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 a 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 the “indirect method of testing,” which is also called statistical sampling.
Most audits start with direct testing. However, 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:
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.
Steps to Determine Sampling
1. Population Stratification and Sample Selection
The information received from the taxpayer is checked for accuracy.
2. Selection of Accounts
The specific transactions are selected for audit. This is also called refinement of the audit population.
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
- Records are then combined to create a unique transaction
4. 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.
5. Sample Size and Sample Selection
Once the sample is allocated to the strata, each stratum is randomly sampled to select the unique transactions to be audited.
Audit Results
Each transaction in the sample is examined by the auditor to determine tax stability and the amount of error, which is tax owed minus tax paid, giving 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.
- This leads to 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.
Conclusion
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.
Frequently Asked Questions
What is statistical sampling in a sales tax audit?
Statistical sampling is an indirect method auditors use when complete records aren’t available. It involves analyzing a representative portion of transactions to estimate the tax liability for the entire audit period. This method can introduce error if the sample isn’t representative of normal business activity.
Why can sampling in a sales tax audit be inaccurate?
Sampling can be inaccurate if the selected sample doesn’t reflect the full range of business operations. For example, sampling only high-sales months for a seasonal business can overestimate annual sales and tax liability, leading to unfair audit results.
What is population stratification in an audit?
Population stratification is the process of dividing transactions into groups (strata) based on similar characteristics, like transaction size. This helps ensure that each group is fairly represented in the sample, improving the accuracy of the audit results.
How do auditors calculate projected tax error?
Auditors calculate projected tax error by determining the average tax error in each stratum and then extrapolating those errors across the full population of transactions. This method assumes the sample is representative of all transactions in that group.
When does an auditor choose statistical sampling over direct testing?
An auditor typically resorts to statistical sampling when primary documents (like tax returns or receipts) are incomplete, inconsistent, or don’t match between state and federal filings. Direct testing is preferred when full, accurate records are available.