A sales tax audit is a formal review conducted by a state tax authority to verify that your business has correctly collected, reported, and remitted sales and use taxes. Tax authorities are stepping up their efforts to audit businesses for compliance, and they have increasingly sophisticated data analytics capabilities. The US Internal Revenue Service (IRS) estimated the tax gap—the difference between taxes owed and those paid—to be $696 billion in 2022, with sales and use taxes making up a sizable portion of it.

Heightened tax scrutiny isn’t limited to large corporations. Small and medium-sized enterprises are also being monitored. 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 multistate or e-commerce operations, are finding it more difficult to self-assess their compliance levels accurately. Even a business that uses robust accounting practices might still find gaps via a sales and use tax audit.

Below, we’ll explain what sales and use tax audits are, what types of businesses are most affected, 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?
  
• Common triggers for a sales tax audit
  
• 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
  
• How Stripe Tax can help
  

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 the business has properly collected, reported, and remitted sales and use taxes according to applicable laws and regulations.

The statute of limitations on how far back a tax authority can audit sales and use tax records depends on the state, but it’s typically 3–4 years from the filing date. This period can be extended or removed entirely in cases that involve unfiled returns or fraud.

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 and e-commerce businesses: High transaction volumes create more opportunities for error, and e-commerce sellers face added complexity from operating across multiple tax jurisdictions.

• 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 closely examine whether use tax was properly paid on those items.

• Food and beverage establishments: Restaurants and bars can process 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 possibly trade-ins, financing, and service contracts. These are all factors that can complicate the tax situation. Therefore, these businesses are 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 high volumes of exempt sales: Companies that make many tax-exempt sales, such as to resellers or non-profits, often attract attention from tax authorities.

• Recently acquired, merged, or audited businesses: Ownership changes and prior compliance issues both increase the likelihood of follow-up audits.

Common triggers for a sales tax audit

Beyond industry type, specific patterns in a business's data and filing history can prompt a state to open an audit. Common triggers include the following:

• Nexus and registration gaps: Failure to register in a state where a business has a tax obligation is one of the top reasons it incurs penalties from sales and use tax audits. Many states have economic nexus laws so exceeding a state's sales or transaction threshold can create a registration and collection obligation, even without a physical presence there.

• Mismatched figures across returns: A sales tax audit often occurs when a state tax agency suspects a business of understating its reported sales or when the sales tax return filed with the state doesn't match what was reported to the IRS.

• Missing or invalid exemption certificates: Missing, expired, or incomplete exemption certificates are found often in audits. And if documentation can't be produced, the business might be held responsible for the unpaid tax.

• Unreported use tax on large purchases: Use tax audits often stem from large capital purchases that show up on depreciation schedules without corresponding use tax payments.

• Late or inconsistent filing history: States view repeated late filings as a sign of potential noncompliance and might initiate an audit to investigate further.

• Third-party and cross-agency data matches: If a business fails the automated matching process that many states use, the resulting error can automatically trigger an audit. And many states share audit data with the IRS or with each other so an audit at the federal level or in one state can lead to a follow-up audit elsewhere.

• Prior audit or high-risk history: Companies that were previously audited by a state department of revenue or the IRS are more likely to receive future audit notices. Cash-based businesses such as convenience stores, restaurants, and construction contractors carry a higher baseline audit risk.

Because these triggers are largely driven by data, keeping sales tax, use tax, and income tax filings reconciled—and exemption certificates current—is one of the more impactful ways to help reduce audit risk before a notice ever arrives.

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.

Documents the auditor will request

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: They’ll look at purchase orders to verify transactions and cross-reference invoices.

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

• Exemption certificates: They’ll 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, and any other digital data that contains relevant financial information.

How the auditor reviews your records

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

• Sample auditing: Instead of scrutinizing every transaction, the auditor might assess a representative sample, extrapolating the error rate from the sample to the entire dataset.

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

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

What the auditor is looking for

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

• Use tax compliance: The auditor is also checking whether the business paid use tax for purchases where sales tax wasn’t 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 properly documented.

Cost of a sales and use tax audit for businesses

The financial impact of a sales and use tax audit can be considerable and expand beyond tax liabilities. Apart from the direct financial costs, audits often demand considerable attention from internal teams for extended time. Staff might 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 on project timelines and other compliance-related activities.

Here’s a rundown of the costs typically associated with audits.

Financial costs

• Back taxes and additional assessments: 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. And if the auditor finds underpayment, that could lead to further assessments.

• Interest: Back taxes are often accompanied by interest, which accrues separately from penalties. In California, for example, the state’s tax department charges monthly interest on late payments. And in Texas, interest begins accruing 61 days after the due date. Because rates and rules shift by state and year, a business should confirm current figures with its state’s department of revenue.

• Penalties: Along with interest, penalties can make the total amount owed substantially higher than the original tax. They vary by state but are often 5%–25% of the unpaid tax, depending on how late the payment is. In California, the business must pay a Collection Cost Recovery Fee once a liability remains unpaid for over 90 days after a demand notice. And the Texas comptroller assesses a 10% penalty if tax is paid more than 30 days after the due date. As mentioned above, these figures can change regularly.

• Legal and consultancy fees: Hiring specialized consultants or attorneys to get through the audit process can also add to expenses. In extreme cases that involve substantial inaccuracies or evidence of intentional fraud, businesses might also face legal action. That can increase these costs considerably.

Non-financial costs

• Time commitment: Preparing for 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 regular business operations.

• Emotional toll: Audits can also lower staff morale, leading to diminished productivity and well-being.

• Reputation: If an audit finds improper practices or results in hefty fines, that can harm a business’s reputation, with potential long-term effects on revenue streams.

Potential upsides

Audits aren't always a net cost. If the auditor finds that a business overpaid, the business could be eligible for a refund. Auditors might also offer recordkeeping recommendations that help the company improve its accounting and tax practices going forward, reducing the likelihood or impact of future audits.

The effect of an audit will vary based on factors such as the business’s size, the depth of the financial irregularities discovered, and the audit’s length. Regardless, the impacts can be far-reaching. That 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. These include 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 you’ve filed during the period that’ll be audited so 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, ensure 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 you’ve paid use tax on all applicable purchases from vendors that didn’t collect sales tax and that you have receipts or other documentation to prove these payments.

• Consult a tax adviser: If you’re uncertain about the nuances of sales and use tax, consult a tax adviser or accountant who’s experienced in this area before the audit. They can review your records, provide expert guidance, and interact with the tax authority on your behalf, if needed.

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

• Understand audit procedures: Familiarise yourself with the procedures 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 able to provide quick access to any documents the auditor might request.

• Keep communication lines open: Maintain open, 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 so staying up-to-date on these changes is important. The prospect of an audit might seem overwhelming, but proper preparation can make a big difference.

How Stripe Tax can help

Stripe Tax reduces the complexity of tax compliance so you can focus on growing your business. Start collecting taxes globally by adding a single line of code to your existing integration, clicking a button in the Dashboard or using our powerful API.

Stripe Tax helps you monitor your obligations and alerts you when you exceed a tax registration threshold based on your Stripe transactions. It can also register to collect tax on your behalf in the US, automate US filings in the Dashboard, and manage global filings through trusted partners. Stripe Tax automatically calculates and collects sales tax, VAT, and GST on:

• Digital goods and services in all US states and over 100 countries
  
• Physical goods in all US states and 42 countries
  

Stripe Tax can help you:

• Understand where to register and collect taxes: See where you need to collect taxes based on your Stripe transactions. After you register, switch on tax collection in a new state or country in seconds. You can start collecting taxes by adding one line of code to your existing Stripe integration, or add tax collection with the click of a button in the Stripe Dashboard.

• Register to pay tax: If you need to register for a sales tax in the US, let Stripe manage your tax registrations. You'll benefit from a simplified process that prefills application details – saving you time and simplifying compliance with local regulations. If you need help registering outside of the US, Stripe partners with Taxually to help you register with local tax authorities.

• Automatically collect tax: Stripe Tax calculates and collects the right amount of tax owed, no matter what or where you sell. It supports hundreds of products and services and is up-to-date on tax rules and rate changes.

• Simplify filing: Stripe Tax automates US filings in the Dashboard, powered by TaxJar. For global filings, Stripe Tax seamlessly integrates with filing partners, so your global filings are accurate and timely. Let our partners manage your filings so you can focus on growing your business. US tax filings can be automated in the Stripe Dashboard, powered by TaxJar.

Learn more about Stripe Tax or get started today.