Sales Tax Audit Triggers

When you receive a sales and use tax audit notice in the mail, it sparks worry, concern and anxiety.  Frequently, the first question that comes to mind is “What triggered this sales and use tax audit?” Understanding the sales and use tax audit triggers or cause of the audit can help companies both prepare for the audit by predicting what the auditor will be looking for, as well as take steps to avoid sales and use tax audits in the future.

Similar to the IRS with income tax audits, states have systems, policies and procedures in place that help them to identify businesses to select for a sales and use tax audit.  While each state’s methodology is different, there are some common reasons taxpayers are flagged for a sales and use tax audit.

Our analysis of common sales and use tax audit triggers is based upon Agile Consulting Group’s 15 years’ worth of sales and use tax audit defense and representation services that we have provided to hundreds of taxpayers across the U.S.  We have arranged these reasons in order of the likelihood of triggering a sales and use tax audit. 

Far and away the most common of all sales and use tax audit triggers is having a large liability in a prior audit.  Audit liabilities are the clearest evidence a state has that a company either does not understand sales and use tax law or is not taking appropriate steps to manage this important function.  Besides that, states want to focus their efforts on audits that will generate revenue.  A prior track record of your company’s audit being “productive” or resulting in a large audit liability makes it more likely you will be flagged for a subsequent sales and use tax audit.  Don’t believe that states track and pay attention to this?  They absolutely do.  Some states even publish public lists of their largest delinquent taxpayers including California , Colorado , Minnesota , New York , Oklahoma and Wisconsin.

“Large” liabilities can mean different things to different states as it can for different taxpayers depending on their size, scope and footprint of operations.  Some states, such as Illinois and Texas, have provided clear guidance to taxpayers about what they consider a large prior audit liability.   Illinois considers $15,000 of tax , exclusive of penalty and interest, to be the threshold for a large audit liability.  Texas considers any prior sales and use tax audit that generated a liability of $25,000 or greater to be a “prior productive” account .  All states have established thresholds, but not all states publicize those amounts.

States continuously evaluate taxpayers’ sales and use tax returns to identify patterns that are suspicious.  Such irregularities are a precursor to many sales and use tax audit notifications.  Here are four of the most prevalent irregularities found in taxpayers’ sales and use tax filings:

Late filings tell the state that a company isn’t managing its sales and use tax compliance obligations well.  The deadline is the same every month, quarter or year so it should never catch a taxpayer unprepared to file.  States initiate audits based off late filings because “where there’s smoke, there’s fire.”

For non-seasonal businesses, the state expects to see your total revenues, exempt revenues, and purchases on which use tax is reported to normalize within a certain range.  Spikes or craters to those amounts raise a red flag for the state.  Of course, from time-to-time all businesses have a month that is an outlier.  A single month outlier is unlikely to trigger a sales and use tax audit.  Month after month of yo-yoing financials will.

If your company never reports any use tax on its sales and use tax returns, that is a red flag for the state.  With the proliferation of internet sales, it is unrealistic for a company to make purchases that don’t require use tax accruals.  The state interprets this pattern as a taxpayer trying to take advantage of the use tax self-reporting system.

High volumes of exempt sales can be a red flag for the state, particularly if this ratio of exempt to taxable sales is not in line with other taxpayers within the same industry.

States recognize these irregularities in sales and use tax filings as surefire sales and use tax audit triggers.  One easy way to combat this risk is by making sure your company’s sales and use tax filings are on time and accurate.  As businesses grow, sales and use tax compliance becomes increasingly more complex and time consuming. 

If your company’s sales and use tax compliance is not getting the attention it requires because of other important day-to-day activities, you should consider outsourcing sales and use tax compliance to a trusted sales tax consulting firm.  It will relieve the stress and headaches that come with your regular filings and reduce the likelihood of erroneous filings triggering a sales and use tax audit for your company.

When a business closes a location, ceases operations, dissolves the business, or declares bankruptcy, these actions will frequently trigger a sales and use tax audit.  The state will view this occurrence as its last opportunity to recover any taxes that might be owed.

States know that certain industries are more likely to have issues with their sales and use tax compliance.  Cash-based businesses such as convenience stores, restaurants and bars are often targets for sales and use tax audits because states have years of data showing that cash sales are frequently under reported on sales and use tax returns.

Another industry that is frequently flagged for sales and use tax audits is construction contractors.  Contractors have very complex rules for which purchases and sales are subject to tax.  Add in the variety of ways in which contracts can be written – lump sum, time and materials, cost plus, etc. – and the state knows the likelihood of errors is high.

Another way that industry may play a role in selection of taxpayers for sales and use tax audits is when the state identifies a common error frequently made industry wide.  If the state has success (read: lucrative audit assessments) in its auditing of doctor’s offices or wineries, for example, expect the state to find additional doctor’s offices or wineries to audit.

Although they’re bureaucratic government organizations, states want to invest their time on projects that yield results.  Sales and use tax audit triggers are the initial signs that peak the interest of the state. When the state conducts audits of other taxpayers, the state auditor will often be on the lookout for targets for future sales and use tax audits.  One way in which this happens is when the auditor identifies sellers not collecting sales and use tax appropriately. 

It is a reasonable assumption that if you are not collecting sales taxes correctly from one of your customers, it is very likely you are making mistakes on other customers’ invoices as well.  States and state auditors will assume these errors are less of a stand-alone problem and are representative of a larger, more endemic problem. Expect to receive a sales and use tax audit notification letter if errors are found on your accounts receivable invoices in the state’s audit of another taxpayer.

Which leads us to…

This is a corollary to #5 above except that instead of following the breadcrumb trail of your accounts receivable invoices back to your company, the auditor may instead be following your suppliers’ or vendors’ accounts payable invoices. 

If in the process of auditing your suppliers’ or vendors’ records the auditor learns that the supplier or vendor in question has errors or irregularities in collecting sales tax from its customers, the state will often issue sales and use tax audit notifications to its largest customers. 

Now it could be that those largest customers are correctly reporting and remitting use tax on those transactions, but auditors are not likely to assume that is the case.  Errors on invoices an auditor reviews in his or her review of another company can absolutely be a sales and use tax audit trigger.

States know that sole proprietorships and partnerships generally are smaller in size and have less resources to dedicate to their sales and use tax compliance filings.  Organizations structured in that manner are more likely to be audited than a corporation because sole proprietorships or partnerships are less likely to have a dedicated tax department.  That means someone in accounts payable, or some other generalist, is filing their returns.  States know that someone whose ancillary duties include filing sales and use tax returns is less likely to understand and comply with current sales and use tax laws.

If a state’s sales and use tax law or the Department of Revenue’s interpretation of a law changes in a manner that is likely to generate sales and use tax audit liabilities, audit notifications will be generated.  A common cause of sales and use tax audits in the wake of the South Dakota v. Wayfair Supreme Court Ruling in June 2018 relates to the new definition of nexus allowed by the Court.  If you’re interested in reading more about the new definition of nexus in the U.S., please see our previous discussion of this change.

Conversely, if sales and use tax law changes in a fashion that would broaden an exemption, the state is less likely to conduct an audit because of the likely sales and use tax refunds it may owe a company.  This is a key time to mention that in ANY sales and use tax audit, the auditor should find both liabilities as well as credits for overpayments.  If your workpapers do not show any transactions where you overpaid sales and use tax, you’re not receiving fair treatment from the state auditor.

Larger businesses may be audited regularly.  Often, members of the Fortune 500 are under continuous audits with the states in which they operate.  This practice is in place because states want to ensure that taxpayers making the most significant volume of sales or purchases within their state are complying with current sales and use tax laws.

It happens…bad luck.  There are times when a business is randomly selected for a sales and use tax audit.  It could be that it is just your turn.

It is a common misconception that filing any sales and use tax refund request will automatically trigger a corresponding sales and use tax audit in response.  In the early 2000’s, some states, such as Georgia, had a policy that any taxpayer who submitted a sales and use tax refund request and had not been subjected to a sales and use tax audit in the previous several years would be audited before any refunds were issued.  In recent years, that policy has been eliminated in Georgia and other states.  States have learned that taxpayers who file sales and use tax refund requests are generally more attuned to sales and use tax law which means they are not the best candidates for audits.  Filing a refund request can trigger an audit, but over 97% of our firm’s sales and use tax refund requests are reviewed without one.

Trigger #12. Whistleblowers or Referrals from an Outside Party

Disgruntled taxpayers, customers or even suppliers or vendors may notify the state of potential sales and use tax audit leads.  Certainly, there is an element of “sour grapes” to these sorts of claims, but states do consider such notifications.  It is difficult to know just how much this trigger is responsible for initiating sales and use tax audits because a state auditor will not inform the taxpayer that this is, in fact, the reason they are being audited.  Our sales tax consultants do not believe that this is a serious concern for most businesses.

 Sales and use tax audit triggers can be avoided if a company is proactivein planning and handling its sales and use tax compliance functions.  Don’t wait until that audit notice arrives inthe mail to begin thinking about what changes and improvements can be made toyour company’s internal systems to help avoid a sales and use tax audit.

What's the sales tax audit lookback limit?

The lookback period for a sales tax audit—the period during which tax authorities can review your business's financial records—varies by jurisdiction. In the United States, for example, the lookback period can range from three to six years, and sometimes longer in cases of suspected fraud.

What are the Consequences if you fail a sales tax audit?

If you fail a sales tax audit, consequences can vary depending on the specific circumstances and the tax laws of the jurisdiction. Potential outcomes may include:

• Penalties and Interest: You could be subject to penalties and interest on the unpaid or underreported sales tax amounts. The severity of penalties and the interest rate can vary based on the jurisdiction.
• Back Taxes and Fines: You may be required to pay the back taxes owed, along with additional fines imposed for non-compliance.
• Revocation of Business License: In some cases, repeated failure to comply with sales tax regulations could lead to the revocation of your business license, temporarily or permanently affecting your ability to operate.
• Legal Action: The tax authorities may take legal action against your business to enforce compliance, which could result in court proceedings and additional legal expenses.

Agile Consulting Group, Inc. is a sales and use tax consulting firm that was founded in 2005.  We have experience working in all 45 U.S. states that have sales and use tax.  We assist our clients with a comprehensive suite of sales and use tax consulting solutions including sales tax audit defense, sales and use tax compliance, sales and use tax recovery reviews and sales and use tax research.  Please reach out to our sales and use tax consultants at info@salesandusetax.com or by calling (888) 350-4TAX or (888) 350-4829.  We welcome the opportunity to assist you with your sales and use tax questions or concerns.

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