How States Make Money On Sales Tax Audits

Why sales tax audits are increasing

Recently – and especially after the 2018 Supreme Court decision in Wayfair) – states have become more serious about sales tax audits.

State retail sales taxes yielded an average of $444.5 billion in revenue in recent years, and states don’t want to miss any of that. Time and expense of audits aren’t free, of course, but states are recognizing the revenue potential, too: For a relatively few dollars a state can recognize thousands in tax income retrieved.

Yes, audits do often result in businesses owing significant amounts in unpaid taxes, interest and penalties. For small to midsize businesses, the total cost of dealing with an audit can exceed than $100,000.

Why vendors are being audited more often

It’s getting harder for vendors to avoid audits – an attention from tax authorities that sometimes isn’t even warranted. States are intensifying audit efforts with more sophisticated data analysis and by collaborating with other states. Auditors target industries they’ve learned have higher audit activity that sell taxable products across multiple jurisdictions, such as merchandisers, manufacturers and sellers of digital products and software.

What causes a sales tax audit?

How states decide who gets audited

States and municipalities have their own systems for deciding which returns trigger an audit. Many states use sales volume, size and complexity of returns to determine whether an audit will take place. Other activities of yours, such as filing a refund claim or amended return, bankruptcy, dissolving the business and closing certain locations may cause an audit as well.

Common paths that lead to an audit

Among other paths to an audit:

• If one of your clients is audited and the state finds that you didn’t charge the client sales tax on a transaction (or worse, a series of transactions), you may end up getting audited.

• If you’re amending a return or seeking a refund from a prior period.

• Auditors know that businesses in the same industry tend to have similar business practices and models. They also know that some industries are more susceptible than others to tax deficiencies.

• A particularly bad firing might result in an employee blowing the whistle to state and federal agencies, including state tax agencies. Generally, that employee is going to need credible evidence to ignite an audit.

What do states make?

Audit volume and revenue by state

It’s difficult to find) the exact annual number of sales tax audits conducted. But some figures by New York, Wisconsin and California give an idea.

Overall, New York conducted a substantial number of audits across various tax types. In the first nine months of 2021, the NY Department of Taxation and Finance (DTF) issued nearly 150,000 audit notices. The number of audits climbed to more than 750,000 for tax years 2022-2023. In the first nine months of 2021 (sales tax audit record keeping tends to move slowly in states), the NYDTF issued nearly 150,000 audit notices. The number of audits climbed to more than 750,000 for tax years 2022-2023.

Wisconsin, one of the freer states with its audit information, reports that in 2023-24 The Wisconsin Department of Revenue’s Audit Bureau issued audit assessments of $474.3 million and had $263.2 million in audit collections. An audit assessment is considered unpaid by the Wisconsin taxpayer after 72 days, after which the assessment is transferred to the Compliance Bureau as a delinquent tax bill. In 2023-24, the DOR’s Compliance Bureau collected delinquent tax revenues of $336.3 million.

Balance that take against the Audit Bureau and Compliance Bureau having had average front-line staffing levels of 356 auditor positions and 160 delinquent tax collection agent positions, respectively, in 2023-24 for an idea of the profit to the state.

California’s audit enforcement and penalties

California has historically audited about 1% of active accounts each year; in FY2019-20, the state’s sales and use tax audit program found $576 million in tax deficiencies. One of the biggest areas for non-compliance is California: out-of-state vendor purchases and assessments for purchases of tangible personal property from out-of-state vendors not collecting state use tax.

California can slap on a 10% negligence or intentional disregard. An additional 10% penalty is added to the deficiency determination and fraud adds a 25% penalty to any deficiency caused by fraud or intent to evade back-due sales, existing penalties and interest. And, as in most states, the expensive transgression is collecting sales tax from customers and knowingly not remitting it.

Tech, questionnaires and trickery

How states identify audit targets

No mistake, successful auditing does take work. For instance, tax authorities use data and systematic methods to compare a business’s sales data to industry averages, cross-referencing state and federal tax filings and data from marketplace facilitators to compare against a seller’s reported sales.

Many states use sales tax nexus questionnaires – detailed questions to determine a company’s taxable activities and fish for audit targets. Examples of questions pertaining to economic nexus: How are sales made into the state? Did your company or affiliate actively solicit sales into the state? What are your gross receipts from sales of tangible property during the last five years? How are deliveries made into the state?

States may also test your compliance by going to your website and submitting the phony order and then seeing you charge sales tax.

Preparing for an audit

Steps businesses should take before an audit

There are concrete steps that a business should take to make sure that they have the proper documentation for an audit.

1. Maintain a thorough audit trail for all taxes charged, reported on a return, and paid to a jurisdiction – including any items that are returned resulting in some type of sales tax credit. It’s common for an auditor to request sales tax returns, federal income tax returns, GL detail, fixed asset schedules, sales journals and purchase journals.

2. Select one staffer as point of contact with the auditor. Make sure all other staffers know they’re not to share any company information with the auditor.

3. If you receive a state nexus questionnaire, handle it with care. Questions on a questionnaire can seem quite broad, for example, and the simple “yes” answer can open your company up to further examination.

4. Be ready with someone to advocate for you. Having TaxConnex act as the intermediary between you and the auditor, for instance, provides several benefits: we’ll conduct a pre-audit review of your systems and processes to identify any gaps or risk factors; we’ll control what information gets shared with the auditor; and we’ll advise you where to push back on the auditor – and where to compromise.

Get help with sales and use tax audits

If you want help with a current audit or have questions about sales and use tax audits in general, get in touch!