; e.g., bales of cotton
Issuing the Sixty-Day Letter
After the audit is billed, the taxpayer must request a redetermination hearing in order to be able to submit documentation, including certificates. The Audit Processing Section of Audit HQ will send an acknowledgement letter to the taxpayer in response to his Statement of Grounds. If certificates are involved, the sixty-day notification will also be included in the body of the letter. The taxpayer will then be allowed sixty days from the date the letter is received in which to provide additional documentation and/or certificates that support his Statement of Grounds.
A deduction will not be granted on the basis of certificates delivered to the Comptroller after the sixty-day period.
An example of a sixty-day letter is shown next.
60-Day Letter Example
STATE OF TEXAS
September 25, 2006
Mr. Allen B. Clark, President
ABC Services, Inc.
P. O. Box 2468
Houston, Texas 77043-2468
Dear Mr. Clark:
I have received your request for a redetermination hearing on the limited sales, excise, and use tax audit performed
on ABC Services, Inc., Taxpayer No. 12345678903, for the audit period April 1, 2004 through March 31, 2006. You
have sixty (60) days from the date of this letter in which to submit any additional documentation to support your
statement of grounds. An Auditor from Houston South Audit will contact you to make arrangements to review this
documentation on the 61st day.
Your case will be reviewed by Houston South Audit, and if any relief can be granted at this initial stage you will be
If we determine the issues in dispute cannot resolved by the audit office, you have the right to meet with an
Independent Audit Reviewer (IAR), if you have not met with one previously. This can be initiated by notifying the
auditor on or before the 61st day. If you previously met with a IAR or choose not to exercise this option, your
request will be forwarded to the Comptroller's General Counsel Division. You will be notified by letter of the name
and telephone number of the hearings attorney assigned to your case.
Please do not hesitate to call Jennifer Hernandez in the Houston South Audit Office if your have any questions. You
can contact the audit office by calling 713/314-5700.
512.936.5872, 1.800.531.5441-Ext. 65872
Letter of Assignment
A Letter of Assignment is used when a taxpayer reports their sales activity under the wrong taxpayer number. This can happen when a sole owner incorporates but continues to report sales tax information under the sole owner's number instead of the corporation's taxpayer number. When this happens, the auditor must obtain a Letter of Assignment, and two audits must be performed. To determine the audit period of each entity, the auditor must remember that the goal is to bring all entities current.
In the situation above, if the corporation were in existence for the entire audit period, the audit of the sole owner would be a no tax change audit. All adjustments, if any, would be assessed in the audit of the corporation. The audit period of the sole owner would start at the beginning of the audit period and go through the last report filed. The audit period of the corporation would also start at the beginning of the audit period and go through the last period of the audit (the two audits may have the same audit period).
If the sole owner incorporated during the audit period but continued to report sales information under the sole owner number, the audit of the sole owner should start at the beginning of the audit period and continue through the last report period filed under the sole owner number. Adjustments, if any, should be made on the sole owner audit through the date they incorporated. Adjustments after incorporation should be included in the audit of the corporation.
If the auditor has to permit the succeeding entity, do not back date the permit within the audit period. First business date should begin one day after the ending audit period. The new entity will be non-permitted for the audit period and will default to monthly filer when the audit is uploaded. Set up CATS and WATS as monthly. Inform the taxpayer that they will be responsible for filing all appropriate returns that fall after the audit period.
In addition, the auditor needs to capture Secretary of State (SOS) file numbers of entities that may be liable for franchise tax. If the taxpayer is a Texas limited partnership, a foreign limited partnership, or a Texas professional association, then the auditor will need to go to the SOS Web site to find the file number. This file number must be entered on XUMAST. If the taxpayer is a corporation or a LLC, the needed information is already captured on XISUMM (tax code 13) for those corporations and LLCs that are registered with the Texas SOS.
The audit procedures are:
- Obtain an assignment from the entity (assignor) that reported amounts to the Comptroller for a related entity under the assignor's number
- Document the procedure in the audit plan if the audit is "no tax change" - be sure to notify the taxpayer that the tax was reported under the wrong number
- Audit all entities in order to close the audit period for each to avoid future problems - submit TCR's and Applications to reflect the correct first sale dates and out-of-business dates of all entities
- Only additional tax due or credits due should be assessed in the audit of each entity - the tax due or credits do not include amounts reported under the incorrect taxpayer number
- A comment should be made on Agency Work Manager for both taxpayers listing the related names and taxpayer numbers for each audit, particularly for credit audits in which tax should not be refunded due to a related deficiency audit
All of the related audits should be batched together.
Letter of Assignment Example
ASSIGNMENT To the Comptroller of Public Accounts for the State of Texas: ______________________________ erroneously reported and remitted (assignor) __________________________ taxes directly to the State of Texas under (tax type) account number _______________________________________ during the period (assignor's acct. #) _________________________ to ________________________ . These taxes were the responsibility of ______________________________ (assignee) and should have been reported and paid to the State by __________________________ under the account number (assignee) ___________________________ . (assignee's acct. # or n/a) ________________________ has assigned all right, title, and (assignor) interest to credit or refund for the taxes erroneously reported and paid to the State as described in this assignment to _____________________________ . ___________________________ further (assignee) (assignor) states that he has not previously claimed a refund nor taken a credit for these taxes and will not claim a refund or credit for these taxes in the future. Sincerely, ______________________ (name) _______________________ (title) ________________________ (date)
Sales to Destinations Outside of Texas
The sale of tangible personal property which, under the sales contract, is shipped to a point outside Texas is exempt from the tax if:
- Merchandise is for export
An exemption can be claimed when tangible personal property is exported beyond the territorial limits of the United States. The first step in reviewing export sales is to refer to the shipping addresses on the invoices.
Proof of export may only be shown by:
- A copy of a bill of lading issued by a licensed and certificated carrier which shows a delivery point outside the territorial limits of the United States
- Formal entry documents from the country of destination showing that the property was imported into a country other than the United States
- A copy of the original airway, ocean or railroad bill of lading issued by a licensed and certificated carrier which describes the property being exported and the freight forwarder's receipt showing that the forwarder took possession of the property in Texas
- Documentation provided by a licensed United States Customs Broker, certifying that delivery will be made to a point outside the United States
- A maquiladora exemption certificate issued by a Maquiladora Enterprise chartered by the Mexican government to import raw materials and component parts into Mexico for use in manufacturing items to be primarily exported from Mexico. The Maquiladora Enterprise must also provide a copy of its maquiladora export permit issued by the Comptroller of Public Accounts.
When merchandise is delivered to a customs broker or a forwarding agent for export, export charges are billed to the retailer's customer, and bills of lading, export declarations, etc. will be in the customer's files.
- Shipment is in the seller's vehicle
Examine delivery receipts, contracts or other correspondence in order to ensure that the taxable items were indeed delivered to a location outside Texas
- Delivery is made by the seller to a common carrier for shipment to a consignee
Examine Bills of Lading, freight invoices, parcel post receipts and record of parcel post shipments in order to verify that the taxable items were delivered to an out-of-state customer
A transaction is not exempt as a sale in interstate commerce if:
- The merchandise is delivered to a purchaser or purchaser's agent in Texas who later removes it from Texas (see Carrier Rule 3.297 for an exception for aircraft) OR
- The merchandise is delivered to a carrier in Texas who is not operating under a commercial bill of lading
The first step in reviewing sales in interstate commerce is to refer to the shipping address on invoices. Out of state sales may be supported by purchase orders and/or shipping documents. These documents usually contain instructions to deliver merchandise to the carrier.
Deductions may include cash discounts. It is important to analyze how the taxpayer reports cash discounts.
Deductions for cash discount are:
- Actual discounts taken on taxable sales or services
- An average percentage of taxable sales or services
- A ratio of the total discounts taken based on the ratio of taxable sales to total sales
- The discount applicable to the sales price
Each discount must meet the following requirements. The discount:
- Was allowed by the seller
- Was taken by the purchaser
- Was applied to a taxable sale or service
- Was computed on the selling price inclusive of tax, or computed on the selling price exclusive of tax and tax was refigured - see the first Example on the following page
- Is really a cash discount – make certain that the difference between the invoice price and the cash received is truly cash discount and that the customer did not deduct sales tax on a taxable item
Examine the taxpayer's working papers to determine how the deduction was computed. Deductions should be verified by tracing sales invoices on which the discounts were allowed to the cash receipts journal.
NOTE: If the discount is calculated on the original sales price excluding tax and tax is not recalculated, then the original tax is still due. See the second example on the following page.
Cash Discounts, Examples
Returns of taxable merchandise are deductible if the following conditions are met:
- The original sale has been reported as taxable, and
- The taxable sales price including tax is refunded
A handling or restocking charge does not affect the deduction allowed for returned merchandise.
In verifying returned merchandise, be sure that only the sales price of taxable merchandise is claimed as a deduction.
Credit for Tax Paid
Allow credit in an audit for taxes paid to a supplier or taxes accrued and reported on a purchase if:
- The item was resold by the purchaser prior to making any use of the item
- The item is attached or becomes an integral part of other tangible personal property which is sold
- Care, custody, and control of the property is transferred to the client in a taxable service
In audits, credits can be given for local taxes paid on purchases even if the taxpayer never reported any local taxes during the audit period. However, taxpayers can claim credits for local taxes on returns only if the taxpayer reported to the same local taxing jurisdictions in which credit is being taken and only up to the amount reported. If the credit taken on a return results in an overall credit figure, Allocations Division will amend prior period returns, zeroing out the applicable local taxes, until the credit is exhausted. If one or more of these returns fall within an audited period, that audit will have to be amended in order to process the credit, and an audit amendment request will be generated.
Multistate Tax Credit
Due to various state sales and use tax laws, it is possible that an item may be legally subject to sales/use tax in more than one state. In this case, the tax must be paid first to the state in which the item is used in a taxable manner. The definition of use also includes possession, storage, or other consumption. If the item is then moved to another state in which the item is also taxable, only the additional percentage of tax is due.
Credit for Texas use tax will not be allowed for taxes paid to another state when the tax was not legally due to that state.
Credit for tax legally paid to another state is applied in the following order:
- Transit (MTA/CTD)
- Special Purpose District (SPD)
A taxable item was purchased in Oklahoma, and the purchaser took possession of the item in Oklahoma. Oklahoma sales tax of 6% was due and paid at the time of purchase. The item was then shipped by the purchaser to Dallas where 8 ¼% use tax was due (6 ¼% State, 1% City of Dallas, and 1% Dallas MTA). Because of the multi-state tax credit, the taxpayer will only owe an additional 2 ¼% tax on the original purchase price. The 6% tax credit is applied to Dallas MTA tax first, then Dallas city, then the State.
Note: If the taxable amount of the item purchased was $25,000, the auditor would enter $9,000 as taxable on the exam for State tax only in order for the system to yield the correct tax amount.
$25,000 x 8 1/4% use tax due - $2,062.50 $25,000 x 6% Ok.sales tax paid - -1,500.00 --------- $562.50 = Texas Use Tax Due
$562.50/.0625 Texas Use Tax Rate = $9,000
A taxable item was purchased via phone order from a vendor in Oklahoma, and the vendor shipped the item directly to the purchaser in Dallas, Texas. The vendor charged 6% Oklahoma sales tax. An audit of the Texas purchaser revealed that no Texas taxes were accrued or paid on the purchase.
The auditor would assess 6 ¼% Texas State Use Tax, 1% City of Dallas Use Tax, and 1% Dallas MTA Use Tax on the entire taxable amount of the item purchased. No credit would be allowed the purchaser for the 6% Oklahoma sales tax paid. The purchaser would have to apply to the Oklahoma vendor for a refund of the Oklahoma tax paid in error.
Bad debt deductions may be claimed for sales and use tax purposes only on the portion of the sales price of a taxable item or service which cannot be collected. Bad debt deductions may not be claimed for unpaid balances if the retailer has been reporting tax liabilities on the cash basis.
A seller's records must show the following in order to claim a bad debt deduction:
- Any evidence to show that the uncollected amount has been designated as a bad debt in the seller's books and records - the seller's records must show that a bad debt deduction has been or will be claimed for income tax purposes
- Date of sale or service
- Name and address of the purchaser
- Amount on which the retailer charged tax
- Amount of the invoice (taxable and nontaxable charge)
- Partial payments or other credits applied to the account of the purchaser
Period In Which Deductions Are Allowed
Bad debts may be deducted:
- In the reporting period in which the retailer recognizes the unpaid amount as a bad debt and the deduction is recognized for federal tax purposes
- In the period in which the federal tax return is filed and deductions are included
If the current federal income tax return has not been filed, the deductions may be allowed if write-offs were consistently made on the federal income tax returns in earlier years and recorded as bad debt expense in the current year
- Within the four years following the date the account is entered in the retailer's books as a bad debt
The procedure used by a taxpayer to record a bad debt may vary depending upon the accounting methods and procedures used. Some common procedures are:
- Charging an account other than bad debt expense
For example - Bad debts/repossession losses are charged directly against the cost of goods sold instead of a bad debts expense account
- Consolidating debts
Examine the consolidated account balance to insure that the balance is applicable to a taxable transaction
- Writing-off of estimated bad debts
Taxpayer may estimate bad debts based on prior year's experience
Amounts Not Deductible
The following items may not be included as bad debt deductions:
- The tax included in the write-off
- Expenses of collecting a bad debt
- Amounts paid to a third party for collecting a bad debt
- Any amount not subject to sales tax
(Example - finance charges, late charges, etc.)
- The tax the customer refuses to pay to the vendor
- Differences in tax charged and current tax rates
- For example, a taxpayer bills $725.00 in sales tax at a rate of 7.25% (6.25% State and 1% City) on a $10,000 sale on August 1, 2006 and reports this sale on his 0608 return. On October 1, 2006, the City tax rate is increased to 2%. The taxpayer recognizes this sale as a bad debt on November 1, 2006. The taxpayer must lower the amount of the bad debt deduction to $5,000 for City Tax purposes. Otherwise, too much credit will be allowed.
- Unpaid balances if the retailer has been reporting tax liabilities on the cash basis
- Amounts which are covered by insurance indemnification
- Amounts not reported as subject to tax
Verification of Bad Debts Deductions
Examine the accounting records and Federal Income Tax returns to determine that bad debt deductions have been properly computed and written off.
Verify deductions by:
- Examining individual accounts receivable write-offs
- Determining if all payments and/or credits were applied to the total sales amount
- Verifying that any unpaid balance is applicable to a taxable transaction
Bad Debt Recoveries
Review the general accounting records to determine that collections of previously charged-off accounts have been reported properly for sales and use tax purposes.
Collections are to be reported on the same pro-rata basis used for claiming the bad debt deductions.
Any indemnification received from insurance should be used to reduce the allowable bad debt loss.
When merchandise is repossessed from a debtor and resold by the creditor, then the value of the merchandise should not be used to lower the value of the claimed bad debt write-off.
Tax Erroneously Collected
Tax is erroneously collected when tax is charged on a transaction but no authority exists under the statutes to charge and collect the tax.
Examples include, but are not limited to:
- City, County, SPD, and/or MTA/CTD tax when none is due
- Tax charged and collected on exempt items
- Tax on non-taxable labor and nontaxable services
- Tax at excessive rates
- Tax on out-of-state shipments
The taxpayer is required to pay tax to the state when tax (state and local) is erroneously collected unless a refund is made to the customer.
Allow credit when the taxpayer shows:
- Refunds are made to customers
- Tax has been credited to a customer's account for tax erroneously collected via a credit memo - verify that the customer has received the credit
During an audit, it is noted that the taxpayer collected $82.50 in State, City, and MTA taxes on a $1,000.00 sale of bottled water; however, the tax was not reported even though it was collected from the customer. The auditor needs to make an audit adjustment for a taxable amount of $1,320.00 allocated to State only ($82.50/.0625 State tax rate).
The auditor may make an audit adjustment for a taxable amount of $1,000.00 allocated to State, Contingent City, and Contingent MTA. By allocating to Contingent City and Contingent MTA, the State will receive the total tax collected in error.
Taxable Purchases are taxable items (tangible personal property or taxable services):
- Purchased for personal or business use from out-of-state or in-state vendors on which no Texas sales or use taxes were paid or accrued
- Removed from a tax-free inventory for personal or business use
- Purchased tax-free for resale but which were given away for promotional purposes or gifts
- Purchased tax-free for an exempt use but which are later used in a taxable manner
- For personal or business use purchased from out-of-state vendors on which another state's sales tax was legally due and paid
Additional use tax is due when the items are brought into Texas if the other state's tax is at a lower rate than the sales tax due in Texas. If tax is paid to an out-of-state vendor that is not legally due, credit is not allowed.
On July 1, 2006, a Texas taxpayer goes into Oklahoma and buys a typewriter for personal use and pays 3% Oklahoma sales tax. The taxpayer then brings the typewriter into Galveston. The taxpayer owes an additional 5 1/4% use tax. The additional tax should be allocated to state tax only. See the "Tax Charged on the Invoice" section of "Audit Procedures for Taxable Purchases" later in this chapter for detailed allocation information.
- Originally purchased for resale but subsequently put to business or personal use
Internal Control Questions to be Analyzed and Evaluated for Taxable Purchases
- Are all purchases routed through the purchasing department?
- What is the policy for issuing resale or exemption certificates? Is a certificate or declaration part of the purchase order?
- Are purchases made by cash? If so, what records are available to support these purchases? What kinds of purchases are made by cash?
- Are some purchases made electronically using a company credit or debit card for payment?
- When purchases are made in this manner "hard copies" of the purchase invoices are not available.
- What is the taxpayer's definition of an asset? Does the Depreciation Schedule account for all capital assets? How are asset write-offs or retirements accounted for? What dollar amount is capitalized? Does the taxpayer manufacture equipment for use in the business? Are parts taken out of inventory to manufacture this equipment?
- How are inter/intra company transfers handled and booked?
Document Controls (Invoices and Purchase Orders)
- What is the volume of purchases per month? Are there any seasonal purchases fluctuations?
- What is the control over purchase invoices? What department makes purchases? Who is authorized to make purchases? Who is responsible for determining whether a purchase is taxable or exempt?
- Are purchase invoices matched with purchase orders or receiving documents? Are purchase invoices numbered so that invoices can be processed by check or voucher number? Were there any changes to the numbering or filing system?
- How are purchase invoices filed (i.e., alphabetically, by invoice number, check number, voucher number, year, month or other)?
- Does the actual purchase invoice or order have the account code written or stamped on it?
Recording Process Controls
- Does the taxpayer maintain an accrual account for use tax? Are the location of the vendor and/or point of first use or storage incorporated in the coding?
- Are all purchases recorded in a summary journal?
- Is a cash disbursement journal, check register, voucher or warrant register available for the entire audit period?
- Is there an accounting manual and employee approval for determining distribution of invoice charges to general ledger accounts?
- Is the distribution of charges double-checked periodically?
- Is the accounts payable ledger balanced periodically with the general ledger control account?
- What controls are used to insure that all purchases and tax accruals were processed to the computer and recorded?
- How are credits for goods returned to vendors accounted for? How are damaged goods, back orders, trade-ins and inventory withdrawals accounted for?
- Are purchases made to employees cleared through the regular purchasing procedures? How are employee reimbursements accounted for?
- Are detailed records computerized? If so, would it be feasible to use computer audit techniques?
- What are the procedures and policies for computer coding for:
- Account distribution?
- State and local taxes?
- Tax rates?
- Taxable or exempt sales?
- Are the codings maintained and kept up to date? How are law change items incorporated into the coding system?
- How are prior contract exemptions handled?
Audit Procedures for Taxable Purchases
In examining taxable purchases or services, perform the following steps:
- Determine the taxpayer's knowledge of the law pertaining to taxable purchases and services
- Evaluate the system of internal controls to determine reliability of the records
- Determine how the taxpayer accounts for taxable purchases and services
- Analyze the tax accrual account and compare to the reported tax - evaluate all differences
- Review all pertinent books and records relating to taxable purchases and services - see "Records to Examine"
The audit procedures used will depend on each specific taxpayer situation. The auditor will have to make some of the following decisions using auditor judgment:
- What expense accounts should be analyzed? The expense accounts should be evaluated based upon materiality and other audit circumstances (i.e., tax law change items, manufacturing exemptions, account code changes, etc.).
- Should expense accounts be sampled or detailed? Consider the volume and detail of the records, the completeness of the records and the cost/benefit; relationship of the procedures involved.
- If sampling procedures are implemented, what sampling unit will be used (i.e., transactions, clusters, months, etc.)?
This will depend on several factors:
- The taxpayer's recordkeeping method (i.e., how invoices are filed.).
- If records are missing, etc.
- Dollar stratums of the items sold.
Once these decisions are made, audit procedures can be implemented.
- Examine source documents in detail or by sampling
- Schedule all additional taxable purchases or services on which tax was not reported
- Direct Payment Permit holders may be authorized by the Comptroller to report Taxable Purchases using a percentage-based reporting method. Audit procedures would have to be implemented accordingly. For more information on Percentage-Based Reporting for Direct Payment Permit holders, see A P Memo 75.
Records to Examine
Review the following records for unreported taxable purchases and services.
- General Ledger
- Depreciation Schedule
- General Journal entries
- Federal Income Tax returns for expenses and asset purchases or services
- Tax accrual work papers
- Chart of Accounts. Look for:
- Expenses involving tangible personal property and taxable services
- Advertising (for promotional items, etc.)
- Experimental and exploratory (for items used)
- Miscellaneous expenses
- Capital assets
- Overhead expenses (office supplies, paper, etc.)
- Research and development
- Purchase invoices. Look for:
- Description of items purchased
- Invoices which include taxable purchases and services along with inventory items (i.e., display items, samples, etc.)
- Date of invoice - if the taxpayer is on the accrual basis of accounting, examine the date of the invoice; if the taxpayer is on the cash basis of accounting, examine the date the invoice was paid
- Unpaid invoices (accounts payable)
- Charges for taxes
- Examine for any refund of sales taxes previously paid to a vendor
- Account codes
NOTE: Occasionally, an invoice may describe merchandise in technical jargon or be a catalog number. An examination of the related purchase order or other documents may be necessary to explain the purchase invoice as to what was actually purchased.
- Contracts, job files
- Cash disbursement and purchase journals
- Accounts payable and notes payable ledgers
- Journal entries for asset transfers between companies
- Leases of assets or construction of assets by the taxpayer
- Asset ledger file
- Financing leases
- Tour the facilities to understand and examine assets maintained and possible manufacturing exemptions. Manufacturers are allowed certain purchase exemptions depending on how the purchases are used in processing and also their useful lives. Make inquiries of the purchase manager, plant manager, etc.
Tax Accrual Reconciliation
Some taxpayers have a tax accrual account which summarizes tax accrued for Taxable Purchases. Analyze the tax accrual account and compare it to reported Taxable Purchases on the sales tax history. Evaluate all differences. Schedule any unreported Taxable Purchases. Evaluate all debit entries.
Purchases can be divided into the following areas:
- Expense Items
Detail or sampling procedures may be used for expenses. Generally, the volume of transactions in this area is numerous and sampling may be necessary. Schedule as audit adjustments any expense items on which taxes have not been paid to the vendor or reported to the Comptroller. See Chapter 6 for more information.
- Capital Assets
Generally, the volume of taxable purchases related to fixed assets is smaller than purchases associated with expense items and involves larger dollar amounts. This portion of the audit should preferably be examined in detail. However, if there is a large volume of capital assets, sampling procedures could be utilized. If capital assets are sampled, the purchases must be shown to be consistent in occurrence and dollar value. In most cases, stratification is necessary.
Items Withdrawn from Inventory
If a taxpayer maintains a tax-free inventory (items purchased with valid resale/exemption certificates) and withdraws items from this inventory for personal use, then taxes are due on the items withdrawn. Tax is based on the fair market rental value for the period of time used. The fair market rental value is the amount that a purchaser would pay on the open market to rent or lease the tangible personal property for use. See Rule 3.285 and 3.287.
A taxpayer may elect to pay the tax on the original purchase price of the item withdrawn from inventory. If the taxpayer makes this election, credit will not be allowed for any taxes previously paid based on fair market rental value.
Examine the following:
- Credits to inventory and purchases accounts
- Costs of goods section on federal income tax returns
- Intra-company transfers
- Journal entries
Discuss any inventory withdrawals with the taxpayer.
Divergent Use by Manufacturers
If a manufacturer issues an exemption certificate to purchase qualifying tangible personal property tax-free and subsequently uses the item for a nonexempt purpose:
- Tax is due in the month in which the divergent use occurs equal to 1/48th of the purchase price multiplied by the percentage of divergent use during that month multiplied by the tax rate (State and any applicable Local taxes).
- The 48-month period used in calculating divergent use begins on the date of purchase of the equipment.
- The divergent use percentage for a month is computed by taking the total divergent use hours of operation of the equipment in the month divided by the total hours of operation of that equipment during the same month.
- If the divergent use percentage in a month is 5.0% or less, no tax is due.
- No tax is due if the divergent use of qualifying equipment is made after the 48-month period.
Tax Charged on the Invoice
If a purchase invoice includes a charge for taxes, confirm that:
- The correct Texas state, city, county, SPD, and/or MTA/CTD tax rates were used to compute the taxes
- Tax was paid on the entire taxable portion of the invoice
- Taxes charged on the invoice were actually paid
- Taxes charged were for Texas sales taxes and not for another state
If taxes were charged for another state, check for the following:
- If taxes were erroneously paid to another state, then set up an adjustment for all Texas taxes due. The taxpayer will have to go to the vendor for credit. If tax was erroneously accrued to another state, then the taxpayer will have to go to that state for credit.
- If correctly and legally paid to another state, credit for this tax paid will be allowed against any Texas use taxes owed. Allow the tax credit in the following sequence:
- MTA/CTD tax
- SPD tax
- County tax
- City tax
- State tax
Multi-State Tax Credit, Examples
NOTE: In both of the above examples, the auditor must enter footnotes explaining why the applicable taxable amounts were entered.
Taxes Not Paid to Vendor
If taxes were not paid to the vendor as indicated on the invoice, confirm if the taxes were accrued and paid to the Comptroller.
- Check to see if any discounts were taken by the taxpayer.
- Double-check that the purchases or services are taxable items.
If tax is not accrued and reported, then make an adjustment for the applicable taxes due.
Automotive Oil Sales Fee
Auditors should always look at purchases of oil when conducting sales tax audits of auto businesses, auto parts stores, and related businesses in order to ensure that the Automotive Oil Sales Fee has been paid. The fee is collected by oil manufacturers or oil importers who make a first sale or use of automotive oil in Texas. The fee is two cents per quart of oil. Many out-of-state sellers of automotive oil are not permitted for this tax, thus do not collect the fee. Run the MTSUMM or XISUMM inquiry on CICS to verify if a seller is permitted for this tax (Tax Code 69). See Audit Memo AM 1688.
Alternative Auditing Methods
An audit estimation should have a valid basis for its assessment. Amounts, though based on estimates, must be defensible in Redetermination Hearings and /or in State District Court. The following auditing techniques may be used to establish amounts for sales or purchases when some records are available but are insufficient for normal auditing techniques.
- Records from Outside Sources
- Bank Deposit Method
- Cost Accountability Method
- Gross Profit (Mark-up) Method
- Unit Volume Method
- Net Profit Method
- Estimated Methods
- Grocery/Convenience Stores
Note: Estimation procedures for grocery and convenience stores are fully discussed in the Audit Procedures for Grocery Stores Manual.
Audit procedure manuals detailing specialized industries are available to all audit staff. Some are currently online at the Comptroller's Web site while others are being revised so that they, too, may be available online. For a complete list of these manuals see Chapter 1 of this manual.
Records from Outside Sources
If a taxpayer will not provide records or is unable to provide records, there are several options for obtaining records from outside sources.
- Bank Records - Auditors can go to the taxpayer's bank in order to obtain information. The auditor must identify himself as an employee of the Comptroller and then follow any procedures requested by the bank. State banks are required to give auditors the information. Federal banks use their own discretion in releasing the information.
- Records from Vendors - If only a few records are needed to complete an audit, the information may be available through the vendor. The request should be handled carefully in order to obtain the vendor's cooperation. If the records are essential to the audit and the vendor will not provide the information, the records may be subpoenaed.
- IRS Records - This method is usually used as one of the final options due to the length of time of the process and the amount of safeguards that are required to protect the information. The auditor sends a memo requesting records, via his supervisor and manager, to the Open Records Section of the General Counsel (current contact is Elaine McDade) who in turn contacts the IRS. These records must be stored in a locked area until they are returned to the IRS or destroyed.
- Subpoena Records - This method is also used as one of the final options and only after two formal requests for records have been made of the taxpayer. The auditor completes a Request for Subpoena of Records form with the following information:
- Type of subpoena: First party or third party
- Name and address of the person or entity to whom subpoena will be served
- Name and address of person or entity for whose records subpoena will be served
- Detailed description of records for which subpoena will be served
- Time period of records
- Name of the person who will serve the subpoena
- Title of person and the Comptroller field office
- The Request for Subpoena of Records form is e-mailed to the auditor's Supervisor or Manager who will then e-mail the form to the General Counsel. The Assistant Manager for Audit Division should be cc'd.
- The General Counsel will issue the subpoena and forward it to the auditor
- The auditor can serve the subpoena or request assistance from the CID Investigators
- A subpoena usually is served to the taxpayer, a vendor, or a bank.
NOTE: For more information on issuing a subpoena to obtain records, please refer to Audit Memo AP 70.
An auditor may encounter a situation where the records of the company to be audited are being held by a court. This situation may occur during bankruptcy, liquidation, or pending litigation of the company. In this case, the Comptroller's General Counsel must petition the court to have the records made available for the auditor's examination.
Bank Deposit Method
If bank statements are available for the entire audit period, use the following formula for auditing sales.
Total Bank Deposits Less: Non-sales receipts deposited -------------------------------------------------------------------------- Subtotal Add: Items paid by cash (i.e., business expenses) Cash accumulated during the year from receipts never deposited -------------------------------------------------------------------------- Subtotal Less: Re-deposits (If not deducted, sales will be over stated as the original deposit was included) -------------------------------------------------------------------------- Subtotal Audited Sales (tax included) Less: Tax free sales supported by the appropriate documentation -------------------------------------------------------------------------- Subtotal Audited Taxable Sales (tax included) Less: Tax included -------------------------------------------------------------------------- Audited Taxable Sales
If bank deposits are available for only a portion of the audit period, calculate the percentage of error using the following procedure.
Audited Taxable Sales Less: Reported Taxable Sales (from audit history) -------------------------------------------------------------------------- Underreported Sales Percentage of Error = Underreported Sales ----------------------------- Reported Sales ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- -----
Note: The Percentage of Error obtained above would be applied to Reported Taxable Sales for those periods where bank deposits were not available.
Cost Accountability Method
This method is useful when performing an audit on a taxpayer involved in construction.
Beginning inventory of materials Add: Purchases of materials ---------------------------------------------------------------------------------- Subtotal Less: Ending Inventory of materials ---------------------------------------------------------------------------------- Less: Cost of goods to be accounted for Over-the-counter-sales (at cost)* ---------------------------------------------------------------------------------- Subtotal Less: Materials on which tax accrued ---------------------------------------------------------------------------------- Underreported Materials at Cost *Sales/1 + average mark-up
Gross Profit (Mark-Up) Method
When the expense and cost of goods sold records are adequate but the sales records are inadequate, then this method may be used. When it is used, one or more of the other auditing techniques should support the estimate of sales.
- Verify inventory purchases for a certain period
- Make adjustments to purchases, if applicable
- Merchandise shrinkage
- Merchandise withdrawn from inventory
- Inventory adjustments
- Determine sales price of inventory purchases
- Compare sales price to purchases to compute the mark-up percentage for the period
Gross Profit Mark-up percentage = ------------------------------- Adjusted Cost of Sales
- Apply the computed mark-up percentage to adjusted cost of goods sold for other periods within the audit.
1 + Mark-up percentage x Adj. Cost of Goods Sold for the other periods ----------------------------------------------- = Audited Gross Sales Audited Gross Sales - Reported Gross Sales --------------------------------------------- = Underreported Gross Sales
Unit Volume Method
This technique is effectively used to determine sales for businesses with only a few product lines, such as bars and nightclubs.
Number of units purchased x Unit Selling Prices ------------------------- = Sales
The price per unit is obtained from current and previous price lists. Make adjustments for changes in selling price during the audit period. Also make adjustments for inventory beginning and ending volumes and items removed from inventory for personal use, if the information is available.
For more information on this audit procedure, consult the Audit Procedures for Mixed Beverage Tax Manual.
Net Profit Method
This method should be used on smaller businesses. Use the following Net Profit worksheets to assist in the calculations.
- Estimate the monthly cost-of-living for the taxpayer
- Estimate the monthly business expenses, including cash outlays
- Add these expenses together and determine an annual cost estimate
- Adjust the annual cost estimate by increases/decreases to savings, bank accounts, investments, etc. – also, deduct any source of other income
- Add the cost-of-goods sold to the adjusted annual estimate of expenses to obtain estimated gross sales
- Deduct reported gross sales from estimated gross sales to obtain unreported gross sales
Net Profit Worksheet
1. Estimated/average personal expenses monthly (1) a. Personal Expenses $____________ b. Household Expenses ____________ c. Auto Expenses ____________ d. Medical ____________ e. Taxes ____________ f. Miscellaneous ____________ Total Avg. Personal Expenses $___________ 2. Estimated/average business expenses monthly a. Salaries $___________ b. Utilities ___________ c. Supplies ___________ d. Rent ___________ e. Repairs & Replacement ___________ f. Other ___________ Total Avg. Business Expenses $___________ 3. Estimated/Average Yearly Expenses Total Avg. Monthly Expenses (1+2) $____________ Multiplied by 12 Months X 12 Total Avg. Yearly Expenses $____________ 4. Adjustments Add: Increase in Bank Account $____________ Subtract: Decrease in Savings Account $____________ Proceeds from C.D./Loans ____________ Spouse's Salary ____________ (Total) $____________ Total Adjustments $____________ (1) See Estimated Average Personal Expenses Worksheet. 5. Total Estimated Expenses (3+4) $____________ Add: Cost of Goods Sold ____________ 6. Total Estimated Gross Sales $____________ Less: Reported Gross Sales ____________ Total Unreported Gross Sales $____________
When records are not available or are not made available to the auditor, other methods must be used to estimate an audit. Some examples are:
- Disallow reported deductions
- Use the Federal Tax Return to schedule sales based on receipts and schedule taxable purchases based on changes in the asset accounts
- Use industry averages to verify the percentage of taxable sales (i.e., grocery stores)
- Compare reported gross sales with the "SALES/FRANCHISE RECEIPTS COMPARISON" portion of the taxpayer sales tax history
Estimated Average Personal Expenses Worksheet
(Step 1 of Net Profit Worksheet)
- Personal Expenses --
Groceries and outside meals
Laundry and dry cleaning
Barber, beauty shop, and cosmetics
Education (tuition, room, board, books, etc.)
Recreation, entertainment, vacations
Dues (clubs, lodge, etc.)
Gifts and allowances
Life and accident insurance
- Household Expenses --
Mortgage payments (including interest)
Utilities (electricity, gas, telephone, water, etc.)
Repairs and improvements
- Auto Expenses --
Gasoline, oil, grease, wash
Tires, batteries, repairs, tags
Auto payments (including interest)
- Medical Expenses --
Doctors, hospital, etc.
- Taxes --
- Miscellaneous/Other --
Account Information Card
If the vendor did not charge any tax and it appears that the vendor has representation in Texas (i.e., vendor is located in Texas; vendor has a salesperson who takes orders in Texas; etc.), complete an Account Information Card on the vendor unless it is known that the taxpayer gave the vendor a resale or exemption certificate.
Audit Lead, Form 00-828
With fluctuating economic conditions, bankruptcy has become a significant topic in auditing. In this section the types of bankruptcy are listed along with the events and audit guidelines to help the auditor understand how it relates to the audit.
Types of Bankruptcy
Chapter 7 - Liquidation
- Available to:
- Provides that all or substantially all of the property be liquidated
- Provides the individual a discharge but not from tax. Corporations and partnerships do not receive a discharge
- Corporations should be liquidated, dissolved, and uncollectible
- Upon filing of petition, business operations are to be terminated
- Available to governmental authorities (cities, MUD's, school districts, etc.)
Chapter 11 - Reorganization
- Available to:
- Generally provides for a reorganization of the entity.
- Provides a discharge from pre-confirmation taxes, including state taxes that are not included under their plan of reorganization.
- Liquidation is allowed and provides for temporary operation of business by a trustee to facilitate an orderly liquidation.
- The debtor obtains relief from creditor harassment while staying in business; is allowed to file a plan of reorganization to implement a means of paying off his pre-petition and administrative expense debt.
- The debtor should be remitting all post-petition taxes.
- Available to family farmers with annual income. May include a corporation or partnership if over 50% owned by farmers.
Chapter 13 - Debt Adjustment
- Available to individuals with regular income only (includes a husband and wife). It may include a business operated as a sole proprietorship.
- Includes limit on debts ($250,000 unsecured; and less than $750,000 secured debt).
- Provides a hardship discharge from taxes for certain individuals after a portion of the taxes have been paid for three or five years under the plan.
- Allows debtor to orderly pay off his debts without harassment from creditors.
- Allows debtor to pay off debts under a plan in small amounts for three years.
- Corporations and partnerships may not file a Chapter B petition.
The following time line shows:
Typical timing requirements, but the sequence of events may vary:
>>>----v--------------v--------------------v---------------------v----->>> Petition Bar Confirmation Case Date Date Date Closed
- Petition Date (Petition for bankruptcy filed): Case is begun by filing under a particular chapter of the Bankruptcy Code. Bankruptcy may be voluntary (debtor files petition) or involuntary (creditor files the petition). The State of Texas is a secured creditor if liens have been filed prior to the filing of the petition. Otherwise, it is a priority creditor and is paid before the unsecured creditors but after the secured creditors.
- Bar Date or File-By Date (Proof of claim deadline): The date by which a claim must be filed in order for the claim to be considered and allowed. This is usually 180 days from the Petition Date; the bankruptcy judge decides the actual date. If the State does not file a proof of claim prior to the Bar Date, the State's claim for taxes in some instances may be discharged. The proof of claim can be an estimate at the time of filing (the estimated amount can be amended up or down), but the final amount must be filed prior to the confirmation of the plan.
- Confirmation Date (Confirmation of plan/discharge): If Chapter 11 bankruptcy, this is the date that plans for reorganization and discharge of debts are approved by the court. If Chapter 13 bankruptcy, this is the date the plan is approved – a discharge of debts is granted after successful completion of all plan payments. If Chapter 7 bankruptcy, there is not a confirmation date.
If a taxpayer is bankrupt and did not file returns and remit taxes collected, the taxes collected generally will not be discharged by the bankruptcy court unless the Chapter 11 or Chapter 13 reorganization plan allows for such a discharge.
- Case closed
The following general guidelines should be followed to protect the State's interest:
- Review the MTSUMM or XISUMM inquiry to determine if the taxpayer's account indicates bankruptcy status.
Records to be requested:
- If the taxpayer is in bankruptcy, and it is not reflected on LISUMM, ask for a copy of the Section 342 Notice or Petition for Bankruptcy and send it to the Bankruptcy Section of Revenue Accounting Division.
- If the taxpayer states that his bankruptcy is near the confirmation date or a discharge, ask for a copy of the Notice of Discharge or the Confirmation of the Plan and forward it to the Bankruptcy Section of Revenue Accounting Division.
- If the taxpayer refuses access to the records, the General Counsel's Litigation and Taxation Section should be contacted.
- Review the LISUMM inquiry for information on the bankruptcy. (This inquiry may not be current due to the lapse of time between filing and the State being notified.) Refer to the STS Quick Reference Guide – CICS Tcodes by System - Automated Bankruptcy System on the Comptroller's Internal Web site under Information Technology Division's Web site.
- Contact and apprise the audit supervisor of the situation.
- Contact the Bankruptcy Section of Revenue Accounting. An accounts examiner will help determine how the audit will proceed and the time frame within which the audit must be conducted.
- If a Chapter 11 taxpayer has a confirmed Plan of Reorganization, then only audit post-confirmation periods unless refunds are requested for the pre-confirmation period, since offsets can still be done. Remember that all pre-confirmation taxes are automatically discharged by the bankruptcy court order authorizing the Plan of Reorganization. Always check the inquiry screen to see if a Chapter 11 case was filed and, if so, when the Plan of Reorganization was approved. Any tax credits and/or taxes due before that date are discharged and cannot be audited.
- If the taxpayer has not yet filed for bankruptcy but is about to or the auditor feels that the taxpayer has financial problems such that collection of taxes would be jeopardized, the auditor's supervisor should also determine whether the audit should be expedited so that a jeopardy determination can be issued. An immediate request for lien filing may be sent to the Certification and Liens Section of Revenue Accounting.
NOTE: There are no set guidelines for determining when a jeopardy determination should be issued. The auditor should obtain as much financial information about the taxpayer as possible and discuss the situation with the supervisor and/or manager.
- Standard auditing and write-up procedures should be expedited on all bankruptcy audits. In some cases, figures may be phoned in to the Bankruptcy Section for claim filing.
- Determine the final amount of the deficiency, both pre-petition and post-petition, prior to the confirmation of the plan. If necessary, estimate the liability prior to the bar date and request that a claim be filed. The claim can be amended later when the actual amount is known. A Notification of Estimation Procedures is required for all estimates.
- In Agency Work Manager, the audit reason should be "Bankruptcy."
- Consider penalty and interest waiver as usual.
- Independent Audit Review Conference requests and Redetermination requests will be the same as for all other taxpayers.
See Audit Directive Memo AD 26 for additional information.
Large Corporations in Bankruptcy
If a large corporation files for Chapter 11 Reorganization, perform an audit unless one was recently completed. The audit must be scheduled as soon after filing as the taxpayer will allow. A bar date for claims is usually set 180 days from the Petition Date after the bankruptcy is filed. Keep in very close contact with the Bankruptcy Section of Revenue Accounting to be sure that the claim based on the audit is timely filed with the court. If the taxpayer is uncooperative, contact the General Counsel's Litigation and Taxation Section. The Comptroller might be able to submit a motion to the bankruptcy court for a turnover of the records or for an extension of time to file a claim. Also, if necessary, an estimated audit should be performed and amended at a later date after discussion with the Bankruptcy Section.
Sales taxes collected prior to the bankruptcy filing are considered "trust funds." The court will be petitioned for immediate payment of these taxes.
Insolvency is the inability to pay debts as they fall due in the usual course of business and/or having liabilities in excess of a reasonable market value of assets held, or insufficient assets to pay all debts. Section 111.102 of the Tax Code, Collection Procedures, gives the Comptroller authority to settle a claim for a tax, penalty, or interest if:
- Collection of the total amount due would make the taxpayer insolvent, and the taxpayer has submitted to the Comptroller all financial records necessary to support his claim for insolvency, or
- The taxpayer is insolvent, is in liquidation, or has ceased to do business, and:
- The taxpayer does not have any property that may be seized by the courts of Texas or another state; or
- The value of the taxpayer's property is less than the total amount due and the amount of debts against the property
A claim for insolvency should not be confused with imminent or actual bankruptcy. A taxpayer can pursue an insolvency claim through the agency without filing for bankruptcy. See the bankruptcy section of this chapter.
When insolvency is claimed, Audit Headquarters generally requires an examination of the records before making a recommendation. Headquarters will issue a memo to the field audit office requesting an insolvency investigation.
The investigation will verify the accuracy of the taxpayer's financial data by the given deadline and convey the findings to the designated contact in Audit Headquarters. The auditor's supervisor should also determine whether the audit should be expedited so that a jeopardy determination can be issued. An immediate request for lien filing may be sent to the Revenue Accounting Liens Section.
NOTE: There are no set guidelines for determining when a jeopardy determination should be issued. The auditor should obtain as much financial information about the taxpayer as possible and discuss the situation with the supervisor and/or manager.
Sources of a Claim of Insolvency
Audit in Progress
The auditor may detect an unstable financial condition. The auditor should consult the supervisor and determine whether or not to continue the audit. If management decides to pursue the audit, management may consult with either the Comptroller's General Counsel Division or the Bankruptcy Section of Revenue Accounting. Field management and Austin will work together to determine the appropriate course of action - deadlines, scope of audit and other measures in the best interest of the state.
If insolvency is claimed at any stage, from the statement of grounds through motion for rehearing:
- The General Counsel Division will issue a request for an insolvency investigation indicating Insolvency Claim. Audit Headquarters will then assign the insolvency claim to the appropriate field office with any attached documents and instructions for completion.
- The Audit Office will have thirty days from receipt to complete the assignment. The auditor should compose a summary memo that highlights the more significant aspects of the findings on each claim and gives a definitive bottom line statement of whether or not the taxpayer is insolvent. The summary should also include the auditor's determination if the taxpayer has the ability to pay, i.e., whether payout terms may be necessary, etc. If the required fieldwork cannot be completed within the thirty-day period, the auditor needs to contact Audit Headquarters and request additional time.
- The entire package, including the summary memo, the Insolvency Investigation Request and related documents, should be returned to Audit Headquarters. Headquarters staff will review the submission and, where required, make recommendations for compromise or settlement. Audit Headquarters will be responsible for notifying the appropriate parties.
The auditor should refer all taxpayers claiming insolvency to the appropriate personnel in Audit Headquarters who will be primarily responsible for handling telephone and mail contact from taxpayers claiming insolvency outside of audits in progress or in redetermination.
In cases of extreme or urgent circumstances, the General Counsel Division will be primarily responsible for action taken in addressing the issue and formulating recommendations for its resolution to appropriate agency divisions or personnel.
Performance of the Review by Auditor
Ascertain that the taxpayer's financial condition as reflected on his books and records has not been the result of intentionally or unintentionally falsified financial data. The major objectives for implementing a review include:
- Confirming balances of financial statements
- Determining that the financial data submitted by the taxpayer is in accordance with G.A.A.P. and that usage is consistent
- Confirming all transactions and balances as bona fide
- Verifying the existence and ownership of all assets
- Verifying that expenses and liabilities are not overstated
- Verifying that income and assets are not understated
In most instances, the taxpayer is a sole proprietorship, partnership, and/or closely held corporation. The records maintained by these taxpayers often represent un-audited financial data. Scrutinize all audit evidence for reliability.
The taxpayer MUST provide records for an insolvency claim to be approved. If the business has been in operation for three years or longer, the MINIMUM records required are:
- The last 3 Federal Income Tax Returns; and
- The last 3 yearly financial statements; and
- The last 3 bank statements; and
- A list of all property and assets owned (not limited to Texas); and
- A list of all liabilities
Businesses operating for less than three years will provide these records for the periods in operation.
The following outline is a basic plan in the overall exam of a taxpayer's books and records. Additional procedures unique to the specific audit and adapted to the size and nature of a taxpayer's business may be needed.
- Review the system of internal control
- Analyze and review the general ledger
- Compare general ledger balances with financial statement balances
- Scan account entries
- Test account balances
- Trace postings from sub-ledgers and general journal
- Analyze and review the subsidiary ledgers
- Obtain trial balances of asset accounts
- Foot trial balances and compare to controlling accounts
- Compare trial balance of Accounts Receivable with individual account balances in the subsidiary ledger
- Examine books of original entry
- Obtain external evidence if necessary
- Confirm accounts receivable
- Confirm bank accounts
- Confirm accounts payable
- Inspect inventory
- Inspect other assets
- Test cut-off of transactions
- Make overall inquiries of accounting policies
- Depreciation policy
- Credit policy; and
- Basis of accounting
- Review financial statements and accounting principles
- Make an overall evaluation of the financial conditions by applying tests of the appropriate ratios:
In analyzing these ratios, consider several factors. Generally, from a creditor's point of view, the higher the current and acid-test ratios and the shorter the operating cycle, the better. However, excessive current and acid-test ratios are unfavorable in management's view.
Similarly, an unusually high rate of inventory turnover may indicate that the company is losing business by failing to maintain an adequate supply of goods; however, a creditor may look favorably upon a high turnover rate.
A high rate of accounts receivable turnover may indicate that the company's credit policies need to be relaxed to encourage more business, while a low debt to equity ratio may indicate a substantial margin of protection against insolvency.
For the purposes of determining the solvency or insolvency of the taxpayer, a comparison of ratios over time is more revealing than studying single measurements. Analyzing the trends may reveal a stable position or a degenerating financial condition. However, do not rely solely on these ratios to determine solvency or insolvency. If the trend is favorable or unfavorable, make further inquiry as to the underlying reasons.
Successor Liability – Liability Incurred by Purchase of a Business
Briefly, successor liability is the liability for any sales tax amounts due and unpaid by the former owner of a business that passes to the succeeding owner. A purchaser of any business or stock of goods is liable for payment of any amount owed the state by the seller under the Tax Code, Title 2, §111.020. The tax liability of the seller/owner includes any previous outstanding successor liability owed by the owner/seller. Thus, each successor/purchaser is liable for any taxes due and not paid by each previous owner or owners in succession until each tax liability has been satisfied.
In order to be relieved from any liability incurred by purchase of a business, the purchaser must, at the time of purchase,
- Withhold a sufficient amount from the purchase price to pay any amounts due by the seller/owner
- The amount withheld must be equal to all tax, penalty, and interest or any other amounts assessed or to be assessed against the seller/owner
- The purchaser shall not be liable for an amount greater than the purchase price of the business or stock of goods
The purchaser must withhold the amount owed by the seller of the business until the seller presents to the purchaser a certificate from the comptroller stating that no tax is due or that any amounts previously due have been paid. The failure of the purchaser of the business to obtain the certificate from the comptroller or to withhold any amounts due would subject the purchaser to successor liability. Either the seller or the purchaser of the business may request that the comptroller issue a certificate that no tax is due or issue a statement of the amount required to be paid before a certificate may be issued.
Certificate from the Comptroller
A certificate from the comptroller stating the amount due or that no tax is due may be obtained in the following manner:
- The seller, the seller's assignee, or the purchaser of the business must make a written request for the certificate before the sale of the business is completed
- The comptroller must issue the certificate to the seller the later of:
- Within 60 days after the records are made available by the seller for audit
- Within 60 days after receiving the written request for the certificate, but
- No later than 90 days after receiving the written request
- If any amount is found to be due, the amount must be paid before the certificate will be issued
- If the comptroller fails to issue the certificate to the seller of the business within the required 90 days, the purchaser is relieved of any successor liability
Purchase Price of the Business
The purchase price paid or to be paid for the business shall include but not limited to
- Monetary consideration
- Assumption of debt
- Transfer of property
- Forgiveness of debt, or
- Issuance of debt instruments
The purchase price paid to the seller for the business or stock of goods must be reasonably equivalent to the value of the business or stock of goods. Otherwise, the purchaser will be assessed the difference as a tax liability.
Factors to Consider if a Sale of a Business Has Occurred
A detailed examination of the transaction may be necessary in order to determine whether or not a business has or will be sold. It must be determined what the parties to the transaction intended to buy and sell. A business may have been sold even if only a few assets were transferred. Depending on the type of business involved, a business may be sold if an owner sells:
- A building, land, furniture, fixtures, inventory, and the right to use the seller's trade name; or
- All of the capital assets of a business; or
- The name and goodwill of a business; or
- All the inventory of a business; or
- Fixed assets and realty necessary to operate a similar business as the seller at the same location
Statute of Limitations
The 4-year statute of limitations for enforcing a successor liability begins the later of:
- When the former owner of the business sells the business or stock of goods; or
- When a determination is made against the former owner
A law dictionary defines a merger as follows:
"Merger: in corporate law, the joining of two corporations in which one corporation transfers all of its assets to the other, which continues to exist. In effect one corporation "swallows" the other, but the shareholders of the swallowed company receive shares of the surviving corporation."
In the case of a merger, all assets, credits and liabilities, including any amounts owed the state, transfer from the "swallowed up" entity to the surviving entity. Thus, a surviving entity could incur a successor liability unless it had obtained a certificate from the comptroller or had paid off any amounts due the state prior to the merger.
Auditors should be aware that any tax credits due to the "swallowed up" entity would transfer to the surviving entity. This issue may be encountered in audits where the taxpayer is requesting a tax refund. Auditors must verify, by examining the necessary legal documentation, that there truly was a merger of two or more entities rather than one entity buying another. If there was not a merger, then each entity stands alone regarding any tax credits due.
Burden of Proof
Numerous comptroller administrative hearings decisions cite that Section 111.020 (Tax Collection on Termination of Business) "is an imposition statute and must be strictly construed against the state." The tax division has the burden of establishing a prima facie case that an entity legitimately owes a successor liability. Sufficient evidence must be presented before a successor liability may be assessed. However, once the tax division has established a prima facie case, the burden shifts to the taxpayer, "by a preponderance of the evidence", that the assessment is not correct.
Penalty and Interest
If the purchaser of a business fails to pay the assessment of successor liability in a timely fashion or fails to request a hearing on the matter within a timely manner, a penalty of 10% will be assessed in addition to any amounts of penalty previously assessed against the seller of the business. In addition, a successor purchaser cannot challenge the validity of the liability of the predecessor seller.