Most organizations view the prospect of an audit by a federal or state taxing authority with trepidation, akin to the prospect of a root canal or a long weekend with the in-laws. However, with the proper preparation and understanding of what the auditor needs to accomplish, much of this fear, loathing and dread can be removed from the equation. Here’s what you can expect from a Washington state tax audit and how best to prepare so that the process is as efficient and painless as possible.
When the Washington State Department of Revenue audits a not-for-profit organization, there are certain targeted objectives for which the auditor will review. The best way to prepare for an audit is to have an understanding of what exactly the auditor is looking to verify and ensure that the corresponding records are well organized and readily available. An excise tax audit of a not-for-profit entity normally encompasses the same four areas covered by audits of for-profit entities: income, deductions, purchases, and exemptions. Discussed below are the key elements of what the auditor will focus on and items to be aware of in each area.
Auditing income starts with this basic question: Does gross revenue reconcile to the gross amounts reported on the excise tax returns? With gross revenue being subject to business and occupation tax rates of 0.138% to 1.63%, depending on the tax classification, significant differences must be identified by the auditor in order for a material adjustment to result.
The primary exposure area with respect to revenue is whether any sales made by the organization are subject to sales tax, and whether all sales tax that was collected has been properly remitted to the state. Although sales tax is imposed on the purchaser, sellers can be held liable for any tax they were obligated to collect if they did not do so. Thus, the auditor will typically spend time reviewing claimed non-taxable sales to determine if any retail sales tax liability exists. This review includes verifying reseller permits of all wholesale customers, and also evaluating whether the business activities are reported under the correct B&O tax classifications.
Exemptions and Deductions
Has the organization taken advantage of any exemptions or deductions from gross revenue on its Washington returns? Adjustments that decrease gross revenue normally require specific supporting documentation to substantiate the deduction. Claimed exemptions or deductions without supporting documentation are seen as low-hanging fruit to an auditor. For example, not-for-profit organizations commonly receive donations and contributions to support operations. To substantiate the deduction of donations and contributions, the organization must retain documents identifying the source of the donation and amount. The auditor may also require the organization to demonstrate that no goods or services were rendered in exchange for the claimed contributions/donations. Since there is no deduction for grants per se, grant revenue will be evaluated on whether it meets the requirements for deducting as contributions/donations.
Similarly, fund-raising revenue earned by a nonprofit organization is exempt from B&O tax as long as it is used in furtherance of the goals of the nonprofit organization, and does not involve the operation of a regular place of business such as thrift shop, restaurant, clinic, etc. If the activity qualifies for the fund-raising exemption, then retail sales tax does not apply. To avoid problems during the audit, the organization’s financial statements and other records should clearly identify all revenue from fund-raising activities. Additionally, the organization should have an explanation available of what the fund-raising activity entails, in order to substantiate the revenue from qualifying fund-raising activities.
One of the more tedious tasks of an excise tax audit is the review of expenses. To more efficiently assess whether sales tax was properly paid or use tax accrued on purchases of consumables and assets, the auditor may perform tests on a sample. An error rate is calculated from the sample population and applied to all purchases made during the audit period, thus amplifying the effect of any errors made with respect to the sampled transactions.
Once the sampling method has been agreed to, the sample result is normally binding. An organization under audit should carefully consider the auditor’s suggested sample plan and the results of the sample to ensure any projection accurately reflects the expense population being sampled, and that sales/use tax exemptions available to the organization have been properly recognized.
Not-for-profit artistic or cultural organizations are allowed a sales/use tax exemption on objects acquired for the purpose of exhibition or presentation to the general public. However, the criteria to qualify as an artistic/cultural organization are very specific and detailed. For example, the auditor will likely review the bylaws of the corporation and articles of incorporation to verify the organization is managed by a governing board of not less than eight individuals, none of whom is a paid employee of the organization.
What happens next?
Once the audit field work is completed and the auditor delivers the draft assessment, the full reality of the audit takes hold. An audit can result either in an assessment of additional taxes due, a refund of over-reported tax, or no tax adjustment. Most organizations would be happy with either of the latter two results, but the first result is the one most feared.
If an assessment is received, the organization and its advisors should scrutinize the assessment to verify that Washington’s tax laws and regulations have been properly applied. If any part of the assessment is based upon incomplete records, there may be an opportunity to provide alternative information to substitute for missing or incomplete records. The best time to dispute any assessment is immediately after receiving the draft from the auditor. Once a final assessment is issued, the organization is allowed just 30 days to either pay the assessment in full or file an administrative appeal with the Department of Revenue.
Contact Clark Nuber or your tax provider for assistance in reviewing any Department of Revenue assessment or to discuss any matters relating to compliance with Washington State excise tax laws.
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