Ask the Expert: How to Prepare for a Sales Tax Audit

Owning a business of any size that sells taxable goods or services means you may be subject to a sales tax audit at any time. Businesses that sell their products in multiple states are especially susceptible, as any one of those states may select you for an audit.

While you may not be able to avoid sales tax audits altogether, knowing what to do before, during, and after an audit will give you some much-needed confidence and may also save you from an overwhelming tax bill at the end. We asked Jennifer Dunn, one of TaxJar’s audit experts, for advice on what to do before, during, and after a sales tax audit.

Why might I be audited?

Sales tax audits provide states and localities with an extra source of revenue (these audits originate from the state revenue board rather than the IRS). Auditors will generally try to get as much revenue as possible by targeting businesses that are most likely to end up owing a ton in back taxes.

Thus, there are certain red flags that are highly likely to draw an auditor’s attention. Avoiding said red flags could help you dodge sales tax audits indefinitely.

According to Dunn, here are some flags they may consider red (aka reasons you might be audited). These reasons are usually out of your control, but it’s still good to be prepared for the possibility of an audit:

You belong to an audit-prone industry.
Auditors will often choose to focus on one industry at a time, especially if the initial audits prove fruitful. For example, if a group of auditors determine that coffee shop owners seem to be be under-reporting their sales taxes, they might issue audit notices to every coffee shop in the state.

You have abnormally high income.
Auditors often compare a business to similar businesses in that industry to see if they stand out in any way. A much higher income than your competitors could easily trigger an audit since auditors generally associate high income with high (potential) tax bills.

The state thinks you may have nexus.
Economic nexus simply means that your business’s sales or revenue in a particular state exceed a certain threshold amount. Thanks to the 2018 South Dakota v. Wayfair court case, if you have nexus, you’re required to collect and pay sales taxes on eligible transactions in that state. State revenue boards will periodically run analyses to find small businesses that show signs of having nexus but have never registered for or paid sales tax.

According to Dunn, “You can be in trouble if you are not collecting sales tax, and the state finds you and says, ‘Oh, you should have given us a million dollars in sales tax.’ So you definitely want to make sure you’re compliant.”

One of your vendors was audited.
An auditor who conducts a successful sales tax audit on one business may use the information gathered during the audit to target that business’s customers or vendors. First, a business that’s sloppy about sales tax may attract customers who are equally sloppy, thus making them profitable targets for the auditor; second, the information collected during the vendor’s audit may be enough to give the auditor a head start on the next wave of targets.

What should I do before an audit?

Preparation is key — whether you expect to be audited or fear being audited. Using tools like Neat and TaxJar can help you be prepared for whenever audit day comes — by giving you the ability to track receipts, calculate and report sales tax, and more.

In addition to the right tools, you can also take the following steps:

First, find a tax professional who specializes in SALT (state and local tax) representation.
Your accountant will likely be able to recommend an expert. In a pinch, you can ask your accountant to represent you during the audit – however, someone who doesn’t specialize in sales tax representation won’t necessarily have the skill set and experience to get you the best possible result.

What does Dunn say? “Your CPA, who does all your tax preparing, is not really going to be equipped to help with a sales tax audit. You want an actual sales tax professional, somebody who’s worked with your state’s department of revenue.” It’s like when a doctor sends you to a specialist, she says.

Next, start pulling together the documents that your auditor is likely to request.
The SALT expert can advise you on specific requirements, but such documents would likely include basic accounting reports, bank statements, invoices, and the like. If you’re missing crucial documents, you may be able to reconstruct them using other records. For example, if you’re missing an invoice, you could use purchase documents and bank statements to figure out how much the invoice was. Or you can look in your Neat account to easily locate the document.

What should I do during an audit?

While your audit takes place, you can take steps to manage the process — which gives you a lot more control over what the auditor sees and does. Consider the following tactics to reduce your risk of a major tax assessment.

Isolate the auditor.
For onsite audits, keeping the auditor isolated is extremely important. Tucking the auditor away in a corner of your office means: one, the process will be less disruptive to both your employees and your customers; two, you can manage how much access the auditor has to your business and its operations. Ideally, you’d put the auditor in an office with a door and keep the door closed, or at least give them a desk of their own complete with the documents you’ve collected. Stock the auditor’s space with plenty of drinks and snacks, so they have less reason to be wandering around your facilities.

Don’t panic over missing documents.
The auditor may ask you for documents that weren’t included in the pile you collected for them. Get those documents if you can, but don’t panic if they’re not available – you may be able to substitute another document or reconstruct the record. If the documents you need are not onsite, let the auditor know you’ll need a little extra time to pull those items together.

Hint: Use Neat to easily organize all your financial documents.

Listen to your SALT tax professional.
Sometimes an auditor will ask for documents or information that you’re not obligated to provide. This is one example of how having a SALT expert to represent you can really help. Your expert will know which requests you can (politely) decline without getting yourself into trouble.

“We treat it kind of like testifying in court,” Dunn says. “Only answer the question that you’re asked. Don’t be giving extra information, and ask for the request in writing as well. That way you have a paper trail.”

Check in with your auditor.
At the end of each day, ask the auditor how the day went and how the audit is looking so far. Auditors aren’t required to give you updates, but most will cooperate if you’ve been polite and respectful. The sooner you find out about any problems the auditor has uncovered, the more time you’ll have to do damage control. For example, if the auditor uncovers unpaid tax issues and tells you about them early on, you’ll have a few extra days to dig up transactions where you overpaid sales taxes and use those to balance out the coming tax bill.

What should I do after an audit?

Unless you’re very lucky indeed, your auditor will find something that will result in a tax assessment at the end of the audit. If the assessment is fairly small, the best course of action may be to just pay it. However, if you feel it’s worthwhile, you can try to get your assessment reduced.

Negotiate with your auditor.
Try talking with the auditor, preferably before they sign the final assessment documents. Depending on what you find in the way of overpayments and the like, you may be able to talk them into giving your business a lower tax assessment. If the auditor seems unreasonable, let them know you plan to contact their supervisor; this may be enough to change their mind.

Appeal in court.
Once you’ve received the final assessment, you have the option to appeal it in court. If you choose to appeal, you’ll definitely want to get experienced legal representation. Keep in mind that appeals will require a lot of time and money from you, so it’s not worth doing unless the potential gain will outweigh those costs.

Offer a partial payment.
Another option is to make a partial offer of payment to the state revenue board. This can be particularly effective if your assessment is very high compared to the size of your business.

“Let’s say you owe $20,000. Say, I can clear this up right now with $12,000,” Dunn says. “They’ll see what you have. If you’re not doing well, you can say, look, this is what I can pay. Otherwise, I’ll have to do a payment plan, or otherwise, I just can’t pay you. I’m going to go out of business.”

Your SALT advisor can help you come up with a reasonable offer based on your specific situation.

Use your sales tax audit experience as an opportunity to improve

Sales tax audits are not a pleasant experience, but they do represent an opportunity. You can use the information from the audit to improve your business operations and bookkeeping protocols. Understanding red flags that triggered the audit in the first place and cleaning up issues that the auditor uncovered will result in a more tightly run business – and help prevent any future audits.