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What is a sales tax audit and what happens if I get audited?

Managing sales and use tax compliance for your business is complex enough without the fear of audits looming over you. Even if you’re a straight-A student when it comes to taxes, getting a letter in the mail from an auditor can be pretty intimidating. This goes double if you’re a small business working with limited resources and managing your own taxes.

In this article, we’ll explain the basics of the sales and use tax audit process and answer some common questions business owners like you have about sales tax audits:

What is a sales tax audit?
How are businesses selected for a tax audit?
Who conducts sales tax audits?
Where will the audit take place?
What happens at the beginning of a sales tax audit?
How do I prepare my business for a sales tax audit?
Can I audit my own business?
What records do auditors want to see?
How far back do auditors look?
What happens after a sales tax audit?
What is an audit assessment?
What are common audit triggers?
How long does a sales tax audit take?
Who can help me with an audit?
What happens if I fail a sales tax audit?

What is a sales tax audit?

A sales tax audit determines whether businesses are on top of sales tax compliance — collecting and remitting the correct amount of sales tax owed to the state. During an audit, audit managers from state agencies will take a look at your records and make sure everything lines up.

How are businesses selected for a tax audit?

Being selected for a sales tax audit doesn’t automatically mean your business has done something wrong. There are a few reasons your business might be audited, including your location, industry, or other factors:

  • It might just be your business’s turn. Some companies are audited regularly as part of a cycle and others are chosen for random audits. 

  • Your industry or associations with other companies are flagged. States sometimes target certain industries for an audit. And if one of your suppliers, customers, or competitors are audited, your business might get extra scrutiny too. 

  • Data analysis. States can use technology to perform automated reviews of records, and if they find that your business has a physical presence in the state or does a lot of sales into the state, you might be required to pay sales tax.  

  • Geography. Even something as simple as the location of your business can make you a target for an audit. 

  • Red flags. If your business has a large number of exempt sales or inconsistencies in your filings, auditors might want to take another look at your records.

Who conducts sales tax audits?

A state’s department of revenue (DOR) will send an auditor out to conduct the audit and look into your business taxes.

Where will the audit take place?

Audits generally take place at your business, at a DOR office, or at your accountant’s or attorney’s office, if you retain one for the audit.

What happens at the beginning of a sales tax audit?

So your business has been chosen for an audit —– now what? The audit begins with a letter, typically from a state’s department of revenue. The letter will include a request for records and other business information.

How do I prepare for a sales tax audit?

It’s time to put together an audit plan. You’ll have a period of time to get the requested documentation together and consult a tax professional if you want representation during the audit process. Just don’t take too long; it’s important to respond to audit notices and requests promptly and to keep lines of communication open.

Can I audit my own business?

Conducting internal audits is a great way to ensure your business operations are in order and you’re staying tax compliant. While it won’t count as an official audit for the state, it will certainly help to make the process less painful (and it’s always a good thing to be on top of your business taxes).

What records do auditors want to see?

Hopefully, your filing cabinet is organized and you have all the documents required at hand. You’ll have to collect sales tax returns, invoices for sales and purchases, till receipts, resale certificates, vendor invoices, and bank statements. 

Some states now use stratified sampling during audits, initially done digitally. All purchase data during the audit period will be downloaded, and criteria applied to determine which purchases should be reviewed. Auditors can also gather information about purchase transactions from other sources, even your vendors.

How far back do auditors look?

While it differs for each state, most states will look at the last 3–4 years of sales tax returns and other records for an audit. But some states might look back 7–8 years, and if your business is suspected of fraud, auditors could look at your entire business history.

What happens after a sales tax audit?

After you provide the requested records, an auditor will prepare preliminary schedules and sub-schedules. These can include expenses, purchases, and the sales tax amount, and usually reflect where the auditor believes sales tax was handled incorrectly. You then can provide comments, clarification, and additional information on the issues that arise.

The auditor will take your new information into consideration and create revised audit schedules. This process can go back and forth until the auditor feels the schedules are complete and correct.

Each state does things its own way, so it’s a good idea to read up on the sales tax audit process in your state. In Washington, after you agree with the audit findings, it generally takes about four to six weeks to get a copy of all the schedules, tax laws, and rules you’ll need to follow up on. You then have 30 days to sort out any owed tax and interest (if the auditor finds that you overpaid tax, you’ll be refunded or credited against amounts due on future sales tax returns). In addition to tax audits, the state of California has field billing orders (FBOs), during which an auditor reviews a business’s records from a shorter period of time (less than a three-year period) than a regular audit (three years).

What is an audit assessment?

When the audit is completed, you’ll have an exit conference with the auditor to receive a final assessment, known as the proposed assessment. This assessment details what the auditor believes you owe the state or tax jurisdiction. If you agree with the assessment, you should follow the requirements for payment and other actions.

If you don’t agree with the assessment, you have a few options. You can continue discussions with the auditor and see if they’re willing to make changes, or appeal the findings and potentially open a court case. In most states, you have 30 days to appeal the assessment, but each state has its own requirements and procedures.

What are common audit triggers?

While you won’t know whether your business is selected for an audit until you receive a letter in the mail, there are a few things you can do to get ahead of the curve and potentially reduce risk of noncompliance. The most common causes of negative sales tax audits are:

 

1. Getting nexus wrong

You probably know you have to pay and remit sales tax in the state where your business is located (physical nexus). But since the 2018 U.S. Supreme Court decision in South Dakota v. Wayfair, Inc., states can require businesses to pay and remit sales tax to them if the businesses have economic nexus, based on a certain number of transactions or amount of sales, in that state. Each state has its own economic nexus thresholds and requirements, so be sure to find out what the economic nexus rules are in the states where you do business. Brush up on your nexus knowledge with the Know Your Nexus ebook.

 

2. Using outdated tax rate information

Sales tax rates change frequently, and if you have customers across jurisdictions, you have that many more rates to track and update. While tax rate information is usually readily available on state DOR websites, manually hunting down the correct rates and updating individual products and categories can be time-consuming and prone to error.

The best way to get it right every time is by using geolocation and identifying the sales tax jurisdiction based on the address or even latitude and longitude coordinates. 

 

3. Getting jurisdiction wrong

Knowing which tax jurisdiction governs each sale is another challenge; determining which jurisdiction governs the sale comes down to sales tax sourcing rules. Make sure you know if destination sourcing, origin sourcing, or mixed sourcing applies to the items you sell.

Many businesses use ZIP codes to know which sales tax rate to charge, but tax jurisdictions and ZIP code boundaries don’t always line up perfectly — one ZIP code can have multiple tax rates.

 

4. Getting product taxability wrong

Is your product classified as a good, a service, a digital object, or a combination of things? Does the classification change when you include a fork and a napkin with a to-go food order? Knowing the answers to these questions is crucial to knowing what sales tax rate to charge — it can also get tricky. States have different ways of classifying products, goods, and services, and it gets really complex if you’re trying to determine the tax rate for a digital good (including whether it’s taxable at all).

 

5. Missing exemptions or issues with exempt sales

Depending on the item, the customer, and the intended use, something normally subject to sales tax might be exempt. All exempt sales must be documented properly. If you’re missing exemption certificates, or the ones you have are out of date or invalid, an auditor will notice.

Sales tax holidays can complicate compliance for business owners too. More than 20 states have tax-free weekends for things like school supplies, energy efficient appliances, and disaster relief purchases. You should be aware of upcoming tax holidays in your state and plan accordingly.

 

6. Getting use tax wrong

Whereas most business owners are familiar with sales tax, use tax is another beast entirely, and is often overlooked. Use tax applies to taxable goods or services that are used or stored in a jurisdiction, when sales tax wasn’t applied at the point of sale. Like everything in tax, use tax has to be properly documented.

Businesses are responsible for reporting use tax on items consumed in the course of business. A sales and use tax audit will determine whether you’ve been paying or remitting the right amount of taxes and keeping appropriate documentation. Learn more about use tax and some of the ways it complicates tax compliance.

How long does a sales tax audit take?

A sales tax audit typically takes a few months to complete. That can feel like a long time for your daily operations to be interrupted, but if you’re adequately prepared and have the proper documentation handy, the process might go faster.

Who can help me with an audit?

If you’ve never been through an audit before, it can be beneficial to hire a lawyer or tax professional who specializes in audits to guide you through the process.

What happens if I fail a sales tax audit?

Sometimes an auditor will discover oversight or even substantial noncompliance on your part, and you’ll be required to pay up. This includes paying all past due taxes, plus penalties and interest to tax authorities. There’s even a risk of criminal charges, though that outcome is rare.

How automation can help

While there’s no way to avoid audits entirely, the best way to prepare your business for an audit is to take the guesswork and risk of human error out of tax compliance by using an automated solution.

Avalara has solutions to help you handle every part of the tax compliance process — automating sales and use tax calculations, filing returns and remitting payment, and managing exemption certificates — to give you a huge advantage over manual bookkeeping practices when state auditors come calling.

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