Key takeaways
- Know what triggers audits: Inconsistent reporting, missing filings, or unverified exemptions are common red flags for sales tax audits.
- Preparation is protection: Organized records, documented exemptions, and strong internal controls greatly reduce audit risks.
- Stay proactive: Regular reviews, tax software, and professional guidance help ensure compliance and smooth the audit process.
In short: A sales tax audit is a state or local tax authority's review of whether a business collected and remitted sales and use tax correctly. Common triggers include unusual reporting, nexus in several states, large exempt sales and late filings. Good records, internal controls and expert help make a sales tax audit easier to survive.
Sales tax audits can be a daunting experience for any business. Having the government check your financial records can feel stressful and overwhelming. But with the right knowledge and preparation, you can get through a sales tax audit with ease. This guide explains what sales tax audits are, what commonly triggers them, how to avoid them, and what to expect if you face one.
What is a sales tax audit?
A sales tax audit is a close look at a company's records to check that it collected and remitted sales and use tax correctly. State or local tax authorities carry out these audits, mainly to make sure businesses follow tax laws. Auditors review transaction records, invoices and tax filings in detail. They look for any discrepancies or underreporting.
By examining these documents, auditors check whether a business has worked out the sales tax it owes correctly, based on the taxable sales it reported. This protects the integrity of the tax system. It also makes sure the government receives the correct amount of tax revenue.
Sales tax audits can start for many reasons. Knowing these reasons shows you which practices may make an audit more likely. A sales tax audit does not just aim to find mistakes. It also aims to teach businesses proper tax reporting and payment practices, which encourages voluntary compliance.
The audit process can be thorough. It may include a review of electronic and paper records, interviews with staff, and sometimes on-site visits to see how the business works. Through this careful review, auditors assess how well a company follows complex sales tax rules. These rules can vary a lot from one jurisdiction to another.
What triggers a sales tax audit?
A sales tax audit is usually triggered by red flags in your filings or activity, such as unusual reporting, multi-state sales, large exemptions, late filings or complaints. Knowing these triggers helps you prepare and avoid common pitfalls. Here are the most common triggers for sales and use tax audits:
Inconsistent or anomalous reporting
Reason: Big gaps between your reported sales and what tax authorities expect can raise red flags. They may compare you with industry standards, your previous filings, or similar businesses of the same size and type. Unusual patterns in sales tax filings may also prompt an audit. One example is a sudden drop in taxable sales without a matching drop in gross sales.
Example: A business keeps reporting sales that are much lower than similar businesses in the same region and industry.
Nexus and interstate sales
Reason: Businesses that operate in several states or make large interstate sales might be audited. The state wants to check that they collect and remit sales tax in every jurisdiction where they should. Having "nexus" in a state means you have enough physical or economic presence there to require sales tax collection. Read more in our guide: State Sales and Use Tax Audits Are Increasing in 2022: Here's How to Avoid One.
Example: An online retailer has substantial sales in a state where it has no physical presence. But its sales exceed the economic nexus threshold for sales tax collection.
Exempt sales and claimed exemptions
Reason: High levels of exempt sales or many claimed exemptions can trigger an audit. States want to check that the exemptions you claim are legitimate and properly documented.
Example: A business claims a large share of its sales as exempt without proper documentation. The reasons given may be sales for resale, out-of-state sales, or sales to tax-exempt organizations.
Late or Non-Filings
Reason: Repeated late filings, missing returns, or unpaid sales tax can lead to an audit. States monitor compliance and may audit businesses that show a pattern of non-compliance.
Example: A business often misses its sales tax filing deadlines or does not file returns at all.
Complaints or referrals
Reason: Customer complaints, tips from competitors, or referrals from other government agencies can lead to an audit. Sometimes internal whistleblowers report suspected tax evasion or fraud.
Example: A competitor reports that a business is not charging sales tax on taxable goods or services, which prompts an investigation.
How can you avoid a sales tax audit?
You can lower the risk of a sales tax audit by reporting accurately, keeping full records and using the right tools and advice. These practices should be standard for any business:
- Ensure accurate reporting and remittance: Report and remit all sales tax on time, using the exact rates and rules of each jurisdiction where your business operates.
- Maintain comprehensive records: Keep detailed, organized records of all transactions, tax payments and filings. Include details of every sale, including exempt sales, with documents that justify any exemptions you claim.
- Stay informed about tax legislation: Sales tax laws keep changing. Stay up to date by subscribing to tax law updates, attending relevant workshops, and consulting tax professionals.
- Implement robust internal controls: Set up strong internal controls over financial reporting and tax calculation. This includes automated systems that are regularly updated with current tax rates and rules.
- Conduct periodic internal reviews: Run regular internal reviews or self-audits. They help you catch and fix mistakes before they attract the attention of tax authorities.
- Engage tax professionals: Work with tax professionals or advisors. They can give tailored guidance, spot potential red flags, and help you deal with them effectively.
- Provide proper documentation for exemptions: Back up every exempt sale with the right exemption certificates or other required documents that justify the tax-exempt status.
- Regularly train staff: Give ongoing training to staff who handle sales tax compliance. This keeps them aware of current rules and best practices.
- Monitor sales tax jurisdictional changes: Regularly review and update the list of jurisdictions where your business operates. This helps you meet local sales or use tax requirements.
- Leverage technology: Use sales tax software and tools to automate how you calculate, collect and remit sales tax. This improves accuracy and reduces the risk of errors.
How should you prepare for a sales tax audit?
To prepare for a sales tax audit, review your records, understand your own tax processes, bring in an expert and brief your team. Good preparation keeps stress and potential financial impact to a minimum.
- Conduct a thorough review of your sales tax records. Make sure all documents, including exemption certificates, are complete and easy to find. They should cover the audit period. Include sales and purchase invoices, exemption and resale certificates, tax returns, and any letters with the tax authorities.
- Develop a comprehensive understanding of your business's sales tax processes. Know how sales tax is calculated on different types of sales. Be ready to explain any anomalies or discrepancies in your tax filings. Your business operations or tax practices may have changed a lot during the audit period. If so, be ready to discuss these changes and how they affect your sales tax obligations.
- Engage a tax professional with experience in handling sales tax audits. They can review your records before the audit and spot potential problem areas. They can also advise you on how to deal with these issues early.
- Educate your team about the audit process. Make sure key staff are available and ready to give information or explain things when needed. This includes people from accounting, sales and IT. They can explain the details of transactions, how you use sales tax software, and how you collect and report sales data.
By taking these steps, you can face a sales tax audit with confidence. You will know your business has done everything it can to keep its sales tax reporting and records accurate.
What happens during a sales tax audit?
During a sales tax audit, an auditor from the tax authority reviews your sales records, financial statements and other relevant documents in detail. The goal is to check how accurate your sales tax compliance is. Expect the auditor to ask for a wide range of documents. These include, but are not limited to, sales invoices, exemption certificates and tax returns.
The auditor may also interview key staff who handle sales, accounting and tax reporting. This helps the auditor understand your processes and controls for collecting and remitting sales tax.
A main focus will be finding unreported or underreported sales, wrong tax rates, or incorrect exemptions. The auditor will carefully compare reported sales with bank deposits and other financial records. This checks that all taxable sales were captured and taxed correctly.
Be ready for the auditor to examine specific transactions in detail. They may ask how you calculated sales tax or why you treated certain sales as exempt. This part of the audit can take a long time if you have a high volume of transactions or many sales with complex taxability issues.
Approach the sales tax audit in a cooperative and open way, and provide the requested information on time and in good order. The smoother the audit, the sooner it ends, and the less it disrupts your business. Showing a commitment to compliance can also improve the outcome of the audit.
What happens after a sales tax audit?
After a sales tax audit, you receive a final report with the auditor's findings and any changes to your sales tax liabilities. You may owe additional taxes, plus potential penalties and interest for any discrepancies found. Check these findings carefully. You may be able to challenge inaccuracies or negotiate the amounts due.
It is highly recommended to bring in a tax professional at this stage. They can advise you on how to respond to the audit outcome, including filing an appeal if you disagree with the findings. They can also help you set up a payment plan if needed, which eases the financial burden.
The end of an audit is also a good time to improve your sales tax practices and prevent future issues. Use what you learned during the audit to strengthen your compliance and reporting procedures.
How can your business handle sales tax audits with confidence?
You can handle a sales tax audit with confidence by understanding the process and preparing early, which keeps you compliant and limits potential issues. Keep accurate records, stay informed about tax laws, and follow best practices. That way you can get through audits smoothly and avoid significant financial penalties.
Do you need help with your sales tax compliance? Book a free call with one of our sales tax experts to find bespoke solutions for your business, optimize your tax costs, and reach millions of new potential customers.
How Taxually handles this
Taxually’s LumaTax runs a nexus analysis on your sales, helps you register in the states where you must collect, and prepares and files multi-state sales tax returns, including Canadian GST/HST. LumaTax is currently available to enterprises and accounting firms. For the full workflow, read how to automate US sales tax filing in every state.
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Frequently asked questions
What is a sales tax audit?
A sales tax audit is an examination of a business's financial records by tax authorities to ensure compliance with sales tax laws.
How often do sales tax audits occur?
The frequency of audits varies by state and business size, but businesses with high sales volumes or previous non-compliance are more likely to be audited.
What documents are needed for a sales tax audit?
Key documents include sales records, tax returns, exemption certificates, and purchase invoices.
How can I prepare for a sales tax audit?
Ensure accurate record keeping, perform internal reviews, and correct any discrepancies before the audit.
What happens if discrepancies are found during the audit?
Businesses may need to pay additional taxes, penalties, or interest. They can also dispute the findings if they disagree.
Can a business dispute the findings of a sales tax audit?
Yes, businesses can dispute the findings through formal procedures and seek resolution with the tax authorities.
