Many businesses that sell goods and services are required to collect and remit sales tax. And when that’s the case, there can be serious consequences for failure to do so.
For many states, sales tax represents an important source of revenue, so they have ways of making sure that companies are collecting and remitting the correct amounts — one way is conducting sales tax audits.
Like an IRS audit, a state sales tax audit involves a professional who works for a taxing authority reviewing financial records. Its goal, though, is to make sure that all taxable sales were reported, that the correct amount of tax was collected, and that this amount was paid to the state.
All states that collect sales tax conduct sales tax audits to encourage compliance with their sales tax laws. However, some states are more likely to conduct audits than others.
Looking at the data
Multiple surveys have been conducted asking businesses which states audited them for sales tax compliance, and data from these surveys shows which states are most aggressive in conducting audits.
For example, according to data from the Sales Tax Institute, the states most likely to conduct audits (based on the number of businesses that received audit requests) are:
- California
- Maine
- Washington
- Wisconsin
- Illinois
- Massachusetts
Maine and Massachusetts, in particular, have been extremely aggressive in initiating sales tax audits. Both states use third-party sources to try to identify companies that may not be in full compliance with sales tax rules and to go after businesses that registered to pay sales tax but did so later than they should have.
Leyton collected similar data, with their research indicating that the states most likely to audit out-of-state businesses for sales tax compliance included California, New York, Alabama, Arizona, Colorado, Georgia, and Texas, while the top states for auditing local businesses included California, Alabama, and Texas.
Many of these states have low thresholds at which remote sellers must begin to collect sales tax — for instance, a $100,000 threshold for Colorado, Maine, Illinois, Washington, Wisconsin, and Massachusetts. Most other states have higher thresholds, from $200,000 to $500,000.
Some, like Washington, also have some of the highest sales tax rates in the country.
Sales tax audits post-Wayfair
The rules for sales tax across the United States changed fundamentally in 2018. as a result of a Supreme Court case called South Dakota v. Wayfair. This major shift in sales tax law also changed the nature of audits — and opened the door to states pursuing enforcement activities against many more businesses.
Prior to the 2018 Wayfair decision, a state could require a business to collect sales tax only if the company had a physical location within the state's borders — such as a storefront or a warehouse. This is called having physical nexus.
With Wayfair, however, the court said that states could begin requiring that remote businesses selling products in a state over the Internet also collect sales tax. States could do this if the business had a certain amount of economic activity in the state. This is called economic nexus.
After Wayfair opened up the door to requiring online businesses to collect and remit state sales tax, states passed laws establishing thresholds for economic nexus. In most cases, economic nexus is based on the amount earned through sales in a state, such as $100,000 worth of sales or more. Some states also set transaction-based thresholds, such as 200 or more transactions.
Once a business meets a state's requirements for economic nexus, it must register to collect sales tax on eligible sales there, begin collecting those taxes on qualifying purchases, file sales tax reports, and remit taxes as required. To ensure that companies were doing that, states could now audit not just businesses within their borders, but also any companies that sold products to their residents.
While a company being audited by a state where it was not located was extremely rare before Wayfair, everything changed with that case. Now, Leyton reports that just 41% of companies that reported receiving an audit notice got that notice from their own state, while 45% received an out-of-state audit notification.
Factors that increase the likelihood of an Audit
Any business is potentially vulnerable to a sales tax audit, but certain factors make an audit more likely to occur. Here are a few of those factors:
- Registering late for sales tax collection. A great many businesses found themselves facing audits in a state because there was a gap between the time that the state passed economic nexus laws and when the company registered to collect sales tax. Reports indicate Maine was particularly aggressive in going after companies that were late to comply with the law.
- Operating in a high-risk industry. E-commerce businesses, SaaS (software as a service) businesses, and retail businesses are at an especially high risk of audits because they often meet economic nexus thresholds in multiple states and may not be aware of their obligations in each one.
- High initial sales tax reports. If a business registers in a state and immediately reports owing high amounts of sales tax, this raises a red flag that the company may have met economic thresholds for registration before actually registering.
- Audited vendors or customers. If a customer or vendor you do business with is audited, the state may extend the audit to your business as part of a broader effort to identify compliance issues.
- Late or inaccurate filings. If you consistently file your sales tax forms late or make payments late, this can cause red flags that prompt a state to take a closer look.
- Significant business changes. Sudden increases or decreases in revenue or other major changes like restructuring or a merger can capture unwanted attention for your business and increase the risk of an audit occurring.
You can try to minimize some of these risks, but others are out of your control, so you simply have to be aware of them and ensure that you're prepared.
How to prepare for a sales tax audit
Every business needs to be prepared for a sales tax audit, especially if it has economic or physical nexus in one of the states known to be aggressive about conducting audits, or if there are other factors that increase risk.
Fortunately, making sure you are audit-ready is possible. Here's what you need to do:
- Charge the correct amount of sales tax on all transactions, based on the rules in the location where the transaction is taking place.
- Keep accurate records of all taxable transactions and sales tax collected, and keep exemption certificates on file for tax-exempt transactions.
- Regularly review your nexus obligations so you can ensure that you register as soon as you hit the economic nexus threshold.
- Register as soon as you are required to begin collecting sales taxes, and submit your forms and remit payment by the deadline every time in every state where you have economic or physical nexus.
- Use automation and tax software to reduce errors in your tax collection and payment process.
You can't wait until the state starts an investigation to begin following best practices for sales tax compliance. You should be proactive about putting the right systems in place early on, so you can fulfill your obligations to all of the different states where you are required to collect sales tax.
By being proactive instead of reactive, you can avoid the types of errors that can lead to an audit and can ensure that if you are audited, you are able to demonstrate compliance. This will help you avoid fines and fees for failing to fulfill the state's sales tax requirements and will reduce the chances of further audits.
Final thoughts
Sales tax audits can come from any state, but if you have sales tax obligations in California, Maine, Washington, Wisconsin, Illinois, or Massachusetts, you may be more likely to face an audit.
The good news is that investing in the right compliance solutions can help you to minimize your risk. Numeral can keep you up-to-date on nexus obligations, register for you when required, and automate the process of collecting, filing, and paying sales tax. It also allows you to store all your sales tax records in one place for easy access.
