Sales tax audits are on the rise in most states. This is due to budget shortfalls of states across the country. In fact, state auditors are much more aggressive about tax laws than the auditors at the IRS. The state has the power to do massive damage to a business as a result of a sales tax audit, including sales and use tax assessments, interest and penalties that continue to accrue over time.
Protecting Your Business from Sales Tax Audits
Many businesses, perhaps most businesses, will get audited for sales tax at some point. This may relate to the purchase of supplies from out of state vendors. Or, it may relate to selling goods and services to customers in another state.
Businesses may be audited due to factors like location, industry affiliations, or data analysis that shows a physical presence in a state, which may obligate them to pay sales tax. Virtually any business that conducts business across state lines is a target for a sales tax audit.
Fear the state, even more than the IRS.
Personal Liability of Officers and Owners
It is incredibly important to know that the officers and owners of a business, as well as other responsible individuals, may be held personally liable for incorrect or underreported sales taxes. That means that tax authority who conducts sales tax audits can go after their personal assets to satisfy a sales tax debt.
Officers and owners of businesses should consider sales tax compliance to be a critical aspect of business operations.
You do not want to fail a sales tax audit.
Sales Tax Audits and Audit Defense: The Background
Many states have tax jurisdiction to require businesses to collect sales tax if their sales into the state are over a specific threshold. This is true even if the business has no physical presence in the state. This is based on a 2018 Supreme Court ruling in South Dakota v. Wayfair, Inc.
It is incumbent upon businesses to determine where they have sales tax exposure, based on this broad standard. Not surprisingly, states are looking for businesses that are not complying with these rules. Sales tax audits are on the rise, as state departments of revenue hunt for businesses that are not following their rules.
We will discuss in this post some of the issues surrounding sales tax audits. We will also talk about challenging a sales tax audit assessment and how to minimize the risk of a sales tax audit.
Audit Period
The term ‘audit period’ refers to the specific time frames during which auditors review business transactions and documentation.
If you are looking for a more general discussion on the basics of sales tax, check out our article on the Georgia Sales Tax.
Tax Audit Process: What is a Nexus Letter?
The sales tax audit process typically starts with a nexus letter (sometimes called a nexus questionnaire). This is a letter sent to the company, looking for information about the activities of the business within a state. This letter is meant to look for nexus, where the business exceeds the threshold of activity which triggers the requirement to collect sales taxes in the state.
A sales tax nexus letter is a serious matter and can have significant tax ramifications. A careful, timely response is required, often with a supplemental letter and other documentation to prove the position of the business with respect to sales tax nexus. We generally recommend that an experienced CPA prepare, or at least review, responses to a nexus letter.
Economic Nexus Rules
The economic nexus rules are powerful and drive the sales and use tax audit process. If nexus in a state is established, then the business is required to register for sales tax in that state. Additionally, the business must collect and remit sales tax in that state.
Sales Tax and Fulfillment Service Providers
A particular area of focus for sales tax auditors is inventory of a business that is in the hands of a fulfillment service provider, such as the Fulfillment by Amazon (FBA) service. Auditors often analyze purchase transactions, reviewing invoices and other related documents to ensure compliance with tax obligations.
The question is if inventory in a fulfillment center triggers sales tax nexus, especially where the fulfillment center handles the shipping and all other aspects of the order. The fulfillment center may even move the product in and out of a number of states without the knowledge of the business.
It is not clear how the courts will rule on the issue of whether or not inventory in a fulfillment center creates nexus (and a sales tax obligation). In some states, the fulfillment center, such as Amazon, is required to collect sales tax on behalf of the business. Nevertheless, the resolution of this issue is currently unclear.
Audit Process: What Triggers a Sales Tax Audit?
Many businesses handle their own sales tax compliance. Most of them do it wrong, failing to match sales on the sales tax returns with receipts on the federal returns, bank deposits, or sales on their Point of Sale (POS) system.
Businesses must ensure they correctly collect and remit the sales tax owed to state authorities to avoid triggering an audit. If the business fails the matching process that many states use, the resulting error message will automatically trigger a sale tax audit. That is one way that a state picks its audit targets.
Common Audit Triggers
Other red flags for audits include:
- large fluctuations in sales or sales taxes that don’t match up with industry averages
- significant volume of sales and exempt sales
- changes in the ratio of sales to exempt sales
- repeated late filings of sales tax returns
Audit Notices
If a business has been audited by the state department of revenue or the IRS in the past, they are more likely to receive audit notices.
Also, cash-based business are at higher risk for audits. Examples of cash-based businesses with potential sales tax issues include convenience stores, mini-marts, pawn shops, bodegas, restaurants and construction contractors.
CPA Tip: Show your sales tax returns to your CPA before the income tax returns are prepared, so that discrepancies can be corrected in advance. This can help to avoid a sales tax audit.
Mark-Up Percentage
Sales tax auditors often calculate sales subject to sales tax based on a mark-up percentage applied to purchases. A sales tax audit determines compliance by assessing whether a business has properly collected and remitted the correct amount of sales tax owed to the state.
These percentages can be based on outdated purchase prices, or they can be totally fictitious. This can result in an enormous bill for under-reporting of sales tax, plus interest and penalties.
Alternatively, the auditor may use a mark-up percentage that is based on industry standards that may not reflect where the business is located or the actual scope of the business. Or the industry standards used by the auditor could be out of date.
Statute of Limitations
To make matters worse, a sales tax auditor can look back many years when investigating a business, depending on the particulars of the state’s statute of limitations. Understanding state-specific tax laws is crucial for businesses to ensure compliance and avoid issues during an audit. Every state has its own rules.
In Georgia, the state has three years to audit, from either the sales tax return due date or the return filing date (whichever comes later). However, in the case of a false or fraudulent return, or a return filed with the intent to evade sales tax, or a failure to file a return, a sales tax assessment may begin at any time.
In Illinois, the state has three years to audit, from the time when the taxable gross receipts were received. However, there is no statute of limitations when there is failure to file a return or a fraudulent return.
This means that, in Georgia or Illinois, for example, a sales tax audit based on inflated mark-up percentages can cause the taxpayer to appear to be fraudulent, even if they are not, allowing the sales tax auditor to review many years of business activity. This can severely damage the finances of a business.
Sales and Use Tax Audit Procedures
A sales tax audit begins in earnest with a letter from the state Department of Revenue notifying the business that it has been selected for audit. Non-compliance can lead to significant sales tax audit penalties, including interest and fines.
The auditor will usually request a meeting with the business owner, although that can be handled by the CPA. Expect a follow up letter in the mail requesting information for the auditor to examine.
Examinations often take place at the taxpayer’s place of business or at the office of your CPA. You will want to give the auditor a comfortable space to work in. If you can give them coffee, all the better. The idea is to make the auditor comfortable and to establish an open line of communication between the auditor and the business. Nevertheless, it is always best to have the CPA handle the process, rather than the staff of the business. The CPA is far more familiar with the rules and is less likely to say something that should be left unsaid.
The CPA should be authorized under a Power of Attorney to speak with the auditor for the tax matters and the years in question.
During the examination, the auditor will compare the sales tax returns with the books and records of the business. Expect the auditor to look at all appropriate documentation, such as:
- Bank records
- Vendor invoices
- QuickBooks files
- Point of sale records (POS)
- Federal and state income tax returns.
Resale Certificates
The sales tax auditor will also want to see copies of sales tax exemption certificates (also called resale certificates) from customers. Missing or invalid exemption certificates are a common cause of problems during a sales tax audit. As an example, here is a link to the sales tax exemption certificate used by the Georgia Department of Revenue.
The responsibility is on the taxpayers (and their CPA or tax professional) to provide documentation to the auditor that demonstrates that the sales taxes were properly paid. Business should ensure that they retain this documentation in their files in the event of an audit.
When audited by the state’s department of revenue, give the auditor what they ask for, once it has been reviewed by your CPA or other tax professional. But only give the auditor what they specifically ask for. There is no reason to give the auditor more than what was requested.
Tax Audit Representation
It is critical that the CPA representing you in the audit is organized and prepared. He or she should understand every document provided to the auditor, including the underlying transactions and how the taxpayer conducts its business. There should never be surprises in an tax audit.
Also, you and your tax professional should treat the audit with respect and courtesy, and be respect of their time. Make sure that your tax representation team has these values, if you want your audit to go smoothly.
Sales Tax Audit Defense and Representation
At the completion of the audit, the auditor will send a list of proposed audit adjustments to the business or their CPA.
Now comes audit defense, which will include a variety of strategies based on the facts of the case and the matters at issue. For example, photos and videos of the business and of what is being sold may be used to disprove the auditor’s assumptions of taxability. Also, the mark-up percentages used by the auditor to calculate sales or sales taxes due may be challenged as out of date or unreasonable for the specific type of business or the location.
By thinking both strategically and creatively, a sales tax audit can often be settled for a fraction of the original bill.
Nexus and Sales Tax Audit Defense
Nexus refers to a specified level of activity that triggers a sales tax obligation in a given state. Every state has its own rules. Please check out our article on the Georgia Sales Tax for an in-depth discussion of this topic.
For purposes of this post, nexus is an issue that is fundamental to sales tax audits for businesses with multi-state operations. This is particularly true for online sellers, eCommerce and software providers. Thus, an evaluation of nexus is often a critical part of an effective sales tax audit defense.
At Massey and Company CPA, we work proactively to evaluate the audit risk of our clients. And where we find an audit risk, we work with our clients to mitigate that risk and adjust their processes accordingly.
Here are some example of the steps that we we take when undertaking an audit defense project for our business clients:
- Provide up-to-date sales tax research for all 50 states and the District of Columbia
- Model fact patterns based on real-life scenarios
- Research sales tax obligations in complex multi-state industries, such as SaaS, technology and eCommerce
- Examine industry-wide sales tax practices on a national basis in such areas as business services, construction, food and beverage, restaurant, healthcare, hospitality, manufacturing, retail, shipping and warehousing
- Develop taxability charts per item across all states
- Validate sales tax rates by city, state, county, zip code, and geolocation
We are respectful and friendly to the sales tax auditor, but our sales tax audit defense is robust, strong and fact-based.
What to Do After the Audit?
Always appeal or protest a sales tax audit. This must usually be done, in writing, within a certain amount of time, based on the rules of the specific jurisdiction.
CPA Tip: It is easier to settle your case at Appeals. Generally, the Appeals Officer is more reasonable and open to re-evaluating evidence than the field auditor.
And, while the case is in Appeals pending a settlement, it is often possible to negotiate an Offer in Compromise to further reduce the amount of the tax to be paid.
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For more information about the tax and accounting services we provide, including audit services, visit our Home Page! The CPAs, Enrolled Agents and tax professionals at Massey and Company CPA are here to assist you with proactive sales tax planning as your business grows, as well as sales tax audit defense.
If you want my team and I to handle your tax matter for you, click here.
You are welcome to email me directly at gary.massey@masseyandcompanyCPA.com.
Massey and Company CPA is a boutique tax and accounting firm serving individuals and small businesses in Atlanta, Chicago and throughout the country. Our services include tax return preparation, tax planning for businesses and individuals, IRS tax problem resolution, IRS audits, sales taxes and small business accounting and bookkeeping.
