May 2011- Special Section
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Implementing a Proactive Sales and Use Tax System

By James Helmus

As state and local taxing jurisdictions scramble for revenue to fill their unprecedented budget gaps, they are looking to construction and real estate businesses as a source of monies. To that end, tax enforcement agencies of state and local governments are ramping up their audit examination staff and increasing the depth and scope of taxpayer audit examinations.

As a result, taxpayers are facing a new audit examination process that takes longer than ever. This drawn-out process, coupled with new technical issues being raised, is causing taxpayers to agree to costly settlements in order to close out never-ending sales and use tax examinations and avoid litigation.

Construction businesses in particular face challenges in making proper state and local sales and use tax determinations with respect to their projects and operations—challenges that largely are attributed to the disparate application of the rules among the 45 states (and various localities) that currently impose such a tax.

Because construction projects are individual in nature, each with its own particular scope of work, businesses often must make their best interpretation of the rules. Any misinterpretation could result in significant sales and use tax exposure, which may not come to light until an examiner knocks on the door—in most cases years after a project’s completion. Any exposure related to sales tax that should have been collected from a customer will become the liability of the construction business under audit, substantially impacting job profitability.

Implement an Internal System
The best way to tackle this problem is to implement an internal, proactive sales and use tax system. This system essentially revolves around maintaining a separate, audit-ready sales and use tax documentation file for each customer project. The file should contain a copy of all the relevant project documentation, including purchase orders, contracts, architectural drawings and schematics, job order changes, subcontractor and materials purchase invoices, exemption certificates and any other documentation supporting of any sales and use tax determinations (e.g., vendor discussions and technical memos).

Creating this file system will preclude the need to search for critical documentation in the event of an examination. Additionally, it will place an emphasis on making accurate state and local sales use tax determinations during the pricing stage of a project.

Proactively reviewing contract language and addressing the sales and use tax applicability before a particular job contract is executed is especially important if a job contains a taxable and nontaxable component. This provides the opportunity to determine a favorable and supportable allocation within the contract to minimize the taxable portion, and shifts the burden of proof to any future examiner to disprove the allocation. The lack of a specific allocation within the contract most likely would result in a less favorable allocation negotiated with an examiner.

Another benefit of having a proactive sales and use tax system in place stems from the area of enterprise zone exemptions and tax-exempt customers. Favorable enterprise zone exemptions in qualified areas across the country are surprisingly overlooked or not maximized to their fullest potential. They directly impact the sales and use tax cost of materials purchased for projects within qualified zones and could favorably affect job profitability.

Opportunities to maximize customer-specific tax exemptions also are overlooked, resulting in lost opportunities to increase job profitability. In most cases, businesses cannot recover any lost benefits after a project’s completion.

It is important to keep in mind that the goal of tax examiners is to raise issues that enhance their tax assessment. Consequently, contractor refund opportunities usually are not identified. These opportunities are more common than businesses realize, and are more likely to be detected early on in a project.

James Helmus is senior managing director of FTI Schonbraun McCann Group, New York. For more information, email jhelmus@smgllp.com.