What Is A Sales Tax Audit?

You might be wondering, what is a sales tax audit? In short, it is what it sounds like. It is the examination of a company’s financial documents by a government’s tax agency to verify if the proper amount of sales tax has been remitted to the proper authority. Most people don’t realise that only 1.1% of individual taxpayers receive an audit letter every year. And if you are one of the few people audited, you most likely won’t have to come face-to-face with an IRS agent.

The biggest problem in what is a sales tax audit is that when you are auditing a business’ sale. That is to say, it is not very reliable, meaning while you can go through a business’ record over three years and audit every single transaction, some businesses have a lot of retail business in cash. As a result, even if you were to go through all and everything, it doesn’t necessarily mean the records are going to align with the way that the auditor thinks. The main problem with sales tax audits is the size of them. That is to say, you are dealing with three years of individual transactions a day in and day out.

What Causes A Sales Tax Audit?

Now we know what is a sales tax audit, let us learn about what can trigger a sales tax audit. It can occur when a business is suspected of having understated its reported sales. That is to say, this occurs in situations where there is a ‘mismatch’ between the sales tax returns filed and what was reported to other agencies. For example, a business that has different total sales amounts on their sales tax returns and their federal income tax returns is likely to get audited. In addition, random audits can be scheduled as well. While we have come across audits that are believed to be random, it is far more common to see audits with some underlying motivation. Keep in mind the following:

The goal of the audit is to:

• Discover Oversight Or Fraud

• Promote Compliance With State Tax Law

• Increase Revenue For The State

• Apply Penalties When Taxes Are Found To Be Owed

In addition, these factors are often looked at to identify potential audit targets:

• Industry Involved
• Past Audit History
• Amount Of Total Sales Tax Reported
• Amount Of Exempt Sales Reported
• Ratio Of Exempt Sales To Total Sales
• Where The Business Is Located

A large company with a high sales volume or that reports a high amount of exempt sales is more often targeted than those with smaller sales volumes or no exempt sales. If the ratio of exempt sales to total sales is out of line for the industry, that can trigger an audit too.

How To Help Your Client Through An Audit?

Now let us move from what is a sales tax audit and learn how to help your clients through one. Tax laws continue to evolve and add new complexities to business operations. As a result, stakeholders expect their tax professionals to be prepared for anything. But, as most accountants know, it is impossible to specialise in every area of taxation or understand the liabilities associated with niche challenges like multi-state sales and use tax regulations. One day, you might encounter a sales tax audit. Understandably, this can be overwhelming and intimidating to tackle. Here are a few things to keep in mind as you face this hurdle.

• Understand Why Businesses Get Targeted For Audits

• Rapid Growth

Some business unknowingly neglects their sales tax obligations, especially during periods of increased sales volume or while expanding into new states. Not to mention the physical nexus created by having employees or contract workers in those locations. These fact patterns can trigger a state to investigate proper compliance.

• Customer Audits

If a state audits your customer and an auditor identifies invoices that your business improperly taxed or missed, the state is likely to audit your company.

• Location

Some states are more aggressive with sales tax audits than others. Some often target small businesses such as Amazon sellers and eCommerce. On the other hand, some tend to audit for sales tax frequently. But nothing is guaranteed, so it is vital to assess the risk wherever there is existing or potential exposure.

• Prepare For Potential Liabilities

• • Examine the number of sales during the audit period to see where potential under-collection might have occurred.
  • Review the sales tax returns during the audit period to ensure sales tax reports reconcile with the returns. 
  • Be prepared to answer when things don’t line up. For expenses, make sure to have copies of invoices, including purchases made with credit cards. Businesses should generally keep invoice records for all purchases for at least 3-5 years

• Understand State-specific Sales Tax Audit Methods

States typically do not audit a company’s entire books and records. Talk to the state auditor to see what audit method options are available. Many offer a sampling method limiting what the state reviews. While this is usually a safe approach, audit results for the limited period will be extrapolated for the entire audit period upon the conclusion of the audit. Meaning, if the sample period contains a significant purchase(s) with missing invoice records or a sizable sales transaction with erroneous sales tax, these errors can get magnified. In addition, while states may allow this method for sales and expenses, they usually do not offer the same for their review of fixed asset purchases.

• Establish Proper Tax Compliance Moving

There’s no better time than the present to start complying. If a sales tax audit exposes underpayments or under-collections, it’s essential to prioritise compliance moving forward. That is to say, even if a single state sales tax audit reveals no violations, be sure to analyze every state for possible economic and physical nexus exposure. Monitor changes in employee locations, sales into new states, and increased transaction volume. Or have a trusted sales tax partner conduct routine multi-state nexus reviews to identify potential red flags.

You should establish a reasonable method to calculate use tax from expenses where sales tax is mistakenly absent. If necessary, explore software solutions to automate sales tax calculation with an understanding that it is not a one size fits all solution. Implementing sales tax software has several pros but, without proper expertise during and after implementation, it can lead to costly errors – like incorrect product mapping. Consider all areas of tax compliance that may be impacted, like gross receipts, franchise and other local taxes.