Key takeaways
- Audit activity is rising: States are increasing sales tax audits to recover lost revenue, particularly from businesses unaware of their nexus or registration obligations.
- Common triggers include inconsistencies: Mismatched tax filings, unreported sales, missing resale certificates, and high-risk industries often attract auditor attention.
- Proactive compliance pays off: Regularly reviewing nexus exposure, maintaining accurate records, and using automation or expert support can help prevent costly audits and penalties.
In short: State sales and use tax audits increased in 2022 as states chased revenue after the 2018 South Dakota v. Wayfair decision created economic nexus. Common audit triggers include unregistered nexus, cash-heavy sales, mismatched returns, and odd taxable-to-exempt ratios. You can lower your audit risk by tracking nexus, keeping resale certificates, and getting expert help.
Update: Every state with a statewide sales tax now enforces economic nexus, since Missouri's $100,000 remote seller rule took effect in 2023.
When a state decides to audit a business, it sends a letter to alert the owners. Audits can seem random. But in most cases, there's a specific reason a business is selected. This post explains why audits are increasing in 2022, what can trigger an audit, and what proactive steps you can take to protect your business.
What's the Purpose of a Sales Tax Audit?
The main purpose of a sales tax audit is to ensure voluntary compliance. State tax authorities use audits to investigate businesses suspected of misreporting sales and tax payments, whether on purpose or not. By reviewing a company's financial records, auditors can find reporting oversights or mistakes and spot fraud. Related reading: Sales Tax Audits: A Comprehensive Guide.
If a business is non-compliant with its sales and use tax obligations, the state can make it pay the unpaid taxes. It can also charge any penalties and fees. All of this money increases state revenue.
Sales and Use Tax (SUT) Compliance 101: What Creates Obligations?
Two main things create sales tax obligations between a business and a state: physical presence and economic nexus. Physical presence means a business has a literal physical connection to a state. 'Presence' can be a physical store or office. A local warehouse, a remote employee, or another physical connection can also trigger it.
The second is economic nexus. This is an inter-state sales tax obligation based on sales and/or transaction volume.
The concept of economic nexus was introduced in 2018 with the South Dakota v. Wayfair Supreme Court decision. Now, most states have passed laws on economic threshold requirements. They're eager to collect money from businesses that aren't keeping up their end of the deal. States hungry for revenue are increasing how often and how many audits they run in 2022. We expect this trend to continue for the next several years.
How Do Auditors Decide Which Businesses to Audit?
Auditors decide which businesses to audit by looking for common triggers. The biggest trigger today is that many companies have not yet registered and remitted taxes in states where they've triggered economic nexus. Some underestimate how many states they have nexus in. Others don't know about their obligations at all. Tax authorities know this. They're using it to run more audits and recover unpaid tax revenue for their state.
State auditors pay close attention to businesses that:
- Operate in a high-risk industry.
Some industries always face a higher audit risk. This is due to the nature of the business and complex financial reporting and sales and use tax rules. However, under the new laws, merchandisers, manufacturers, software, cloud computing, and digital products companies are highly vulnerable to exposure. - Do lots of cash transactions.
Cash is harder to track. Without a good system, it's easier to end up with gaps between your financial reports and tax returns. So auditors often target businesses with a high share of cash sales, because they're more likely to have bookkeeping errors. - Get flagged by disgruntled employees.
Unhappy employees can report their employer to the state. Complaints about workplace conditions, financial mishandling, or HR issues, true or not, can catch a state auditor's attention. - Report mismatched or inaccurate revenue - intentionally or not.
Your business may invite an audit if your books don't match your tax returns. The same applies if your state business tax filings don't match your federal return. Sometimes the person filing misunderstands how a type of tax works. Other times, someone just mistypes a number on a return. - Have questionable taxable and exempt sales ratios.
Auditors review business books in many industries every day. So they get used to seeing patterns in the ratios between taxable and exempt sales. If your ratios look off, a state may want to look deeper. - Have recently undergone a significant change.
Your business might acquire another company, go through a merger, or open or close a location. These changes can signal that something is going on within the business. States pay attention, and big changes like these can trigger an audit.
Lesser-known things can also trigger an audit. For example, if one of your vendors or customers is audited, it can lead to an audit by association. After all, where there's smoke, there's often fire.
How Do Auditors Find Out a Business Is Non-Compliant?
Auditors find out a business is non-compliant by comparing data from many sources against its filings. Let's look at how auditors would spot that your business is missing its tax obligations in one of the top non-compliance categories.
The top three areas of non-compliance are:
1. Disallowed sales for resale.
A resale business buys goods, then re-sells the same goods. Say your business sells goods that will be resold (ex; you sell tires to tire shops). If your customers have a resale certificate, those sales are tax-exempt, because tax is collected from the buyer on resale.
However, you must collect resale certificates and keep them on file if you sell any wholesale (exempt) items. Otherwise, you're likely to have disallowed sales for resale in an audit. State agencies look at the ratio of a business's taxable and exempt sales when they choose whom to audit.
2. Unreported sales.
Say you haven't registered as a seller in a state where you have nexus. How does the state find out that your business should be paying tax?
States can:
- Compare directories of high-volume businesses to state registration databases to check if each company's website or phone number is in the state's tax system.
- Look at businesses registered to pay payroll tax or other taxes to a state and compare them to companies in their sales tax database.
- Cross-check state business registration records with import/customs records to spot businesses avoiding state sales tax obligations.
- Cross-check tax payments from marketplace facilitators (Amazon) on behalf of marketplace sellers (your business) to confirm your business is registered in their state.
Auditors also use common sense to find potential targets. They may investigate if something they see when visiting a business doesn't line up with the returns they have on file.
3. Recorded vs. reported differences
Your business ledger may show different numbers than your state or federal return. That's a signal that there may be bigger issues. Auditors can review all your filed records and use tools that flag businesses with mismatched revenue reporting.
What's Assessed During a Sales Tax Audit?
During a sales tax audit, auditors compare primary source data to your filed (or missing) sales tax returns. Tax compliance errors can range from unintentional negligence to willful fraud. If auditors find gaps in your returns, they'll likely investigate more closely. An auditor may run specific tests to check whether tax is being reported properly. They may also contact vendors directly to confirm.
How Can You Keep Your Business Compliant and Avoid State Audits?
You can keep your business compliant by getting expert help instead of leaving SUT compliance to chance. Put the long-term financial health of your business first. Work with a trusted accounting firm that keeps your business in the state's good graces.
For a closer look, see Contingent Liabilities and Wayfair: The Impact on SUT and Audit Teams.
An experienced accountant will help you understand your tax liabilities. They help you stay compliant by keeping on top of tax payments and return filing deadlines. They can also help you set up smart technology to simplify the process. This gives you an up-to-date view of nexus obligations and your compliance risks in each state. Read more in our guide: Missed Sales Tax Deadlines: What Enterprise Teams Overlook.
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.
Related guides
Frequently asked questions
Why do states conduct sales tax audits?
The main goal of a sales tax audit is to ensure businesses are compliant with state tax laws. Auditors review financial records to confirm that sales and use taxes are being reported and paid correctly — identifying underpayments, errors, or fraud where applicable.
What triggers a sales tax audit?
Audits can be triggered by many factors, including unreported sales, mismatched tax filings, missing resale certificates, or operating in a high-risk industry. States also target businesses with economic nexus that haven’t registered or remitted tax in jurisdictions where they owe it.
How can my business avoid being audited?
Stay compliant by regularly reviewing where your business has nexus, filing returns accurately and on time, and maintaining organized financial records. Automating tax compliance and consulting a professional accountant can help reduce audit risk and ensure accuracy across all jurisdictions.
