A sales tax audit is a routine compliance review that nearly every business faces at some point. Even so, many businesses find the process uncomfortable. To make this process a bit easier and more comfortable, this overview provides key insights that help tax and finance teams understand why audits happen, how the audit process works, and what steps can be taken to reduce the likelihood of future audits.

What Triggers a Sales Tax Audit

Sales tax audits are often triggered by signs that a business may not be collecting, reporting, or paying the correct amount of sales tax. This is particularly true for online sellers selling across multiple US states. Since US Tax Authorities are increasingly using automated systems, data matching, and targeted compliance programs to identify businesses that appear to have a higher risk of sales tax errors, the possibility of being subject to a tax audit is greater.

One of the most common triggers is failing to register for sales tax on time. For local businesses, this means complying with the physical nexus rule, whereas for online sellers, this means failing to register despite exceeding the economic nexus threshold. When an online seller exceeds the required sales threshold, typically set at USD 100,000 in many states, but does not obtain a sales tax permit and begin collecting tax, it may attract attention from Tax Authorities.

Storing inventory within a state may also trigger a sales tax audit. Businesses that use third-party fulfillment providers, such as marketplace fulfillment programs, may create physical nexus because their inventory is located in that state. By tracking fulfillment records, shipping information, and marketplace reporting data, Tax Authorities can identify businesses that established a nexus but failed to register for sales tax purposes.

The list of triggers also includes the following: inconsistencies between different sources of information, large amounts of exempt sales without proper exemption certificates, incorrect sales tax rates, improper tax sourcing, failure to apply local or special district taxes, and poor filing compliance.

In some cases, a tax audit of a customer or vendor can also lead the Tax Authorities to audit linked businesses based on its findings. Notably, high-revenue, high-volume industries attract more attention and are prone to more frequent audits.

Examples of Tax Audit Triggers

It is important to pay attention to how a business activity is classified and correctly determine whether certain tax exemptions apply. For example, the Indiana Department of Revenue denied a tax exemption for a company because it determined that a subsidiary of a primary logistics provider qualifies as a fulfillment company rather than an industrial processor.

On the other hand, Skims paid a USD 200,000 civil penalty in New Jersey to settle allegations that it violated the state's Consumer Fraud Act and improperly collected sales tax from New Jersey customers on clothing items that are exempt from sales tax. Skims was not part of a tax audit but rather under investigation. Nonetheless, this example shows what may prompt Tax Authorities to act.

Understanding the Sales Tax Audit Process

While there is no official rule on when tax audits occur, data suggests that businesses are generally audited within three to four years after their first tax filing. The process begins when Tax Authorities send an audit notification explaining the audit period, scope, and required documentation. Throughout the process, auditors examine the business's financial records in detail to verify that sales tax has been correctly collected, reported, and remitted.

Depending on the scope, time period, and amount of documents and data being audited, a tax audit may last from several days to several months, or even years in complex cases. Notably, the statute of limitations determines how far back state auditors can review a business's sales tax returns and transactions during an audit. However, it is important to note that the general statute of limitations typically does not apply in cases involving fraud, tax evasion, or gross negligence.

Auditors primarily focus on reviewing transactions to identify reporting errors, omissions, or potential fraud while ensuring compliance with state tax laws. One of the main methods auditors use is to compare sales tax returns with a company's accounting records. This enables auditors to identify discrepancies or reporting mistakes, verify that the correct amount of sales tax was charged and paid on taxable purchases, confirm that shipping and handling charges were taxed correctly where required, and review exemption and resale certificates to ensure exempt transactions are properly documented.

Once auditors complete the audit, they issue a Notice of Audit Results or similar document that outlines the tax audit's result. If businesses disagree with a finding or conclusion, they may notify auditors. Depending on the provided arguments, the auditor may reject them or request additional documents. If businesses are still not satisfied with the audit's outcome, they may appeal the auditors' decision.

Sales Tax Audit Preparation Steps

The most important thing to understand is that effective preparation begins before a business receives an audit notice. Businesses should regularly review their sales tax compliance processes and maintain organized records. To achieve this, businesses should follow several steps.

First, businesses should conduct internal sales tax reviews. More specifically, businesses should compare sales tax returns against accounting records to identify inconsistencies. Second, businesses should verify their sales tax registrations. This includes monitoring physical and economic nexus rules and thresholds. 

Another key step is to maintain complete and accurate records of sales invoices, customer exemption certificates, purchase invoices, tax returns, and payment confirmations. In addition to maintaining these records, businesses must retain sales tax records for several years. The retention periods vary by jurisdiction.

Given that tax rates and rules frequently change across more than 13,000 US sales tax jurisdictions, businesses should regularly monitor and update their tax calculation processes. Those using tax automation software should confirm that product tax codes, customer locations, and tax rules are accurately configured.

Final Thoughts

Businesses that confidently check every item on their sales tax audit preparation checklist are generally well positioned to withstand a sales tax audit. Those who regularly conduct internal reviews, accurately document transactions, make timely filings, and continuously monitor nexus obligations and changing state tax rules significantly reduce audit risk and improve the likelihood of a smooth audit process if one occurs.