Sales Tax Sampling in a sales tax audit – sales tax audits are not always a precise science of calculating the true number that a business might owe. A lot of times it’s almost guessing at the most reasonable number.
Transcript
What’s the big deal about sampling and error rates in the sales tax audit? I’m Mansoor Ansari with Nexus Tax Defense. At the beginning of a sales tax audit, the auditor is either going to do what’s called the “direct method of testing,”” which is based on those primary source documents so there’s no guessing, or they’re going to do something called “indirect method of testing,” which is also called statistical sampling. Most audits start with direct but if, for example, the federal returns don’t match the state returns, then they’ll move to an indirect method.
The problem with the indirect method is that it is based on statistics. For example, let’s say a dessert shop in Milwaukee only sells ice cream for two months out of the year, and the audit period is for three years. If the auditor is only sampling the summer months when the sales are higher, because it is warmer outside, and people are buying a lot of ice cream, it is entirely not representative of the other 10 months of the year when nobody is buying ice cream and the sales are significantly lower. This will skew the true projection.
Here are the steps to determine sampling. Step one is population stratification and sample selection: the information received from the taxpayer is checked for accuracy. Step two — selection of accounts: the specific transactions are selected for audit. This is also called refinement of the audit population. Step 3 — defining the audit population: the audit population is a total set of unique transactions from which the sample is selected. Using the data record submitted by the taxpayer, records outside of the audit period and records with no tax implications are removed, and then records are combined to create a unique transaction. Step four is called stratification: this is the process of dividing the population into groups. The units within a stratum are more alike than units compared across the strata. The audit population is stratified on the dollar amount of the transaction. Step 5 — this is the sample size: sample selection once the sample is allocated to the strata. Each stratum is randomly sampled to select the unique transactions to be audited.
When it comes to audit results each transaction in the sample is examined by the auditor to determine tax stability and the amount of error, tax owed minus tax paid, which gives you the average tax error. For each stratum, the average tax error for the sample is determined by summing all the errors in the stratum sample and dividing by the stratum sample size. Then, you have a projected stratum error. The average sample error in each stratum is extrapolated to obtain the projected error per stratum. Then you’ll have the estimated total tax error. To estimate the total tax error in the audit population, the strata is projected where errors are assumed.
In its entirety, this is how a sales tax audit will be conducted when you don’t have all the books and records in place. Thank you.
