Amid crackdown by states, auditors hold key to detecting sales tax cheats

(Editor’s Note: this story is adapted from a piece that originally ran on the site of Sales Tax DataLINK, a software company for tax professionals. Please visit their blog for more coverage of sales tax issues).

Across the United States and elsewhere, state regulators and law enforcement agencies are hunting down a quiet fraud epidemic. It’s widespread, routine at some businesses, and can be very difficult to detect. It goes by the name of sales tax fraud.

While there are no reliable estimates of the amounts stolen in sales tax fraud in the US or globally, anecdotal evidence of cases abounds, with schemes ranging from the simple to sophisticated. A recent sting operation on a chain of New York jewelry stores, dubbed “Operation Bracelet,” found underreporting on $1.3 million in sales tax. Another New York small business owner was arrested after auditors discovered he had skimmed nearly $800,000 in sales tax from his gas station business.

It is these big-ticket thefts, and their modest analogues — such as one interior designer in Tennessee who failed to pay $21,000 — that are increasingly a target of state government agencies.

States have started attacking underreporting and targeting businesses that do not report similar sales tax numbers as their competitors. Illinois, for instance, has adopted this practice, adding jail time on top of monetary penalties and interest to send a message to sales tax evaders.

Despite stiffer enforcement, sales tax fraud remains particularly hard to detect because sales tax is a self-reported, transactional-based tax. It’s easier to spot skimming, or the practice of pocketing sales tax, than institutionalized sales tax fraud, where businesses use sales tax reporting to pad their revenue and profit numbers.

Although states like New York have used sting operations in the past to target skimming, the same tactics don’t work against institutionalized sales tax fraud. However, even complex schemes can be spotted by keen internal and external auditors, who form a key line of defense against sales tax fraud.

Complexity attracts, and hides, fraud

When a business generates a sale, it is responsible for collecting the sales tax.  Since sales tax is governed by each state in the US, state tax authorities determine what products are taxable and the tax rate that should apply to each.

It is complex, considering there are 45 tax-collecting states and Washington, DC, all with different sales tax rate structures and regulations for determining the taxability of products and services. It takes a full-time specialist to make sense of it all.

Many auditors don’t thoroughly examine general ledger accounts used for sales tax collected from transactions because they are unfamiliar with sales tax principles. If they do, the review is simple. They will check to see if  tax dollars collected match sales tax paid on a return, less vendor compensation (a percentage of tax collected that is paid to the business for collecting and remitting the tax). If so, the account balances and they move on.

Fraud often lurks in “reserve” accounts  

It is the fringe accounts related to sales tax compliance, however, that can be used for fraud.  These fringe accounts are referred to as “Contingent Sales Tax Liabilities.”

They are used to factor in “what if” scenarios and create a reserve to cover any sales tax liabilities that might result from accidental misreporting. For example, a large corporation may use software purchased many years ago for calculating sales tax on invoices. This software has serious design limitations that lead to occasional inaccurate calculations, but the cost of replacing the software is in the millions, so the company continues to use it.

The company therefore creates a Contingent Sales Tax Liability or reserve account to offset any tax exposure resulting from the miscalculation of sales tax due to the software. Such accounts can be used to offset other perceived liabilities.

Unfortunately, unscrupulous companies know that many auditors do not have the skill set to challenge the reasonableness of the accounts, and can use them to fraudulent ends. These companies are not pocketing the money but instead use these accounts to manipulate earnings or minimize income tax liability for each quarter.  It is a sophisticated type of fraud — certainly more complex than tax zapper fraud that deletes transaction history from point-of-sale systems.

Several red flags point to fraudulent activity

The following are legitimate reasons for the existence of a reserve account.

  1. Sales tax software is unable to keep up with enterprise resource planning upgrades or is dated or vice-versa. Often software with legacy systems isn’t easily updated.
  2. States don’t provide clear sales tax regulations covering taxability of products or services.
  3. The company being audited is in an emerging industry for which sales tax regulation has not been created or clarified; an example is digital goods and services.
  4. Officers of the company know there is sales tax liability for past errors but assume it will not be challenged by auditors before the statute of limitations expires.  The audit period of most states is a three-year look back, while a few can go up to five years.
  5. A reserve account is established to offset general unknowns with sales tax.

The following activities, however, likely indicate fraud.

  1. A balance in a sales tax liability account is not in proportion to annualized sales tax paid per state.  For example, sales tax paid to California for 2012 is $12.5 million while the liability account has a balance $50 million.
  2. Account balances in the sale tax liability account fluctuate up and down each quarter. Tax laws do not change each quarter. They are normally static once enacted.
  3. Earnings are steady with entries posted to liability accounts prior to reporting. Repetitive entries for reserve accounts are uncommon.
  4. Contingent sales tax liability accounts have been dormant for three years or past the average statute of limitations for sales tax. This is a sign of warehousing income for future use.
  5. Accounts were brought to zero prior to a merger or divesting. This shows an attempt to make the company look more profitable, while the true nature of the income was not reported historically.

It is normal for large corporations to have contingent sales tax liability accounts and auditors should expect to see these accounts. The challenge lies in recognizing if the accounts are being used for legitimate purposes. Auditors should approach these accounts with professional skepticism, always asking the same question: “Are they being used to manipulate earnings or income tax?”