Tax & AccountingSeptember 01, 2019

Construction Company Audits: Red Flags in the In-Person Interview

Red Flags in the In-Person Interview

Previously, I’ve identified some red flags that might get the attention of the tax auditor both before and during the various stages of a sales and use tax audit. In this blog, I focus on lights to go off for auditors during your initial in-person interview. This meeting often results in changes to the pre-audit plan.

In-person Initial Interview — General Questions

Although every audit is different, the initial interview may go a long way in determining the auditors next steps. Therefore, you should be prepared to answer these more general questions in a knowledgeable, comfortable, straightforward and nonconfrontational way. Here are some examples of the types of general questions that might be asked in the initial interview, organized into four categories:

  • Nature of your company’s construction business
  • Accounting, finance, internal controls and sales & use tax tools (software, legal research, etc.)
  • Employee and subcontractor
  • Materials and supplies process

Nature of the Company’s Construction Business

You can anticipate broader-type questions like the how, when, where, who, and how much of the business, e.g., how long have you been in business, what types of construction do you do, where geographically do you perform these jobs, what type of contracts do you use and how do you get customers?

Accounting, Finance, Internal Controls and Sales and Use Tax Applications

You should expect to be asked:

  1. What is your ERP system and how does the accounting system and methods work within that system?
  2. Have you recently changed ERP systems?
  3. Do you have specialized tools, e.g., software, to process the sales and use tax component of transactions, and how do these applications work with your ERP and accounting system?
  4. Describe your internal control systems.
  5. Are your books and records audited regularly by outside accounting firms?
  6. How do you finance your jobs?
  7. How is overhead handled?
  8. How do you process change orders?
  9. How does your budgeting system work?
  10. How is cash/income received and disbursed?

Supply of Labor: Employees and Subcontractors

Most often, there will be many questions on who does the construction work and how that work gets done. Subcontractor-related questions will be a major emphasis. This would include questions about the type of subcontractors needed for each job, how they are selected, the types of contracts used to establish the roles and responsibilities of the subcontractor, how fees are determined, and even mere detailed questions like who will be issuing the Form 1099s for the work.

For some jobs, internal personnel will do more of the work than subcontractors. In other jobs, subcontractors may do the lions-share of the work. The auditor will want to know more about how that allocation is determined in general and for each type of job.

Supply of Materials and Supplies

The materials and supply questions may drive a lot of the interview because of the sales and use tax implications for such purchase and subsequent use of such materials and supplies. So, expect questions like, what materials are purchased for each job and are where these suppliers are located? Who orders materials and are they shipped to you directly or the job site? Do subcontractors provide their own material, or do you purchase it for them? And, do you have an inventory for unused materials and supplies?

Tax Audit Interview: Be careful what you say and how you say it

Your in-person interview with the auditor is a critical step in the audit process that might raise some serious questions for the auditor that will drive or at least significantly influence subsequent audit steps like:

  • Audit and verification procedures (sampling, computer-aided, etc.)
  • Use tax audit
  • Identifying tax issues raised during audit and follow up audit procedures
  • Proposed Adjustments and Appeals

Although the audit plan may change depending upon what the auditor learns from the actual audit of your books, you must understand the importance of the initial in-person interview. It is a best practice to honestly and straightforwardly answer all the questions you are asked. Do not volunteer information outside the scope of the question. This means that you should anticipate and prepare for answers to the kinds of questions that will be asked in the interview. This will help to avoid any misstatements in the interview that might lead to unnecessary and undesirable results.

The Multi-State Tax Commission (MTC) in a public draft, Sales & Use Tax Audit Manual, recommends the following with respect to the conduct in an audit by both the auditor and the company:

The audit staff shall:

  • Practice professional courtesy during the audit.
  • Request information that is pertinent to the audit based on state requirements.
  • Conduct the audit as efficiently as possible.
  • Discuss all audit findings with the taxpayer.
  • Make every effort to accommodate the taxpayer’s schedule.
  • Ask for waivers when needed to allow sufficient time for the state and taxpayer to review the audit findings.
  • Know and obey the confidentiality laws of each participating state.

Taxpayers will:

  • Respect the state’s role to conduct the audit.
  • Extend professional courtesy to the audit staff.
  • Respond to the information requests in a timely manner.
  • Sign reasonable waiver requests.

In future blogs, I will look deeper into the actual conduct of the audit of your books and records. I will describe other possible red flags in a construction industry that has many complex sales and use tax issues. Given the complexity of these types of audits and the different approaches that can be taken by auditors, it is important of having access to experienced tax professionals who can provide sound compliance advice backed up and supported by best-in-class technology tools. This advice and tools can help to surface risk areas before they become audit issues.

Mark Friedlich
Author at Tax & Accounting
Mark Friedlich, a CPA & tax lawyer, is the principal international & corporate indirect taxation analyst for Wolters Kluwer Tax & Accounting. He is a member of the U.S. Senate Finance Committee’s Chief Tax Counsel’s Advisory Board, advisor to 14 state taxing authorities, and a member of the American Bar Association’s Tax Section and AICPA’s Tax Section leadership teams. Prior to joining Wolters Kluwer he was a Managing Tax Partner at PricewaterhouseCoopers.
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