Top 10 sales and use tax audit triggers for 2021

August 19, 2021 3:31 PM

States disagree on many things, but one thing they agree on are the activities businesses engage in, or things they fail to do, in meeting their sales and use tax obligations that are most likely to lead to a sales and use tax audit.

I have interviewed many state revenue authorities across the country, as well as companies that have been through a sales and use tax audit over the past 12 months. These interviews and additional research surfaced a top 10 list of the most common sales and use audit triggers across most industries and states.

Being aware of these key triggers is important to companies and their tax advisors for three primary reasons:

It provides a clear understanding of what auditors will be looking for, thereby helping companies prepare for the audit.
It reduces the time a company will spend during the audit.
It will surface actions a company should take going forward to reduce or even eliminate future sales and use tax audits.

Here are the top 10 triggers for audits:

Prior sales and use tax audit liabilities

The most common sales and use tax audit trigger is significant liabilities that businesses have had in previous audits. The primary objective of auditors is to focus their time on companies that are most likely to have not accurately complied because such audits lead to identifying deficiencies that result in a significant “return on investment.” Most states keep track of taxpayers who have had significant deficiencies on audits. Several states make the list of these taxpayers publicly available. Typically, these are the largest states, which include California, Texas, Illinois, and New York.

Defining what is considered a “significant liability” varies by state. In Texas, it’s a liability of $25,000 or more in a prior sales and use tax audit, and in Illinois, it’s $15,000. Most states don’t make this information publicly available.

Pattern of late or irregular sales and use tax filings

Many states track the history and pattern of sales and use tax filings by companies. Auditors often focus on those businesses that have a history of late or irregular filings. In addition, large differences from month to month or year to year in revenues and/or purchases on which the use tax is based will catch an auditor’s attention. An occasional dip or increase normally will not. A purchase or sale of a large number of exempt goods or services will raise a red flag, particularly if it's not in line with other companies in the same industry. Finally, a pattern of filing amended returns will be flagged.

Amount of exempt sales compared to gross sales reported on sales and use tax returns

A high volume of exempt sales as compared to traditional sales in the ordinary course of a business is often a red flag for a state that’s indicative of inaccuracies in sales and use tax compliance, particularly if the ratio of exempt to taxable sales is not in line with other businesses in the same industry.

Industries that are frequent sales and use tax audit targets

Many industries are frequent targets of state sales and use tax audits because they are known to have issues with sales and use tax compliance. In the post-Wayfair economic environment, remote retail sellers (i.e., those businesses that sell goods into a state where they don’t have a physical presence) have become frequent audit targets. The same goes for cash businesses, such as convenience stores and restaurants.

Companies in industries that face especially complex sales and use tax rules, such as construction, are commonly targeted for audits, regardless of their size.

Type of business entity

Smaller businesses that are structured as sole proprietorships or partnerships are commonly targeted by state revenue authorities for sales and use tax audits. This is because states recognize that these businesses don’t have the necessary resources required to closely track sales and use tax rates, monitor rule changes, and collect and remit these taxes in an accurate and timely manner.

Changes in a state’s sales and use tax law

Changes in a state’s sales and use tax rates and rules, including changes in exempt transactions, and new or revised interpretations from the Department of Revenue, often result in more errors in sales and use tax filings. This is particularly the case with remote businesses that may be unaware of the changes.

In 2021, three additional states that were holdouts as far as adopting the economic nexus standard for sales and use tax purposes finally enacted “Wayfair-like” economic nexus laws. These new Florida, Missouri and Kansas economic nexus sales and use tax rules are expected to result in more remote sellers being tagged for audit.

Regularly scheduled audits for a state’s largest taxpayers

Larger businesses may be audited regularly. Often, Fortune 500 companies are under continuous audits in the states where they operate. This practice is in place because states want to ensure taxpayers making the most significant volume of sales or purchases within their state are complying with current sales and use tax laws.

Whistleblowers or referrals from third parties

Disgruntled employees, shareholders, customers and even suppliers or vendors sometimes alert the state to potential sales and use tax compliance errors or noncompliance. Whistleblower information has not been a key sales and use tax audit trigger in the past. However, the increasing importance of e-commerce and remote selling in the post-Wayfair and pandemic era has increased the use of this trigger to initiate an audit as states look to increase their tax collections from potentially non-complying taxpayers.

Next steps

Sales and use tax audits have become more of a fact of life for businesses across most industries. Predicting what makes a company more vulnerable to a sales and use tax audit is a valuable exercise that can save businesses time and money. Knowing what may trigger an audit will help businesses prepare for the inevitable.

A business shouldn’t wait until an audit notice arrives at its doorstep. It is important to begin thinking about what changes to sales and tax compliance functions can be implemented across the company’s internal systems to help avoid or reduce the financial impact of a sales and use tax audit.

Many businesses have turned to software to automate the increasingly complex sales and use tax compliance process. Others have outsourced the compliance function in whole or in part to third parties that specialize in sales and use tax compliance and planning in order to reduce the substantial risk of failure to accurately comply. By taking these steps, business owners, executives, and employees can focus on what they do best — running and growing their businesses.