After the U.S. Supreme Court’s 2017 decision in South Dakota vs. Wayfair, many states quickly enacted laws resembling South Dakota’s to collect sales tax on remote purchases.
While physical nexus remains the first consideration in whether businesses are legally bound to collect and remit sales taxes on online sales, most states have adopted “economic nexus” rules, stating a business’ tax obligations kick in after it crosses a set level of sales in terms of quantity, dollar amounts, or both.
Receiving an audit notice from a state tax authority is one of the worst feelings a small business can have. Unfortunately, as states pursue tax collection, sales and use tax audits have become a standard part of doing business.
If your business is undergoing a sales tax audit or is worried about dealing with one in the future, here are four tips to navigate, prepare for, and avoid a sales tax audit.
How to reduce the risk of a sales tax audit
Several factors can trigger a sales tax audit. Many states use systematic methods and data analytics to identify businesses at risk for underreporting or underpaying their sales taxes. According to Thomson Reuters, some of the most common triggers for a sales tax audit include:
- Being in a high-risk industry with a reputation for substantial non-compliance.
- Operating in a complex industry with high revenue and transaction volumes.
- Your vendor or customer was audited, and the trail leads back to your business.
- A whistleblower or disgruntled employee reports your business to the tax authorities.
- You consistently file sales tax reports late, leading authorities to believe you might be struggling.
Your business also might be randomly selected for audit, so there’s no sure-fire way to avoid facing a sales tax audit. However, familiarizing yourself with the sales and use tax laws in the states where you do business, analyzing your nexus exposure, and registering and paying taxes in the proper jurisdictions is a good first step.
How to prepare for a sales tax audit
Time is of the essence once you receive notice you’ve been selected for an audit. Gathering and preparing the appropriate records takes time, so you want to start the process immediately.
- Step 1: Gather your records. Identify the period selected for audit and start gathering the necessary records. Typically, the audit notice will include an Information Document Request (IDR) that lists the records the auditor wants to review as part of the audit. If it doesn’t, set up a call to discuss the scope of the audit and the records needed.
Documents requested in the IDR typically include:
- Sales tax returns and work papers for the audit period
- General ledgers
- Chart of accounts
- Sales and purchase journals
- Sales and purchase invoices
- Exemption certificates for any tax-exempt sales
- Federal and state income tax returns or franchise tax returns
- Depreciation schedules
- Bank statements
- Shipping documentation
- Financial statements and trial balances for the audit period
If any requested items aren’t available or you don’t believe they apply to the audit, be prepared to explain your reasons for not providing them.
- Step 2: Review your records for potential exposure areas. Conduct a brief review of your documents to identify any potential exposure areas, such as:
- Source data that doesn’t tie to the general ledger
- Workpapers that don’t tie to sales and use tax returns
- Using the wrong sales tax rate
- Missing exemption certificates
In addition to looking for potential underpayments, look for overpayments, such as using a higher sales tax rate or charging tax on non-taxable items. These can potentially offset any underpayments uncovered during the audit.
- Step 3: Develop a good working relationship with your auditor. First impressions can set the tone for the entire audit. Be professional, respectful, and courteous. Auditors have some influence over penalties, so you have a better chance of minimizing or even avoiding those penalties if you develop a good working relationship.
Being under the microscope of a sales tax audit is stressful and can take up a lot of time. A professional who is well versed in sales and use taxes and knows how to deal with auditors can be an invaluable member of your team. By crafting a game plan for the audit and managing auditor expectations, they can potentially save your business thousands of dollars in taxes and penalties.
- Step 4: Get professional support. Working with a professional experienced with sales and use tax audits can be extremely helpful. Your accountant or advisor can conduct the initial record review, host the auditor, and respond to all the auditor’s questions.
These professionals typically know how to answer the auditor’s questions truthfully without volunteering extra information that can invite additional scrutiny.
Have you received notice that you’re a target for a sale tax audit, or are you worried you may be on the radar? Contact us today to help you prepare for and navigate the process!