State Sales and Use Tax Audits Are Increasing in 2022: Here's How to Avoid One

When a state decides to audit a business, they send a letter to alert the owners of the impending investigation. Though audits can seem random, in most cases, there’s a specific motivation behind why businesses are selected. This post will explain why audits are increasing in 2022, define what can trigger an audit, and explain what proactive steps you can take to protect your business.

What’s the Purpose of an Audit

The primary purpose of an audit is to ensure voluntary compliance. State tax authorities use audits to investigate businesses suspected of misreporting sales and tax payments - whether intentionally or not. By evaluating a company’s financial records, auditors can identify reporting oversights or mistakes and spot fraudulent activities. If a business is non-compliant with its sales and use tax obligations, states can require them to remit unpaid taxes and any applicable penalties and fees – all money that increases state revenue.

Sales and Use Tax (SUT) Compliance 101

Two primary things trigger sales tax obligations between a business and a state. The first is physical presence - meaning a business has a literal physical connection to a state. 'Presence' can exist in the form of a physical store or office or can be triggered by a local warehouse, remote employee, or other physical connection. The second is economic nexus, an inter-state sales tax obligation based on sales and/or transaction volume.

The concept of economic nexus was introduced in 2018 with the decision in the South Dakota v. Wayfair Supreme Court case. Now, most states have passed legislation on economic threshold requirements, and they're eager to start collecting money from businesses that aren't keeping up their end of the deal. States hungry for increased revenue are increasing their audit frequency and volume in 2022, and we expect to see this trend continue for the next several years.

How Auditors Decide Which Businesses to Audit

Various activities can trigger an audit, but these are the most common things that prompt a state to take a closer look at a business. By and large, the biggest trigger facing businesses today is that many companies have yet to register and remit taxes in states where they've triggered economic nexus. Some underestimate the number of states where they have nexus; others are unaware of their obligations altogether. Tax authorities know this and are taking advantage of this opportunity to conduct more audits and recoup unpaid tax revenue for their state.

State auditors pay close attention to businesses that:

• Operate in a high-risk industry.
  A handful of industries are always at higher risk of audits due to the nature of the business and the complexity involved in financial reporting and sales and use tax regulations. 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, and without a good system in place, it’s easier to end up with discrepancies between your financial reports and tax returns. Therefore, auditors often target businesses with a high percentage 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 mishandlings, or HR issues – true or not – can capture a state auditor’s attention.
  
  
• Report mismatched or inaccurate revenue - intentionally or not.
  If your books don't match your tax returns or your state business tax filings don't match the numbers on your federal return, your business may be inviting an audit. Sometimes the person filing a business return misunderstands how a specific 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 various industries day in and day out, so they get used to seeing patterns in the ratios between taxable and exempt sales. If expected ratios are off, a state may want to look deeper.
  
  
• Have recently undergone a significant change.
  If your business acquires another company, goes through a merger, or opens or closes a location - it can signal that something is going on within the business. States pay attention to these things, and big changes like those listed above can trigger an audit.
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Lesser-known things can also trigger an audit. For example, if one of your vendors or customers is audited, it can trigger an audit by association. After all, where there’s smoke, there’s often fire.

How Auditors Find Out a Business is Non-Compliant

Let’s take a look at how auditors would figure out that your business is not meeting 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 purchases goods, then re-sells the same goods. If your business sells goods that will be resold (ex; you sell tires to tire shops) and your customers have a resale certificate, they are tax-exempt because tax will be collected from the purchaser upon resale. However, you must collect resale certificates and keep them on file if you sell any wholesale (exempt) items in order to remain tax compliant. Neglecting to do so means you’re likely to have disallowed sales for resale in an audit. State agencies analyze the ratio of a business's taxable and exempt sales to determine audit selection.

2. Unreported sales.

If you haven’t registered as a seller in a state where you have nexus, how does the state figure out that your business should be paying tax but isn’t?

States can:

• Compare directories of high-volume businesses to state registration databases to verify 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-reference state business registration records with import/customs records to spot businesses dodging state sales tax obligations.
• Cross-reference tax payments from marketplace facilitators (Amazon) on behalf of marketplace sellers (your business) to verify your business is registered in their state.

Auditors also use common sense to identify potential targets and may opt to investigate if something they see when visiting a business doesn’t line up with returns they have on file.

3. Recorded vs. reported differences

If your business ledger reflects different numbers than your state or federal return, that’s a signal that there may be bigger issues at hand. Auditors have access to assess all your filed records and use tools that flag businesses with mismatched revenue reporting.

What’s Assessed During an Audit

Tax compliance misrepresentation can range from unintentional negligence to willful fraud. To determine what’s happening, auditors compare primary source data to your filed (or missing) sales tax returns. If they find discrepancies on your returns, they’ll likely do a more thorough investigation. An auditor may run specific tests to evaluate whether tax is being properly reported or may contact vendors directly to confirm.

How to Keep Your Business Compliant and Avoid State Audits

Don’t leave SUT compliance to chance. Instead, prioritize the long-term financial health of your business by enlisting the help of a trusted accounting firm dedicated to keeping your business in the state’s good graces.

An experienced accountant will help you understand your tax liabilities and remain compliant by staying on top of tax payments and return filing deadlines. They can also help you implement smart technology that enables you to simplify the process by having an up-to-date view of nexus obligations and understanding your compliance risks in each state.