Tax Analysts Blog

What Triggers a Sales and Use Tax Audit?

Posted on Feb 19, 2014

Being the subject of a sales and use tax audit is a fact of life for many large corporate taxpayers. For other taxpayers, an audit comes as an unwelcome surprise. Predicting what makes a company more vulnerable to a sales and use tax audit can prove to be a valuable exercise. Knowing what triggers an audit can help taxpayers avoid or prepare for the inevitable.

States generally have a system for selecting taxpayers for audit, and they will use a variety of selection methods within that system. Some taxpayers are selected regularly because of their size, sales volume, or the complexity of their returns. Others may be chosen because of a specific event. For example, closing a store in a particular location, bankruptcy, or the dissolution of the business may trigger an audit.

Taxpayers should be aware that auditors compare sales and use tax returns for multiple years. For example, in Texas, taxpayers labeled as "prior productive," meaning their accounts yielded tax adjustments of more than $10,000 in previous audits, are likely to be audited in the year (or several) following an audit.

Taxpayers with significant exempt sales or that have a large increase in the amount of exempt sales are also more likely to be audited often because there is some discretion in determining what constitutes an exempt sale. And on the flip side, a drop in taxable sales may make a taxpayer more susceptible to audit, as will claiming frequent refunds or large tax credits.

Nexus is another common reason for an audit because of the complexity surrounding nexus determinations (and the lack of a unified standard for what constitutes nexus). Taxpayers, particularly those that make sales over the Internet, may have unknowingly created nexus in a state. Once nexus has been established, a taxpayer is generally required to register for sales and use tax and begin filing returns. If it hasn't done that, a simple Internet search can often lead an auditor to finding out about the company and then calling to check on its registration status and number.

Another common trigger is late filing. Taxpayers that continually file late will be scrutinized and likely eventually audited. Likewise, those taxpayers that file sales tax returns but don't remit use tax may be opening themselves up to an audit. A company may also find that if one of its vendors did not charge the proper use tax and that vendor gets audited, the company may be next in line for an audit.

While this list is far from exhaustive (and in fact just scratches the surface), there are a few important pieces of advice. Taxpayers that file consistently on time and accurately are the least likely to raise red flags for auditors. To that end, taxpayers should also consider outsourcing their sales and use tax compliance to a third party. For many taxpayers, this means hiring an accounting firm to provide regular accounting and financial advice. For others, particularly small taxpayers, using third-party software to manage their sales and use tax compliance may well be worth the cost.

Small businesses may want to consider forming a corporation. Sole proprietors are audited more frequently than small business corporations (including C corporations, S corporations, and limited liability companies). That is because tax departments have determined that sole proprietors are more likely to file self-prepared returns, and those returns are more likely to have errors. Still, there is no guarantee that any taxpayer won't be selected for audit, even the most careful filer.

And one final word of caution: State tax departments will not turn a deaf ear on tips or whistleblowing from disgruntled employees or ex-employees. While this may not be a trigger that produces a lot of audits, it has happened. Given that states are constantly looking for more revenue (and often get that revenue through audits), they are likely to follow up on a solid lead from a whistleblower about a company that may be underreporting its tax liability.

Read Comments (1)

Jay StarkmanFeb 19, 2014

Georgia is now engaged in a major effort to audit all kinds of small businesses
centering on use tax. Service businesses that make no taxable sales wind up
with assessments for a 36-month period of about $5,000 (half penalties and
interest) for out-of-state supplies and equipment purchases. An extension of
the statute of limitations is demanded upon receipt of the audit invitation. A
sales tax auditor spends 3 to 5 days on premises poring over the records. The
net revenue gain to the state must be marginal after expenses, and a nuisance
in a state normally considered business-friendly.

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