Sales tax audits: what triggers them and how to prepare

What triggers a sales tax audit?

• Differences between reported sales and other data, such as income tax returns, Forms 1099-K or marketplace reports.
• A high share of exempt or resale sales.
• Industries with frequent errors, such as construction, restaurants and e-commerce.
• Late or missing returns, or sudden drops in reported sales.
• Nexus questionnaires or information from other states.
• Random selection.

How does an audit work?

1. Notice and scope

   The state sets the period and taxes covered.

2. Information request

   Returns, sales records, invoices, exemption certificates and purchase records.

3. Testing

   Often a sample of transactions, with errors projected across the period.

4. Findings

   A preliminary report of tax, interest and any penalties.

5. Response and appeal

   Provide missing documents, challenge errors, then appeal if needed.

Which areas produce the most assessments?

See exemption certificates, sales tax vs use tax and sales tax on shipping.

How should you prepare?

• Reconcile sales on returns to the books each period.
• Keep exemption certificates complete and filed by customer.
• Accrue use tax on untaxed purchases.
• Keep records for the full audit period, and longer for unfiled years.

How does sampling affect the result?

Auditors often test a sample of transactions, such as one quarter or a random selection of invoices, and project the error rate across the whole audit period. If a sample of $100,000 of exempt sales contains $5,000 without valid certificates, a 5% error, and the period has $2 million of exempt sales, the projected under-collected sales are $100,000, with tax on top. Finding missing certificates for the sample before the report is final can reduce the projection substantially.

What rights do you have during an audit?

You can be represented by an adviser, ask for the auditor's working papers and method, provide additional documents before findings are final, and appeal assessments through the state's administrative process and then the courts. Agree a sampling method in writing at the start where possible. Respond to every request by its deadline; missing documents are usually treated against you.

How far back can an audit go?

Usually three or four years from when returns were filed, longer in cases of fraud or substantial under-reporting. For periods where no return was filed, there is generally no time limit, which is why unregistered sellers with nexus face the greatest risk. See voluntary disclosure agreements.

Why does use tax matter in an audit?

Businesses often buy equipment, software and supplies from out-of-state sellers who did not charge sales tax. Where those purchases are taxable in your state, you owe use tax on them yourself. Auditors routinely review fixed asset additions and expense accounts for this. Accruing use tax on each return as you go avoids a large assessment later. See sales tax vs use tax.

What should you change after an audit?

Fix the cause of each finding, such as a certificate process, a rate setting or use tax accrual, so the same issue does not appear in the next audit. States often revisit businesses with past findings.

Are marketplace sellers audited?

Less often for marketplace sales, since the marketplace collects the tax, but direct sales, use tax on purchases and nexus in other states can still be reviewed.

This guide is general information. It is not tax or legal advice for your situation.