A Complete Guide to Sales Tax Audits

If you’ve found this article, chances are you’re experiencing the pain of a sales tax audit. 

If you received one of those dreaded audit notifications from a state’s Department of Revenue (DOR), we recommend contacting a state and local tax expert (SaLT) immediately. These professionals will guide you and prevent you from making any mistakes in the audit process. 

And after that, read on for what you need to know about state sales tax audits.

What Is a Sales Tax Audit?

States perform sales tax audits when they suspect their state and local sales tax laws are not followed. This usually happens because a company or business may not have paid the right amount of tax to the state or failed to file a tax return after hitting an economic nexus threshold.

States use sales tax revenue for budget items like ambulances and elementary schools, so they have a vested interest in closing the tax gap between what tax is owed to them and what is actually paid.

How Sales Tax Audits and Penalties Work

When a sales tax audit doesn't go as planned, you might face some penalties that are more than just a minor inconvenience. These can include fines, interest charges, and, in extreme cases, even criminal charges, depending on the severity and intent behind the discrepancies found.

• Fines typically vary based on the amount of tax owed and the jurisdiction. For example, the fine might be relatively small if your business underreported sales tax due to an honest mistake. However, if there's evidence of intentional evasion in the audit findings, the fines can skyrocket quickly, sometimes up to 25% or more of the unpaid tax.
• Interest charges are another standard penalty. They are calculated based on the amount of tax owed and how long it has gone unpaid. Like with credit card debt, the longer you go without addressing the issue, the more interest accumulates, making the original amount much more burdensome.
• In the most serious cases, criminal charges may be pursued. This is rare and usually only happens if there is clear evidence of fraudulent behavior or gross negligence. Being slapped with a criminal charge is akin to finding yourself in deep legal waters over what started as a financial oversight.

How Are Companies Chosen for Sales Tax Audits?

It is also understood, but not explicitly stated, that state sales tax auditors will collect multiples of their salary in newly found sales tax every year. 

The entire process can feel unfair and punitive when you are the subject of a sales tax audit. But in the auditor’s (and the state’s) mind, the goal is to ensure that all businesses that have been noncompliant become compliant and contribute to the state’s revenue going forward. Of course, they also want the past due sales tax you should have collected, plus any penalties and interest owed.

States may choose to audit your business for several reasons, but here are the most common sales tax audit triggers:

1. You Made Sales Tax Filing and Payment Mistakes

Auditors are looking for taxpayers who are careless or clueless about sales tax. These taxpayers are more prone to errors, which could mean they’re noncompliant or not complying correctly. Some mistakes audit procedures look for include the following:

• Returns filed late or not filed at all — This can lead auditors to believe that you’re careless in other ways when it comes to sales tax compliance. 
• Returns filed, but with mistakes — This could include not filling out the entire return, not filling in local sales tax collected, sales tax amounts not balancing, etc.
• Filing and payment don’t follow the rules — Some states and jurisdictions require taxpayers to file electronically or pay a certain way. If your business continues to ignore these administrative rules, it might be subject to further scrutiny. 
• Zero consumer use tax reported — Many businesses, especially new businesses, have capital startup costs like buying office furniture or new machinery. You must pay “consumer use tax” to your state if you purchase those items without paying sales tax. Auditors will look suspiciously upon a new or growing business with no consumer use tax reported. 
• Erroneously reported exempt sales — For example, you sell clothing and report exempt sales in a jurisdiction where clothing is not tax-exempt. This can be a red flag to an auditor that you are not collecting sales tax correctly.

2. You or Your Industry is Under Scrutiny

Was there an article about your business in the local business journal? Maybe you were acquired or are raising money? A savvy auditor may check that you are registered to collect sales tax and do it properly. 

The same goes for whole industries. Sales tax auditors pay attention to business trends. When a new trend sweeps the market, they may audit everyone on that bandwagon to ensure they understand current sales tax laws related to their industry. One current trend is double-checking that retailers selling digital products like videos, e-books, or online courses are taxing them correctly. 

Speaking of industries, auditors also look at the general range of gross sales and sales tax collected across various sectors, and if yours varies too far from the norm, you may receive an audit letter.

Fair or not, auditors also love to look at businesses in industries with complicated sales tax rules. In their eyes, it’s up to your business to understand and comply, even if the industry’s sales tax law is complex enough to make your ears bleed. 

3. You Were Caught Up in Another Audit

When auditors conduct a thorough audit that takes six months to multiple years, they look for clues about other businesses that might also be non-compliant. 

If you did business, either as a vendor or a customer, with a company found to be non-compliant, the auditor might also have some questions for you.

4. You Were Caught Being Non-Compliant

Have you ever had an eager sales clerk promise, “If you pay cash, I won’t charge you sales tax?”  I have, and so have auditors. 

Unfortunately, not following the law regarding sales tax can expose you to an audit. Disgruntled employees, competitors, tax professionals, and even customers have been known to report a company for sales tax non-compliance. 

Some auditors will go to a business’s website, add items to the cart, enter a shipping address, and see how much sales tax is charged. Or, an auditor might become aware that you have been doing business in the state for three years but only applied for a sales tax permit 18 months ago.

All of these sales tax compliance discrepancies can lead to audits.

How to Prepare for a Sales Tax Audit

Before the audit begins, you can take steps to make the process less painful. Being organized and concise can even endear the auditor to you by proving that you take your sales tax compliance seriously and have nothing to hide.

Before the audit:

• Consult with a sales tax expert — State and local tax experts (SaLTs) can advise you on how best to handle the audit and how to interact with the auditor.
• Determine your sales tax liability — The auditor will determine how much sales tax, plus interest and penalties, you owe to the state. And if you don’t have at least a ballpark figure in mind, you’ll have a harder time challenging the auditor’s assessment. 
• Collect all resale certificates -— Ensure you have documentation of every single time you did not charge sales tax to a customer. Make sure all of these exemption certificates are on file, fully filled out, and signed by the customer.
• Ensure your sales tax returns are up-to-date and paid — Cleaning up any missing state tax filings or tax payments shows good faith that you are getting your sales tax house in order.

Common Issues Uncovered During Sales and Use Tax Audits

It's not uncommon for a sales and use tax audit to reveal a few hiccups in your tax records. Some of the usual suspects include unreported sales, misapplied tax codes, and poor sales tax exemption management. 

While these issues might sound serious, they're actually quite manageable. The key is not to panic but to address them head-on with your auditor. Be honest about any mistakes and work collaboratively to correct them. This could involve revising past returns, amending records, or implementing new procedures to prevent similar issues in the future.

Taking these steps helps resolve the immediate problems and demonstrates your commitment to compliance. Auditors appreciate transparency and cooperation, which makes the entire process smoother and potentially mitigates penalties.

Strategies to Handle a Sales Tax Audit

Here are some strategies to help you handle the sales tax audit process.

Isolate the Auditor 

But be nice about it!

When the auditor is visiting your facility, it’s best to put them in a room by themselves with the documentation they request. Be sure to instruct any employees who might interact with the auditor to be courteous and professional and follow the rest of the tips in this article, such as getting all requests in writing.

On the one hand, there’s no need to have them wandering around your facility (and potentially discovering further avenues for inquiry into your business, such as a new machine they can wonder if you paid the use tax on). But on the other hand, you also want to keep the auditor well-disposed toward you. There's no need to shove them in a closet or turn the heat up to 80 degrees and deny them water. 

Plus, a happy auditor can go easier on you or even fight on your behalf with their superiors. 

Give the Auditor What They Ask For (But Nothing More)

If your books or recordkeeping are disorganized, it can be tempting to turn all your financial information over to the auditor and let them have it. But this is also the worst thing that you can do. 

You must only give the auditor the exact information they ask for and nothing else. Also, be sure to instruct your employees on this. Providing the auditor with too much information can lead them down more rabbit holes where they find more non-compliance.

At Zamp, we have an Accuracy Commitment in place for API customers. This means that if an inaccurate result returned by our service triggers a state sales tax audit, Zamp will cover any uncollected sales tax, penalties, and interest resulting from the inaccuracy, up to what you paid Zamp over the prior 12 months, provided you meet the requirements.

Be Careful What You Sign

Carefully read and understand everything you are asked to sign. The auditor is not on your side, and explaining what you are signing isn’t their job. We recommend having a SaLT or legal counsel review all documentation before signing.

Decline Statute of Limitations Waivers

The auditor might ask you to sign a waiver, allowing them more time to review your case. Your SaLT advisor will often advise you not to sign this, thus giving the state more time to audit you.

However, there may be cases where you need more time to produce the information the auditor requires. In that case, consider signing the waiver. However, think carefully before signing because this gives the auditor a longer audit period and more time to look into your business.

Be Wary of Sampling Methods

Your auditor generally does not look at every single transaction you make. Instead, they will sample your records using either random or block sampling. 

With random sampling, they audit your business activities at random times. With block sampling, they audit a block of time. Either way, they use these methods to determine how much you might owe. 

In general, you want your auditor to use random sampling. This gives a clearer and broader picture of your business. If they use block sampling, they may inadvertently sample a block where your business is busiest, such as the holiday season. This could lead to the auditor concluding that you owe much more past due sales tax (with the associated interest and penalties) than you actually do. 

On the other hand, if the auditor offers to use block sampling over a period that benefits you, such as your slow season, you may decide to take them up on their (probably unintentional) generosity. 

Keep Track of Everything You Give the Auditor

The sad fact is that sales tax audits can take years. They can span employee turnover at your business and the state’s taxing authority. Keep track of every document and information you give to the auditor. Not only does this make the audit go faster, but it works in your favor if you find yourself applying for a penalty waiver later.

Get Everything in Writing

Regarding tracking everything, ask the auditor to send you written requests or instructions. This is just good business practice, and a tricky auditor might ask for unreasonable information. They are unlikely to want to put this type of request in writing and thus create a paper trail.

Be Timely and Meet All Deadlines

Failing to get information to the auditor by the due date can drag the audit process out. While that might sound good, you can lose the right to appeal the audit results. If you end up with fines and penalties, you can also lose the chance of waiving penalties because you are deemed noncompliant with the audit.

Issues a Sales Tax Auditor Might Find

If an audit finds unpaid or underpaid sales tax, the auditor will likely look to state sales tax laws and regulations to assess interest and penalties. 

These are the most common issues that sales tax auditors find. Use this as a checklist to ensure your sales tax house is in order before the auditor arrives.

Failure to Charge the Right Amount of Sales Tax

With more than 13,000 taxing jurisdictions in the US, pinpointing the exact combined sales tax rate at your customer’s address can be challenging. (Unless you use Zamp, of course.) These common sales tax charging mistakes often come up in audits:

• You charged sales tax for the wrong jurisdiction (for example, you charged your customer the wrong county’s sales tax).
• You failed to collect additional taxes (for example, you charged a customer county tax but didn’t charge the applicable city tax).
• You charged sales tax based on the wrong sales tax sourcing (for example, you charged everyone sales tax at your business’s combined sales tax rate rather than the rate at your customers’ ship-to addresses).

Failure to Charge Sales Tax on Taxable Transactions

Since sales tax varies from state to state, it’s easy for retailers to fail to realize that some transactions are taxable. Common errors here include:

• Failure to charge tax on sales made to non-profit organizations that the seller believed to be exempt, but are not
• No sales tax collected on shipping charges in states where that is required
• No sales tax collected on services in states where that is required
• Failure to tax bundled transactions (such as a product plus a service) according to state law

Missing Resale Certificates 

One of the most common mistakes auditors find is that you are missing exemption certificates (AKA resale certificates) for untaxed sales. 

If you did not charge sales tax to a customer but don’t have that customer’s resale certificate to prove it, you must pay the uncharged sales tax.

Every time your business does something unusual regarding sales and use tax, it’s vital to have documentation to back up your decision.

Use Tax Mistakes

When you buy an item without paying sales tax on it, you are required to document why. If the item is for use in your business, such as a desk or a piece of machinery, and you didn’t pay sales tax at purchase, you must pay use tax. 

Auditors will look for instances where you did not pay use tax. These include: 

• Failure to pay use tax on untaxed purchases used by your business and not resold
• Failure to pay additional local tax when purchases are consumed in multiple local jurisdictions (i.e., you paid the use tax for a purchase)
• Failure to have proper documentation to support non-taxable purchases, such as downloaded software and other digital products
• Failure to have receipts to support charges made on credit cards to show where the purchase occurred, and that tax was charged
• Improper or unclear invoices that don’t accurately portray the sales transaction
• Operating and capital leases that are not taxed properly
• Intercompany transactions that are not properly taxed or documented
• Asset sales or business dispositions that are not properly taxed

What to Do After a Sales Tax Audit

When the audit is complete, your auditor will provide you with a Notice of Assessment that informs you of any interest and penalties your business may be subject to. 

Penalties vary from state to state and depend on other factors, but they are generally around 30% of the underpaid sales tax.

We recommend always applying for a penalty waiver, even if the process is time-consuming. While state law often dictates how much interest you must pay, the state taxing authorities usually have some discretion over how much they levy in additional penalties. 

You can also protest an audit. States have different rules regarding how long you have to appeal, but sometimes, this can be as short as 30 days. Again, we recommend consulting a SaLT when protesting the results of an audit. 

On the other hand, if you are sure the audit was fair, paying your penalties and getting sales tax compliant may be worthwhile. 

In rare cases, sales tax audits can also result in criminal penalties. However, criminal penalties generally only result in cases of fraud. The most common type of fraud is a merchant purporting to collect sales tax from customers but keeping it in their own pocket instead of remitting it to the state.

Avoiding a Sales Tax Audit: Conclusion

In the long run, being proactive and updating your business operations is the best strategy to avoid penalties. Conducting regular internal audits is a great start. It's like doing a routine check-up on your business to catch and address any issues before they escalate. 

Utilizing modern technology can also play a crucial role. Sales tax automation software, for example, can help streamline and error-proof the process of calculating and filing taxes, especially if you operate in multiple jurisdictions with varying tax laws.

Keeping informed of the latest tax laws and regulations is equally important. Tax rules and product taxability can change, and staying informed ensures you remain compliant without any last-minute scrambles. Investing in continuous learning and professional development in sales tax management keeps your business compliant and provides you with the knowledge to handle complex tax scenarios confidently.

By taking these steps, you minimize the risk of penalties and secure peace of mind. It allows you to focus more on growing your business and less on fretting over potential tax issues.

Get Started With Zamp

Ready to say goodbye to sales tax worries? 

Book a demo with Zamp today and discover how our solutions can transform your approach to handling sales taxes. With Zamp supporting you, you can focus more on your business and less on the complexities of sales tax compliance. Our team of experts is ready to show you how easy managing sales tax can be when you have the right tools. 

Contact us now to learn more and take the first step towards a smoother financial operation!