March 29, 2007
Taking the fear out of state excise tax audits
By DARCY KOOIKER
Berntson Porter & Co.
People fear what they do not understand. The thought of a state excise tax audit is enough to send many contractors into a cold sweat because they are subject to some of the most complex applications of business and occupation and sales/use taxes.
Washington state distinguishes seven types of contracting, all with different tax implications. The tax on any given job is determined by who owns the land, what specific activities are taking place on the land, who is hiring the contractor and where the construction activity takes place. Because the revenue per customer is typically greater in construction than other retail industries and Washington’s sales tax rate is one of the highest in the nation, a simple mistake can turn into a huge financial nightmare.
However, if you understand the methodology used by Washington revenue auditors, you can be prepared and confident that there will be no big surprises when your company is selected for an audit.
The audit process can be broken down into four steps:
Performing these steps as a self check-up or having a trusted state tax professional perform a compliance review will give you confidence you are reporting your taxes correctly.
Gross receipts reconciliation
Auditors catch many contractors for failing to report some portion of their total revenue on their Washington excise tax returns. Auditors are able to find unreported revenue by comparing the annual gross amounts reported to the state with the amounts reported on the federal income tax returns or shown on the company’s financial statements. Developing an internal procedure to reconcile these amounts and ensure all the revenue is being properly reported is a simple, yet effective way to identify any potential problems.
If there is a valid reason for having different amounts reported to the state than to the Internal Revenue Service, you should keep documentation to prove the differences.
Verifying the classification of revenue for business and occupation tax purposes is more complicated. Depending on the nature of the work, contractors could report their revenue under any of the following classifications: Retailing, Wholesaling, Government Contracting, Public Road Construction, Cleanup of Radioactive Waste for the U.S. Government, Manufacturing, Extracting, or Service and Other Activities.
It is common for more than one of these revenue classifications to apply to the same job. Therefore, it is critical to know your activities and document them properly. Because Retailing and retail sales tax is the default classification for contractors, without documentation to prove that your activities are classified as something else, you could be assessed with the sales tax that could have been collected from the customer. Ouch.
Deductions common to contractors include bad debts, interstate sales, and sales-tax incentives claimed by customers. Note that there are also some great deductions and exemptions available to prime contractors doing work for tribal members on tribal land. Any deductions claimed that reduce the amount of gross receipts and sales tax must be properly documented.
Paying sales and use tax
Another area that is full of traps for prime and subcontractors is determining which purchased items and services are subject to sales or use tax.
The general rule is if materials are included in the finished project and are desired by the customer they may be “purchased for resale” with no sales tax payable to the vendor and no use tax to be remitted. If items are not desired by the customer, they are “consumables” and sales or use tax must be paid on the purchase price.
For example, when my office was painted, the contractor should have purchased the paint for resale and not paid sales tax to the paint supplier. However, the masking tape workers left on the molding was not desirable and I pulled it off, so the contractor should have paid sales or use tax when the tape was purchased.
If you are performing work for the federal government or building certain public roads, the rules change completely because the contractor is the deemed consumer and must pay sales or use tax on all the materials used on the job.
One area of particular ambiguity for prime contractors is determining when the purchase of certain services is classified as subcontracting where sales tax does not need to be paid, versus renting equipment with an operator where sales tax does need to be paid. An in-depth review of the facts may be necessary to make the distinction. In one case, the Department of Revenue held that the services of a water truck operator at the job site were not subject to sales tax when water was applied using specialized skill and knowledge to compact the soil to job specifications. When the same operator applied water around the site to control dust, that activity was subject to sales tax.
Even if you think you’re pretty good at appropriately paying sales and use tax, a review of your accounts payable invoices may reveal some surprises.
Prior tax assessments
If your company has been audited by the state Department of Revenue in the last five years and the auditor found additional tax due, you should make sure that you understand and agree with the assessment. The Department of Revenue unfortunately has difficulty attracting and retaining good auditors so many of the auditors out there are new and not yet experienced with the intricacies of the tax application to the construction industry. As a result, mistakes can happen, and often they are not in the contractor’s favor.
For example, a dirt contractor was recently assessed $30,000 too much tax so we are working with the Department of Revenue to get the audit assessment corrected.
If you have questions about whether a tax assessment is correct, you should consult a state tax professional. If the tax assessment was incorrect, any tax payment you made that is still within the statute of limitations can be refunded.
Darcy Kooiker, CPA, is the director of the State and Local Tax Services Department at Berntson Porter & Co. in Bellevue. She is a former Washington Department of Revenue auditor and frequent instructor on state and local tax issues for the construction industry.
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