Taking the Fear Out of
Washington State Excise Tax Audits

People fear what they do not understand.

The thought of a Washington State excise tax audit is enough to send many contractors into a cold sweat, and for good reason. Contractors are subject to some of the most complex applications of business and occupation and sales/use taxes. Washington State distinguishes seven different 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. Plus, given that the revenue per customer is typically greater in construction than other retail industries and: 1. Washington’s sales tax rate is one of the highest in the nation; 2. recent legislation created a mandatory 5% penalty on any assessment issued by the Department of Revenue; a simple mistake can turn into a huge financial nightmare.

Unfortunately, the fear of the unknown is likely to become reality. With state budget shortfalls and no new increase in general business and occupation or sales/use tax rates, the Department of Revenue is hiring more auditors to increase taxpayer compliance - read "tax assessments" - so the State can meet its budgeted revenue requirements.

However, if you understand the methodology used by Washington revenue auditors, you can be prepared and confident there will be no surprises if your company is selected for an audit.

Gross Receipts Reconciliation

Auditors catch many contractors for failing to report some portion of their total revenue on their Washington excise tax returns. Auditors 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 to 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, keep documentation to prove the differences.

Classification

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. In fact, 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

Deductions common to contractors include bad debts, interstate sales, and cash discounts. Any deductions claimed that reduce the amount of gross receipts and sales tax must be properly documented.

The audit process can be broken down into the following four steps:

1. Verifying the gross receipts reported
2. Verifying the business and occupation tax classifications reported and sales tax collections from customers, if applicable
3. Verifying deductions taken and
4. Verifying sales and sales tax paid on purchases items.

Paying Sales and Use Tax

Another area full of traps for contractors is determining which purchased items are subject to sales or use tax. The general rule of thumb is if materials are included in the finished project and are desired by the customer they are “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 they left on the molding was not desirable and I pulled it off, so the painter should have paid sales or use tax when the tape was purchased.

It is important to note that if you are performing work for the federal government or building certain public roads, the contractor is the deemed consumer and must pay sales or use tax on all the materials used on the job.

One area of 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 soil to job specifications. If the same operator applied water only to control dust, that activity would be subject to sales tax.

Even if you think you’re pretty good at correctly paying sales and use tax, a review of your accounts payable invoices may reveal some surprises.

Performing these steps as a self check-up or having a trusted state tax professional perform a compliance review will give you confidence that you understand the tax laws as they apply to your business activities and you are reporting your taxes correctly. If you have any concern that your company may not be reporting its tax obligation to the state appropriately you should give us a call to discuss it.

If you have any questions, please contact Darcy Kooiker, Director of State and Local Tax Services at dkooiker@bpcpa.com or 425.454.7990