How to Prepare for a Sales Tax Audit
Sales tax is extremely complicated and can cause a whirlwind of trouble for sellers and businesses. One mistake can cost hundreds of thousands of dollars in penalties and interest. Because of this, sales tax audits can be very stressful. However, understanding audits and taking proactive steps toward sales tax compliance can help eliminate many issues that may arise.
Why You May Be Audited
States rely heavily on tax revenue for budget funding. And now, with the expansion of nexus in 2018, sales tax audits are becoming increasingly common for states to find sellers who underpay or don’t pay their taxes at all. There are many reasons why a state may decide to audit a certain seller or business. These reasons may be different for registered sellers and unregistered sellers. For registered sellers, there are some common “red flags” that may trigger an audit, but an audit may also be completely random. So, if you’re being audited, it could mean the state is aware of a potential issue, or it could mean nothing at all.
Some of the “red flags” that may trigger an audit for registered sellers include the following:
A pattern of filing your returns late
A pattern of filing substantial amounts of exempt sales
Filing returns that do not balance with what the state expects to receive
The use of incorrect forms
The use of incorrect rates
Industry issues - sometimes states will focus on all companies in an industry
Tips from former employees, competitors, customers, or vendors
Working to ensure you limit “red flags” will greatly lower your chances of being audited, but it will not completely eliminate the possibility.
For unregistered sellers here are some of the ways states find companies to audit:
Auditing of a seller's customers and seeing tax not being charged
Being registered for another tax type, like payroll taxes, and not sales tax
Web searches and website reviews either manually or by specialized software
Information sharing with the IRS or other states
Being registered with any agency within the state and not registered for sales tax
Amazon sharing inventory information
Inquiries to U.S. Customs and Border Patrol to track imports
Tips from former employees, competitors, customers, or vendors
There are many more ways that states may choose both registered and unregistered sellers for audit, but the ones we have listed are some of the most common.
The Audit Process
The audit process will be unique depending upon the state conducting the audit, the auditor, the seller, and the facts. However, there is a general process you can expect if audited. For example, the Texas comptroller outlines the following procedure:
Notice of audit: The seller or business receives a letter notifying them of the audit in the mail (often accompanied by other documents such as a questionnaire that must be returned).
Pre-audit research: The auditor studies the accounts, reporting history, and prior audits of the seller or business.
Taxpayer contact: The auditor decides what documentation is needed from the seller or business. The taxpayer should then gather and provide all documentation required by the auditor.
Entrance Conference: The auditor discusses the plan for the audit with the taxpayer.
Fieldwork: Transactions are studied, either entirely or by sampling. The auditor should keep the seller or business informed and relay any findings.
Exit conference: The auditor explains any taxes, penalties, or interest owed. The seller or business can ask for a reconciliation conference or an independent audit review conference for any disputes at this time.
Finalization and Review: The auditor finalizes the audit and has it reviewed by their supervisor. Results are then mailed to the seller or business.
(Original source: Texas Comptroller)
Throughout the audit process, it is important to maintain a good working relationship with your auditor. Be sure to provide any information requested in a timely manner, but never volunteer information on your own. You should also keep in mind that auditors can be wrong, so never hesitate to ask for clarification or for their supervisor. And finally, if you believe the results of the audit are inaccurate, you may request a hearing to amend the outcome.
How to Proactively Prepare for a Sales Tax Audit
When a seller or business is audited for sales tax, there are typically seven topics that come into play: nexus, taxability/rates, use tax, exemption certificate management, registrations, sales tax returns, and sales tax audit defense. A large majority of the issues found during an audit can be traced back to one of these topics, so it is important to understand and work to perfect each of them now. By doing so, you are likely to eliminate exposure and avoid many issues that could arise during a sales tax audit.
Of these topics, nexus is arguably the most important. Nexus is the link or connection with a state which must be present before the state can require you to collect and remit its taxes. If you have this link or connection with a state, then you may be required to collect and remit the state’s taxes dependent upon other factors, such as taxability. Understanding your nexus footprint is very important and is the first step towards compliance.
When it comes to taxability, each state is unique. What may be taxable in one state may not be taxable in another. Furthermore, it is important to have a reliable source of information for rates. You should then understand where the sale is sourced and understand which state’s rate should be charged. Thorough research should be completed for both taxability and rates to ensure compliance.
The next important topic is use tax. Sales that cross a state line are subject to use tax rather than sales tax. While the terms “sales tax” and “use tax” are sometimes used interchangeably, the difference between the two does matter when it comes to registrations, tax rates, and return forms. Again, the use of correct forms is an important part of sales tax compliance, so understanding use tax is essential.
This is followed by exemption certificate management. Exemption certificate management includes the collection of certificates as well as the validation of those certificates. They must be on the correct forms, completely filled out, and without error.
Next are registrations and returns. When doing returns, make sure that the returns match the type of registration that you have.
The best way to limit exposure for a future audit is by being proactive. Make sure you have good policies in place concerning nexus, taxability, rates, use tax, exemption certificates, returns, and registrations (hear more on these topics here). By keeping these items in line, you will lower your chances of ever being audited in the first place. However, if you do get audited, having good policies in place will help limit any exposure. And as previously mentioned, you should also keep a professional relationship with your auditor and avoid volunteering information.
While audits are never fun, they are very important. Understanding and practicing compliance in each of the topics discussed can help you to avoid issues that may arise during an audit. If you require assistance in any of the items discussed, let us know - we’d be happy to help!
By: Briana Wagner
This blog is intended for educational purposes and not as tax advice. Tax policies and procedures change frequently, so specific information, such as thresholds, rates, etc. included in this blog may have changed since it was originally published. Please request a consultation for more in-depth information.