US tax authorities are stepping up efforts to audit businesses for compliance, and they have increasingly sophisticated data analytics capabilities. The US Internal Revenue Service (IRS) estimated that the tax gap – the difference between the taxes owed and those paid – to be US$625 billion in 2021, with sales and use taxes making up a sizable portion of that gap.

Heightened tax scrutiny isn't limited to large corporations. Small and medium enterprises are also finding themselves under the microscope. Audits often require considerable time and resources to manage, creating financial risks and operational disruptions for businesses.

The complexity of sales and use tax laws, which differ by state and municipality, adds another layer to this issue. Businesses, particularly those with multi-state or e-commerce operations, are finding it more difficult to self-assess their compliance levels accurately. Even a business that uses robust accounting practices may still find gaps via a sales and use tax audit.

Below, we'll walk through what sales and use tax audits are, what types of businesses they affect the most, how audits are conducted and how businesses can prepare for them.

What's in this article?

• What is a sales and use tax audit?
  
• What types of businesses are audited most frequently?
  
• What happens during a sales and use tax audit?
  
• Cost of a sales and use tax audit for businesses
  
• How to prepare for a sales and use tax audit
  

What is a sales and use tax audit?

A sales and use tax audit is a formal examination conducted by a governmental tax authority to verify the accuracy of a business's sales and use tax records, payments and compliance. This review assesses whether a business has collected, reported and remitted sales and use taxes properly, according to applicable laws and regulations.

What types of businesses are audited most frequently?

A variety of factors influence which businesses are most prone to sales and use tax audits, including the complexity of their transactions, their overall revenue and the nature of their goods and services. Here are some categories of businesses that are commonly subject to these audits:

• Retail businesses: Shops that sell directly to customers often face audits. The high volume of transactions present more opportunities for errors or inconsistency in tax collection.

• E-commerce businesses: Online businesses are more likely to face audits because they operate across jurisdictions and therefore deal with different tax rates, which makes compliance challenging.

• Construction businesses: Depending on the state and the circumstances, construction businesses aren't always responsible for paying sales tax on construction materials at the time of purchase. Auditors examine closely whether use tax was paid properly on such items.

• Food and beverage establishments: Restaurants and bars can have complex transactions that involve taxable and non-taxable items. These transactions make them more susceptible to errors and consequently, audits.

• Car dealerships: The sale of vehicles involves large transaction amounts and may involve trade-ins, financing and service contracts – all factors that can complicate the tax situation. These businesses are therefore more likely to be audited.

• Manufacturing firms: Manufacturers often claim tax exemptions for raw materials and machinery acquired for production. This makes them a focus for auditors who want to verify that these exemptions are legitimate.

• Businesses with a high volume of exempt sales: Businesses that make many tax-exempt sales, such as to resellers or non-profits, often attract attention from tax authorities in the form of audits.

• Recently acquired or merged businesses: After a change in ownership or structure, businesses may be audited to ensure that all tax liabilities have been identified correctly and are being managed appropriately.

• Businesses with past audit issues: Businesses that have faced penalties or adjustments during a previous audit are more likely to be audited again to check for compliance.

No business is immune to the possibility of an audit, and maintaining accurate and thorough records is the best way to mitigate potential risks and make the process more manageable. If your business falls into a category that is often audited, consider working with a tax adviser to minimise potential issues.

What happens during a sales and use tax audit?

During a sales and use tax audit, an auditor conducts a comprehensive examination of a business's financial activities related to the collection and payment of these taxes. Here's a look at the process.

Document requests

The auditor begins by asking for documents that relate to the business's sales and purchases:

• Invoices: Auditors will request invoices for sales to customers and purchases from suppliers.

• Purchase orders: Auditors will look at purchase orders to verify transactions and cross-reference these with invoices.

• Tax returns: Auditors will also want to look at the business's previously filed sales and use tax returns.

• Exemption certificates: Auditors will examine exemption certificates to validate any tax-exempt sales.

• Electronic records: Auditors will want to see electronic records, such as accounting software files, spreadsheet records or any other digital data that contains relevant financial information.

Examination methods

The auditor will assess the requested documents in one of these ways:

• Sample auditing: Instead of scrutinising every transaction, the auditor may assess a representative sample, extrapolating the error rate from the sample to the entire data set.

• Line-by-line review: The auditor may examine each transaction in detail. This is more common for audits of smaller businesses with fewer transactions.

• Third-party verification: The auditor may verify the information that the business provides by contacting customers, suppliers or other parties involved in the transactions.

Audit objectives

• Sales tax accuracy: The primary goal of this type of audit is to determine whether the business has collected tax from customers correctly at the point of sale.

• Use tax compliance: The auditor is also checking whether the business paid use tax for purchases on which sales tax was not collected, such as items bought from out-of-state suppliers.

• Exemptions and deductions: Finally, the auditor verifies whether exemptions claimed by the business are valid and have been documented properly.

Outcomes and consequences

• Additional taxes and penalties: If the auditor finds any underpayment, the business is usually required to pay the outstanding amounts, plus interest and possibly penalties.

• Refunds: Conversely, if the auditor finds an overpayment, the business may be eligible for a refund.

• Recordkeeping recommendations: Auditors may offer recommendations for improving the business's accounting and tax practices.

• Legal actions: In extreme cases involving substantial inaccuracies or evidence of intentional fraud, businesses may face legal consequences.

Although an audit can be stressful, good recordkeeping and open communication with the auditor will ease the process. Businesses often seek advice from tax experts to help them prepare for audits and clarify their rights and responsibilities during the examination.

Cost of a sales and use tax audit for businesses

The financial impact of a sales and use tax audit can be considerable, going beyond tax liabilities. Apart from the direct financial costs, there's also the resource drain to consider. Audits often demand considerable attention from internal teams for an extended period of time. Staff may be pulled from other projects to collect documents, clarify operations or reconstruct past transactions. This loss of time and focus can have a ripple effect throughout the business, including project timelines and other compliance-related activities.

Here's an overview of the costs typically involved with audits:

Financial costs

• Back taxes: One immediate repercussion of a failed audit is the obligation to pay any unpaid taxes. This amount can range from negligible to substantial, depending on the scale of the discrepancy.
  
• Penalties and interest: Back taxes are often accompanied by penalties and interest – additional charges that can make the total amount substantially more than the original tax owed.
  
• Legal and consultancy fees: Recruiting specialised consultants or lawyers to get through the audit process can also add to expenses.
  

Non-financial costs

• Time commitment: Preparing and going through an audit can be a time-consuming process, demanding considerable effort from business owners and staff members. This diverted focus can affect normal business operations.
  
• Emotional toll: Audits can also put a strain on staff morale, leading to diminished productivity and well-being.
  
• Reputation: If an audit finds improper practices or results in hefty fines, it can leave a stain on a business's reputation, with potential long-term effects on revenue streams.
  

The effect of an audit will vary depending on several factors, such as the size of the business, the depth of the financial irregularities discovered and the length of the audit. Regardless, the impacts can be far-reaching – which makes it even more important for businesses to prepare.

How to prepare for a sales and use tax audit

Preparing for a sales and use tax audit involves multiple steps to ensure that your financial records are in order and that you're well equipped to handle the scrutiny.

• Organise all relevant documents: Before the audit, gather all necessary documents together. This includes invoices, purchase orders, sales receipts, tax exemption certificates and any other relevant financial records. Keeping these documents organised will facilitate easier access during the audit, which can expedite the process.

• Review sales and use tax returns: Examine the sales and use tax returns that have been filed during the period to be audited so that you can identify potential issues before the auditor does. Check for any inconsistencies or errors and make corrections if possible.

• Check exemption certificates: If tax-exempt sales are a part of your business, make sure that you have valid exemption certificates for each transaction. Each certificate should be complete, accurate and up to date to avoid unnecessary complications.

• Validate use tax payments: Review your records to confirm that you've paid use tax on all applicable purchases from vendors that did not collect sales tax ,and that you have receipts or other documentation to prove these payments.

• Consult with a tax adviser: If you're uncertain about the nuances of sales and use tax, speak to a tax adviser or accountant that has experience in this area before the audit begins. They can review your records, provide expert guidance and interact with the tax authority on your behalf, if needed.

• Conduct a pre-audit: Performing a self-audit before the actual audit can help with identifying problem areas. A tax adviser can assist with this by simulating some of the methods that an auditor may use, such as sampling transactions for errors.

• Understand audit procedures: Familiarise yourself with the procedures that the auditor will follow. This will help you understand what to expect, what the auditor will be looking for and how you should respond to their queries.

• Set up a designated audit space: Establish a specific location within your business premises where the audit will take place, if it's happening in person. This should be a quiet space away from daily business operations where the auditor can work undisturbed.

• Assign a point person: Appoint a knowledgeable staff member to serve as the liaison between your business and the auditor. This person should be familiar with your financial processes and also able to provide quick access to any documents that the auditor may request.

• Keep communication lines open: Maintain open and polite communication with the auditor throughout the process. Being cooperative and transparent can facilitate a smoother audit experience.

Although what we've covered is common in most sales and use tax audits, each audit can differ based on the jurisdiction and the focus of the tax authority. New tax laws and regulations can also change the audit landscape, so staying up to date with these changes is important. The prospect of an audit may seem overwhelming, but proper preparation can make a big difference.