Texas Sales Tax Audit: What If You Didn’t Collect Tax or Are Missing Certificates
By John LaBorde, CPA, State Tax Resources
The short answer: In Texas, sellers are required to either collect sales tax on taxable transactions or obtain a resale or exemption certificate from the purchaser (Texas Tax Code §151.052(a) and §151.054(a)–(c)). If sales tax should have been charged and wasn't, the Comptroller can assess your company for the tax, plus interest and possibly penalties.
This is one of the most frustrating situations a business can face. Sales tax is supposed to be paid by the customer. When it isn't collected, the seller can end up bearing the cost, often years after the sale and long after the customer could have easily been invoiced for it.
The good news is that there are often ways to reduce, or even eliminate, much of the exposure.
I began my career as a Texas Comptroller auditor, and uncollected sales tax and missing certificates were common sources of large audit assessments. Here is how the exposure arises, what it can cost, and what you can do about it.
Why companies end up not collecting sales tax
Companies with exposure for uncollected sales tax can often trace the problem to one of these situations:
• Not realizing a service is taxable. Texas imposes sales tax on a number of services that surprise many businesses, including data processing, information services, certain repair and maintenance work, and security services.
• Missing or invalid exemption and resale certificates. To be relieved of the responsibility to collect sales tax, a seller should obtain a properly completed resale or exemption certificate from its customer at the time of the sale. Properly completed certificates accepted in good faith relieve the seller of the sales tax responsibility (34 Tex. Admin. Code §§3.285 and 3.287).
• New products or business lines. A company adds software, subscriptions, installation or other offerings without revisiting whether they are taxable.
• Acquiring a company that already had exposure. This is relatively common. Tax exposure of an acquired company should be identified during due diligence, but sometimes it is missed.
• Billing system settings. A product, service or customer is erroneously coded as nontaxable in the billing system, and the error repeats on every invoice for years.
• Not recognizing Texas nexus. An out-of-state company may have employees or inventory in Texas, or may have exceeded the Texas economic nexus threshold, and be required to collect without realizing it.
How far back can the Comptroller go?
In most cases, the Comptroller can assess Texas sales tax for four years from the date the tax was due (Texas Tax Code §111.201). For a company that has been undercollecting on a large revenue stream, four years of tax can add up quickly.
There are important exceptions. The four-year limit generally does not apply if a business never filed the required returns, or if the corrected tax due exceeds the reported tax by 25 percent or more (Texas Tax Code §111.205). Companies that were never registered to collect Texas tax can face a much longer look-back period, which is one reason it is better to address the problem before the Comptroller does.
What the exposure includes
An assessment for uncollected tax typically has three parts:
1. The tax itself: the state and local tax that should have been charged on taxable transactions.
2. Interest: interest begins accruing 60 days after the date the tax was originally due (Texas Tax Code §151.512).
3. Penalties: late-payment penalties generally apply, and larger penalties can apply in more serious cases.
When sales tax is collected properly, it passes through the seller to the state. When uncollected tax is assessed on a seller, it becomes an expense for that company. For a business with thin margins, an audit assessment for uncollected tax from prior years can cause serious financial strain.
Ways to reduce the assessment
An uncollected sales tax problem is rarely as large as the first estimate suggests. These are the most common options for reducing the exposure.
Obtain resale and exemption certificates after the fact. If some customers were actually exempt or buying for resale, a valid certificate can remove those sales from the assessment, even if it is obtained late. Certificates obtained after the audit begins are subject to verification, and incomplete certificates are disallowed regardless of when they were obtained. Best practice is to start collecting missing certificates as soon as an audit notice is received. Keep in mind that some customers may have been acquired by other companies or may no longer be in business.
Identify out-of-state transactions. Sales of tangible personal property by a Texas-based seller are not subject to Texas sales tax if the seller delivers the property to a carrier or a forwarding agent for shipment outside Texas (Texas Tax Code §151.330(a)). The seller must keep documentation such as a bill of lading or carrier receipt, and invoices should show the out-of-state shipping address. Taxable services such as data processing are generally subject to Texas sales tax only if the service is used in Texas (Texas Tax Code §151.330(e)–(f)). A customer that uses a taxable service in multiple states can give the seller a multistate use certificate (34 Tex. Admin. Code §3.330(g)(6)).
Show that the customer paid the tax directly. Many larger businesses accrue and pay use tax on their own purchases when a vendor doesn't charge sales tax. Auditors generally accept documentation from customers showing that the tax has already been paid.
Bill your customers for the tax. Legally, the sales tax is the customer's obligation, and you can ask customers to pay it. In practice, this is much easier for recent transactions and for customers with whom the company has strong relationships. Larger customers that are routinely audited by Texas usually do not have a problem paying sales tax for prior periods, because they expect they would otherwise owe the tax, plus interest and possibly penalties, if the transactions were assessed in their own audit.
If you haven't received an audit notice yet, consider a voluntary disclosure agreement. If the Comptroller has not yet contacted your company, a voluntary disclosure agreement can limit the look-back period and usually results in a waiver of penalties. This option is usually lost once the Comptroller contacts you.
Request a managed audit. In a managed audit, the company or its advisor reviews its own records and prepares the audit schedules under a written agreement with the Comptroller, and the agreement can be limited to specific areas, such as sales of certain types of taxable items. The benefits can be significant: unless the audit discloses fraud or willful evasion, the Comptroller may not assess penalties and may waive all or part of the interest, and any overpayments identified in the audit are refunded (Texas Tax Code §151.0231). Timing is critical: under the Comptroller's guidelines, a request generally must be received within 60 days of the date the Audit Notification Letter was sent, and requests are denied once fieldwork has begun (Texas Comptroller, Managed Audit Program: Managed Audit Time Guidelines). Approval rests solely with the Comptroller, who considers factors such as the company's compliance history, the time and resources the company can dedicate to the audit, the availability of its records, and its ability to pay any liability.
Ask for a detailed review instead of a sample. Auditors are authorized to sample transactions rather than review all of them in detail (Texas Tax Code §111.0042(b)). If you plan to invoice customers for uncollected sales tax, a detailed review of sales is preferable to a sample and projection. If you develop a good working relationship with the auditor, you may be able to agree that at least the larger transactions will be reviewed in detail. If the auditor moves forward with a sample, review the sample notification carefully and evaluate whether the proposed sample is representative, based on your knowledge of the company's customers and sales. The sample must reflect normal business conditions, and transactions shown to be unrepresentative can be removed from the sample, though they may then be assessed separately (Texas Tax Code §111.0042(d)).
What to do now
If you suspect your company has not been collecting tax it should have, these steps can put you in a stronger position:
1. Confirm the taxability question. Review your company's types of transactions and determine which ones are subject to sales tax in Texas. The rules are not always easy to understand.
2. Estimate the exposure. If you think there is exposure, estimate the total amount to understand the size of the issue before deciding how to handle it.
3. Start gathering certificates and customer records. The documents that reduce your exposure are easier to collect now than in the middle of an audit.
4. If the Comptroller hasn't contacted you yet, consider your options. Once an audit begins, some options, including voluntary disclosure, are no longer available.
5. Decide quickly whether to request a managed audit. The request generally must be made within 60 days of the Audit Notification Letter and before fieldwork begins.
6. Correct the problem going forward. Update your billing system and your process for obtaining resale and exemption certificates so the problem stops growing.
Taxpayers who have the best results in audits are the ones who prepare before the audit starts. A few weeks of preparation can make a meaningful difference in the results.
Frequently asked questions
Can I bill my customers now for tax I didn't collect? Yes. The tax is the customer's obligation, so you can ask customers to pay it. However, companies often balance their desire to collect the tax with the benefits of not harming customer relationships.
Will the Comptroller waive penalties? Penalties are generally waived through a voluntary disclosure agreement, which must be requested before the Comptroller contacts you. In a managed audit, penalties are not assessed unless the audit discloses fraud or willful evasion. In a regular audit, the auditor is the person who makes the initial recommendation regarding penalties. Penalties are usually not waived if the current audit has errors similar to prior audits.
Can I still use voluntary disclosure if I'm already under audit? No. The voluntary disclosure agreement is designed for businesses that come forward before the Comptroller contacts them.
What if my customer already paid the tax to the state? If you can document that the customer accrued and paid the tax directly to the Comptroller's Office, the auditor will generally remove those transactions from your audit.
References
• Texas Tax Code §151.052, §151.054, §151.0231, §151.330 and §151.512: seller's duty to collect, resale and exemption certificates, managed audits, out-of-state shipments and services, interest
• Texas Tax Code §111.0042, §111.201 and §111.205: sampling, limitation period and exceptions
• 34 Tex. Admin. Code §3.285: resale certificates
• 34 Tex. Admin. Code §3.287: exemption certificates
• 34 Tex. Admin. Code §3.330: data processing services
• Texas Comptroller, Managed Audit Program: managed audit time guidelines
This article provides general information only and is not tax or legal advice. Every situation depends on its own facts. This firm is not a CPA firm and these services are not regulated by the Texas State Board of Public Accountancy.