Five Indirect Tax Mistakes That Could Cost You Money

Sales and use tax processes at many businesses are in need of some serious revamping. Here's where companies get it wrong -- and how one got it right.

For something that's supposed to be one of only two certainties in life, tax surely generates a vast amount of uncertainty. This is especially true in the realm of sales and use taxes, where businesses must cope with a patchwork of thousands of jurisdictions across the United States and constantly fluctuating rules and rates. The average number of rate changes per year is around 800, according to a March report from tax software firm Vertex. Since 2000, 2,631 new indirect taxes have been levied. And the rate of change seems to be speeding up; the average number of changes in 2008 and 2009 was 30 percent higher than the average number from 2000 to 2007.

The average sales tax rate nationwide is around 5.5 percent, and of course it goes much higher when local rates overlay the state levy (as high as 9.4 percent in Tennessee). Unlike income taxes, sales and use taxes have to be collected and remitted whether you make a profit or not; for any given transaction, an error could translate to a direct loss to the company's bottom line.

The complexities of indirect tax compliance result in companies carrying large reserves to cover possible penalties. But the risk is reputational as well as financial, notes Jon Sweet, principal and chief strategy officer with tax solutions provider Ryan Inc. "There's a critical new relationship between the quality of tax management and the overall corporate reputation and market capitalization," he says. "With transaction tax representing such a large portion of overall corporate risk and cash flow, it's critical that the tax function actively participate in mitigating risk."

As a first step in that direction, tax managers may need to convince the upper echelons of management that the sales and use tax process is in need of some serious revamping. Here are some of the more common, and costly, missteps that companies make.

1. Striving for the lowest cost. While many organizations set their sights on maximum cost efficiency, giving too little weight to effectiveness in the equation can backfire. Costs per return vary between roughly $150 and $1,600, according to "Transactional Tax Benchmarking: An Executive Report and Summary of Findings," released in May 2009 by corporate tax solutions provider Ducharme, McMillen and Associates Inc. (DMA). But companies that shoot for the low end are not effectively managing their tax decisions. By reducing the time they spend on planning and research, they end up with higher levels of overpayments. Underpayments are higher, too; companies with the lowest cost per return allocate 22 percent of staff time to audits, as opposed to 15 percent for those with the highest cost per return.

Companies that underinvest in the function tend to remain stuck in what Sweet calls "the low-value loop," a cycle of reacting to demands on an unplanned, as-needed basis. "Compliance can be overwhelming," notes Michael Moore, managing director at audit firm CBIZ MHM. "If employees responsible for the tax area don't have the time they need to prepare and analyze the tax positions the company is taking, the benefits of positive planning won't occur." Another hidden cost is stress and strain on tax professionals, resulting in long hours, burnout, and, in the long run, staffing problems.

2. Skimping on technology. Many companies rely on their ERP and billing systems to handle indirect taxes, often supplemented with homegrown tax databases and spreadsheets. For small companies with limited exposure to multiple jurisdictions, such a setup may work just fine. But as a firm grows, does more business across state lines, acquires nexus in more jurisdictions, and adds customers via M&A activity, it quickly runs up against limitations. Researching the ever-shifting maze of rules and rates becomes increasingly onerous.

Relying solely on a standard ERP system means depending on a salesperson or billing clerk to know not only the right rates, but also the taxability rules, points out Diane L. Yetter, president of Yetter Consulting Services Inc. in Chicago and a 25-year veteran of the tax tech field. While most ERP systems can handle taxability by customer location, taxability by product is a different matter. "This requires somebody to be aware, to override," she says. "Let's say in 80 percent of the states it's taxable, and in 20 percent it's exempt. You might say ‘OK, I'll set it up as taxable,' but let somebody override it at billing time. To rely on somebody to remember when and how to do that manually is obviously very time-consuming and very risky."