Auditors typically direct their attention to organizations most prone to tax mistakes — whether opportunities for error lie within an industry or a tax category. Businesses that must collect and remit sales and use tax are among those that tend to attract a lot of auditor scrutiny.
For some states, sales tax makes up more than 40% of their collected tax revenue, so it’s no surprise auditors keep a close eye on companies in the retail sector.
Let’s look at how controllers can help keep their organizations steer clear of an auditor’s detection and remain in full sales tax compliance should one come calling.
A guide to navigating sales tax audits
Audit by association
Even if an organization has escaped auditor attention in the past, an auditor may check in if one of the company’s suppliers gets audited. The opposite can also be true: A supplier runs the risk of audit if one of its sellers is audited. It’s reminiscent of guilt by association. Any company runs a higher risk of an audit if one of its supply chain links incurs one. Organizations should be looking over their proverbial shoulder at their business connections’ compliance and audit history and take precautions to reduce risks.
Some more than others
As mentioned earlier, certain industries are more likely to draw an auditor’s attention. Some industries bear inherent regulatory or operational complexities that challenge compliance for even the most thorough of controllers. Retail, manufacturing, construction, and wholesale/distribution sit at the top four spots for most audits with triggers such as:
- Failure to remit sales tax in states where nexus or economic nexus has been established
- Failure to remit use tax
- Undocumented exempt sales or related errors
- Product taxability errors
However, it’s not always about the industry. A joint study revealed that auditors scrutinize businesses that:
- Have an audit history, particularly one with negative findings
- Demonstrate a high sales volume
- Report numerous exempt sales, particularly a high ratio to total sales
Economic nexus complexity
The opened dam on economic nexus has created myriad tax complications for many companies. Before the South Dakota v. Wayfair, Inc. ruling, tax authorities across the nation generally collected sales and use tax only from businesses that maintained a physical presence in their respective jurisdiction. A connection, which was typically physical in nature, between a merchant and a tax jurisdiction that establishes a tax obligation is “nexus.” After the ruling, it didn’t take long for states to enforce economic nexus and tax remote sellers based on sales — economic activity — for additional revenue.
States vary on their economic nexus parameters, but in general, remote sellers that surpass a designated revenue threshold in a given location must collect and remit sales and use tax. There is no longer a physical presence requirement to establish nexus. Considering that 45 states, the District of Columbia, and even some Alaskan local governments currently impose some form economic nexus, an ecommerce vendor could have to juggle at least 45 unique sales tax criteria.
Companies that sell remotely should keep a close, steady watch on locations where they sell and the constantly changing tax requirements for each.
Still in the economic nexus vein, we have unregistered remote sellers that auditors seek out. A merchant is required to register with a state when nexus is established. At the onset of new economic nexus laws, many tax authorities granted vendors time to adapt and were forgiving to various degrees. But no longer. States now expect companies to know and comply with their economic nexus directives and hold unregistered merchants fully accountable.
Even one missed location can put a seller on an auditor’s radar.
Additionally, remote vendors can establish physical presence when they hold inventory in another state. Although marketplace facilitators are now responsible for collecting and remitting tax on third-party sales in all states with a sales tax (except Missouri, whose marketplace facilitator law takes effect in 2023), marketplace inventory can give an individual seller physical nexus and a requirement to register. California and Washington have taken a particularly aggressive stance on this.
Getting even more intricate, some states still enforce click-through and cookie nexus laws instituted prior to economic nexus. An out-of-state merchant can establish click-through nexus when an in-state business collects a commission (usually above a certain threshold) for referring sales to the out-of-state seller, such as through a website link. Cookie nexus occurs when a company’s sales or transactions surpass a designated threshold if the seller used cookies on users’ electronic devices in that state.
Some states have repealed cookie and click-through nexus in the wake of the Wayfair decision. However, businesses can still be held liable for back taxes under those laws. In announcing the repeal of cookie nexus, for example, the Massachusetts Department of Revenue said it no longer applies “as of October 1, 2019” — not that it wouldn’t enforce cookie nexus for sales occurring between October 1, 2017, and September 30, 2019.
Most organizations understand the basics of sales tax: A tax paid at the time of purchase for a product or service. But use tax can cause some confusion or complacency.Occasionally, businesses fail to report use tax either because they don’t fully understand it or they believe it’s not as mandatory as sales tax. But it is. Vendors can owe use tax in any state that imposes sales tax.
Organizations must pay use tax when sales tax is not paid in full on a product or service or if a product is used for resale.
Companies commonly owe use tax on:
- Promotional giveaways
- Inventory transfers or withdrawals
- Charitable donations
Of course, many other situations may warrant use tax, but the above are the three most common.
Common errors auditors catch most
Reasons for errors are endless, but some mistakes are more frequent than others, and many seem to stem from exemption certificates and consumer use tax issues. A report from California’s audit program points to three top mistakes auditors find most often:
- No documentation for exempt sales
- Unreported sales (on sales and use tax return)
- Assessments made for tangible personal property sales from out-of-state vendors that did not collect use tax
Sales and use tax can present a complicated labyrinth in which a business can easily lose its way, and mistakenly land itself in noncompliance. There are no absolutes or one-size-fits-all tax equations. Regular research and awareness of tax laws in every service location is critical to fending off audits and eliciting a positive outcome should an audit occur.
To gain some insider tips on sales tax audits, listen to confessions of former auditors.
Angie Longacre is a content writer at Avalara. She helps decipher tax complexities for business professionals across all industries.