Sales tax audit guide for indirect tax departments to help identify common audit triggers, tips on what to expect, and how to reduce the risk of an audit.
What triggers a sales tax audit and how do you reduce the risk of an audit?
Almost all companies undergo a sales tax audit at some point. It is not only time-consuming, but also takes lots of resources as the process can take from a few weeks to several months. This sales tax audit guide can help indirect tax teams avoid common audit triggers and manage the sales tax audit as smoothly as possible.
What is a sales tax audit?
A sales tax audit determines whether a business has collected and paid the correct amount of sales tax owed to the state for taxable transactions. Auditors examine financial documents and compare total sales revenue with sales that resulted in the collection of sales tax. The process also involves a review of sales tax payable against the sales tax the company actually paid.
A sales tax audit often occurs when a state tax agency suspects a business of understating its reported sales or when the sales tax return filed with the state doesn’t match what was reported to the Internal Revenue Service (IRS). Indirect tax departments are under increasing pressure to stay on top of new sales tax laws and regulations, while reducing audit risks. Sales tax audits are distracting and come with the potential for costly penalties and fees that can have a negative effect on a company’s bottom line.
Download our free whitepaper on managing sales and use tax audits. This survival guide offers strategies and tips from former auditors on how indirect tax teams can avoid audits and minimize their effects.
How do you prepare for a sales tax audit?
Sales tax auditors examine federal income tax returns to reconcile the gross sales between the federal return, the sales tax return, and the sales recorded in accounting records. Auditors also examine the depreciation schedule to determine if any sales or purchases of fixed assets occurred during the audit period.
If your business has been selected for an audit, consider using a specialist, such as a CPA, a sales tax expert, or a tax professional who specializes in state and local taxes (SALT). A specialist can negotiate the terms of the audit and manage how much access the auditor has to your business.
The next step is to gather the documents required for an audit while also controlling the scope of information you give to the auditor. Providing well-organized documents that are easy to understand (invoices, exemption and resale certificates, summary reports, tax returns, etc.) can help ensure a smooth process. Be prepared to produce additional financial documents, including general ledgers and sales journals.
Other strategies for streamlining audits include:
- Disclose known errors to the auditor up front
- Treat the auditor with respect
- Assign one person from your company to manage the relationship with the auditor
- Ask the auditor for updates during the process
- Negotiate with the auditor before the final assessment
Which indirect tax reports fulfill sales tax audit requests?
Audit requests can be complicated and time-consuming. Advanced indirect tax reporting and analytics software allows you to fulfill sales tax audit requests and quickly generate reports.
- Find taxes that have been collected for specific tax jurisdictions
- Export audit data to other file formats
- Create custom ad hoc audit defense reports
The ability to produce audit data quickly saves time and can both strengthen your audit defense and protect your company’s bottom line.
How far back can a sales tax audit go?
Each state has a statute of limitations for a sales tax audit or assessment that defines how far back an auditor can inspect transactions and sales tax returns. Most states’ statute of limitations on a sales tax audit is 3 years from either the return due date or the return filing date (whichever comes later), though that time can be higher in any given state. The statute of limitations can be expanded if an auditor believes that the amount the business may owe is misrepresented by a certain percentage (such as 25%).
In most states, the statute of limitation periods for sales tax audits don’t apply in instances of fraud, evasion, or gross negligence. If you think your business may owe taxes, a sales tax amnesty program or voluntary disclosure agreement (VDA) may be available.
How does a sales tax audit work?
The auditor reviews your records over a period of days, weeks, or months in an effort to discover oversight or fraud and promote compliance with tax laws. The auditor’s goal is to increase revenue for the state and apply penalties when a business owes taxes.
The job of a sales tax auditor is to:
- Examine discrepancies between primary source data and sales tax returns
- Search for mistakes, errors, and omissions in data
- Make sure you charged and paid the appropriate amount of tax on purchases
- Ensure you charge appropriate taxes on shipping
- Review sales tax exemption certificates with resales
How long does a sales tax audit take?
The duration of a sales tax audit depends on a number of factors, including company size, audit schedules, activity in the local jurisdiction, the complexity of the data and issues involved, and the transparency of the data. Large, complex companies may have very short audit cycles because tax departments are equipped to provide the exact documents and data auditors require. The best-case scenario is that a sales tax audit will take 1 to 6 months to complete — or, worst case, up to years.
What are the top sales tax audit triggers?
A sales tax audit can be triggered for several reasons by state tax authorities. Most states use systematic methods and data to evaluate and determine businesses that are at potential risk for under-reporting or underpaying sales and use taxes. Authorities take audits seriously as sales and use tax revenue accounts for nearly a third of state tax revenue.
If you know what the authorities are looking for, your business can take steps to reduce the chances of being audited. While you can control some factors that may trigger an audit, like the location of your business, other factors, including high net sales or the ratio of exempt sales to total sales, are just part of doing business.
11 most common reasons for sales tax audit triggers:
- High risk industry – Your industry is known for substantial non-compliance or under-reporting sales taxes.
- Complex industry – You operate in a high-revenue, high-volume industry with complex sales and purchases. For example, companies in the oil and gas industry are targeted more frequently for audits, and would benefit from a tax determination software for that industry.
- Compliance check on new company – You’re a new and/or small company selected for an audit by the Department of Revenue to help keep your books and processes in order and maintain compliance with state tax regulations before you grow too quickly or get too big.
- Audited vendor or customer – One of your customers or vendors was audited, and the trail leads back to you.
- Reported to tax authorities – A whistleblower, outside party, or disgruntled employee reported you.
- Unusual financials – Your business has a much higher income than your competitors, or your revenue exceeds the threshold that requires your business to comply with changing sales and use tax requirements, and register and collect sales tax in the state.
- Past audits – You have been audited in the past and had sales and use tax audit liabilities. In addition, businesses that request sales and use tax refunds are often selected for audits.
- Major business change – Your business had a major change—an acquisition, opening/closing a location, or filed for bankruptcy—or state sales and use tax laws have changed.
- Type of business entity – Your business operates as a sole proprietorship, partnership, or other business structure that is more likely to be audited. Large corporations are also audited regularly.
- Use of resale certificates – Your business issued resale certificates, or you claimed a high amount of exempt sales or deductions.
- Late reporting and filings – Your business consistently reports or files sales taxes late, so tax authorities see that you are struggling.
Tax authorities don’t need a particular trigger to launch an audit. State agencies also schedule random audits, or your business may be statistically selected for an audit.
What happens if you fail a sales tax audit?
If an IRS audit finds that your business has not collected and paid the appropriate sales taxes, you may be subject to substantial penalties and interests, as determined by state policy.
By failing to collect sales taxes from customers, you:
- Are required to pay all past-due taxes out of pocket because you failed to collect it from your customer
- Have to pay penalties and interest. Each state sets its own penalties for not paying sales tax, but the amount generally totals about 30% of the total sales tax due
- May face criminal charges if the audit shows that your business intentionally defrauded the state. This rarely happens, but it is possible.
How can you reduce the risk of a sales tax audit?
You can take steps to avoid common pitfalls that can lead to sales tax audit penalties by:
- Determining use tax relevancy
- Maintaining exemption and resale certificates
- Accurately reporting sales
- Calculating and charging correct rates
- Analyzing previous audits and assessments
- Understanding the unique sales and use tax rules and regulations where your company does business
- Reviewing all records for discrepancies before reporting and remitting sales tax accruals
- Validating proper pre- and post-acquisition taxes from a recently-purchased business
- Ensuring that marketplace facilitators have collected and remitted the right amount of taxes on your organization’s internet sales
Automated processes that determine and calculate taxes, apply rates in real time, and ensure compliance for each tax jurisdiction can help businesses avoid common pitfalls. A centralized tax data warehouse for corporate taxes allows indirect tax teams to control tax reporting, find data quickly, and gain confidence about the company’s tax reporting and compliance processes.
How can you help your tax department?
States enact hundreds of new tax laws each year, so your indirect tax team needs to stay up to date on the changes and apply the latest rules and rates the moment they become effective. Plus, every time your company launches a new product or introduces a newly taxable item or service, it increases your odds of being audited.
It’s essential to develop a solid understanding of common sales tax audit triggers and how changes in your business can increase your odds of being audited. Using tax software like ONESOURCE Determination allows companies to automate indirect tax calculations on transactions without the headache of managing and maintaining an in-house solution or reporting system. As a cloud-native application, ONESOURCE minimizes the cost of scaling quickly to meet the needs of a growing business, without the worry of downtime for updates.
Replacing end-to end manual processes with a suite of automated indirect tax solutions minimizes the potential for human error and omission and ultimately reduces operating costs. Tax technology can also reduce the risk of an audit, saving your business time and the need to pay costly penalties. If you are audited, indirect tax software enables you to respond to audits faster and more accurately.
No business wants to be audited, but you can use what you learned from the experience to improve your business operations and bookkeeping practices. To help prevent future audits, make sure you understand the red flags that triggered the audit. If you’re faced with another sales tax audit, address all the issues uncovered by the auditor as soon as possible to ensure the process goes quickly and won’t require much of your resources. And get tips and advice from former auditors on how to manage a sales and use tax audit.