Watch Out for These Sales Tax Audit Triggers

By Scott Peterson.

With more than 13,000 sales and use tax jurisdictions across the United States, tax rates are subject to change as new policies are implemented and others expire. In a typical fiscal year, there are thousands of sales tax rate updates. Keeping up with sales tax changes can be difficult and, even if you’re careful, your business can be selected for a state audit.

Just the thought of being selected for a sales tax audit can be intimidating. Small and medium-sized business owners often have limited knowledge about the audit process, from understanding why they were selected to knowing how to navigate the process once it begins. However, knowledge is power. Business owners and finance teams equipped with information on potential audit triggers can approach the process with greater confidence, viewing it as a manageable annoyance, rather than a daunting burden. While many factors can trigger an audit by the state, the following examples are common instances that may cause a business to be selected for an audit and solutions for how to avoid further financial inspection.

Changes to Business Practices

If you’ve recently made changes to business operations, this could be considered a red flag to the state–but the question is, how big does the change have to be to catch their attention?

Newly established businesses or those undergoing major operational changes, such as new ownership or expanding business across state lines, may trigger an audit to ensure proper sales tax collection and remittance of sales taxes and compliance with interstate laws. Additionally, small cash-only businesses like restaurants, bars, and laundromats face a greater risk of being selected for a sales tax audit due to the increased likelihood of errors in sales tax collection and recordkeeping.

Another operational trigger may include businesses with significant or rapidly growing revenue, as they have a higher potential for tax calculation errors and typically engage in more complex financial practices such as international sales transactions.

When large sums are involved, small discrepancies or mistakes in the filing process are magnified, leading auditors to closely monitor and potentially audit the business. Leaders at businesses undergoing operational changes or complex financial practices should allocate resources towards up-to-date sales tax compliance tools and accountants to accurately collect and remit, and mitigate against risk in the event of an audit.

Reporting Red Flags

Diligent and consistent reporting of sales tax is essential to ensuring a business is in good standing with the state and crucial for avoiding an audit. If state authorities suspect a business has not reported all sales tax collected or significant changes in sales tax are reported on returns year over year, an audit may be called for.

State auditors conduct comparative data analysis across similar businesses to identify outliers with significantly different ratios or tax filings, which may then be selected for an audit. Statistical models and machine learning algorithms utilized by the state can analyze patterns based on historical data on previous sales tax remittances, financial statements shared with investors, and credit card processing records to detect anomalies and outliers.

Consistently low sales tax remittances or an unusually high number of sales reported as tax-exempt may also trigger state auditors to become suspicious, especially when compared to similar businesses. If a company’s figures differ greatly from those of comparable businesses in their state, it could prompt the state to investigate further. This discrepancy may lead auditors to question whether the company is keeping up to date with changes in sales tax laws as they are issued–– a potential record-keeping disaster waiting to happen.

Though close attention to detail in the reporting process may seem tedious, it doesn’t have to be. Equipping your business with the right tools to keep pace with changes in compliance standards can help your business avoid or minimize risk in an audit.

The Snowball Effect of Improper Documentation

The best way to ensure a business is prepared for an audit is proper documentation. All exemption certificates should be cataloged for transactions where sales tax is collected and for all transactions where products or services are not taxable and buyers are therefore exempt from paying tax. If a business does not accurately document tax collection or exemption certificates, it can lead to further audits or monetary penalties.

The commerce landscape has drastically changed in the last few decades. From predominantly mom-and-pop stores to the explosion of mega-retailers, there is an exponentially larger number of retailers operating in the United States. In addition to this, an increasing number of retailers are conducting business both in-person and online. 2023 saw an unprecedented 5.5 million new business applications filed, with the trend expected to grow in 2024. Auditors are now focused on the prioritization of businesses for audit as the over-saturation of the retail landscape brings increasing challenges in identifying businesses.

In an attempt to tackle this, auditors in states like California utilize various data points, including sales tax rates and local economic conditions, which can be broken down by ZIP code, to help assess tax compliance risks. In these cases, auditors focus on low-hanging fruit like verification of proper exemption certificate documentation. If the business lacks the required exemption certificates or has expired certificates on file, it can trigger an audit and lead to additional assessments for the uncollected sales tax. Business owners should ensure proper exemption certificate management as an “insurance policy” against further audits and penalties.

You’ve Been Randomly Selected by the State – Now What?

When all is said and done, an audit by a state where you conduct business may be unavoidable. Even outside the above circumstances, state auditors identify some businesses or industries for audit through random selection. In other instances, the state may utilize computer algorithms to identify returns with characteristics commonly associated with non-compliance and make audit selections that way.

No matter the reason your business is selected for a sales tax audit, approach the process with preparedness. In the event of any audit, business owners should contact their tax professional such as a CPA to help guide the process, review materials, and help identify the potential discrepancy that triggered the audit. Addressing potential problems before engaging auditors can help streamline the process, and minimize potential penalties, as can prompt communication and delivery of requested documentation.

Even if you have never been selected for an audit, there are smart, proactive steps that can be taken to protect your business and be positioned for a positive outcome. This includes evaluating modern tax automation tools that can help your organization remain compliant with changing sales tax laws across states and facilitate accurate reporting come tax season or an audit, in addition to maintaining organized digital documentation of all transactions and identifying changes in tax laws that may affect your business. Establishing good business practices sooner rather than later can make an arduous process less daunting and easier to navigate for your organization.

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Scott Peterson is the Vice President of U.S. Tax Policy and Government Relations for Avalara, Inc. In his role, Scott leads Avalara’s effort to be the first name in sales tax automation.