Why might your business get audited? 

People often hear “tax audit” and negatively associate it with tax fraud or error. This is far from the case.

Statistically, only about 1% of all tax returns filed get audited due to limited resources at state and local tax authorities. Therefore, most tax authorities rely on their internal systems to automatically flag taxpayer accounts that have a higher likelihood of finding issues upon audit. 

The factors increasing risk to be flagged for audit include (but are not limited) to the following:

• The business sales exceed a material threshold, classifying them a “large” taxpayer.
• The tax reported significantly increases or decreases period-over-period.
• The business has inconsistent reporting (i.e. first reporting as a remote seller, then reporting as an in-state retailer, then remote seller again).
• The business establishes a pattern of late filings and/or outstanding tax liability.
• The statute of limitation (a.k.a. the time period that a tax authority is allowed to initiate an audit) is about to expire.

Additionally, high-profile businesses with complex pricing models, customers across multiple states, and bundled software and services offerings may have a higher likelihood of undergoing a sales tax audit. 

Companies that fail to comply with a sales tax audit can be subject to notable penalties. Non-compliance costs the average SaaS business 4.3% of revenue, and can lead to increased future audits, public disclosure of tax status, and even license revocation. By being aware of what to expect in a sales tax audit, however, businesses can ensure they’re prepared to navigate an audit successfully should they have to. 

5 Best practices for managing an active sales tax audit

The longer your business operates, the greater the likelihood of undergoing a sales tax audit. If you receive notice that your business is going to be audited, here are six best practices for successfully navigating the audit process. 

1. Respond promptly

Once receiving communication from the tax authorities that you’re being audited, it’s beneficial to document the receipt of the audit notice, as this record may be helpful later. Next, assemble your audit team to review the audit scope, identify potential risk areas, and engage external tax professionals. 

If you haven't already, designate a single point of contact on your audit team to engage your auditors and drive the process forward. 

2. Review the scope of the audit

Whether by design or by accident, state and local tax authorities often request more information than they need and/or have the authority to review under the scope of the audit. Provide auditors with the exact information they ask for, not more or less. Sharing unrequested information with auditors may make it more difficult for them to complete their review or could expand the scope of the audit. 

Some common examples below:

• Legal entity subject to audit - Sales tax liability and reporting is required on a legal-entity by legal-entity basis. As such, the audit letter is typically issued to a specific legal entity (i.e. SaaS Business Galore, LLC). A sister legal entity (i.e. Book Sales Galore, LLC) does not automatically become part of the audit simply because both legal entities report up to a common parent corporation. The auditor may expand the scope of the audit to include other legal entities, but this is typically a subsequent request that must be explicitly made. You do not have to volunteer financial information from other legal entities.
• Years subject to audit - Tax authorities often apply the business formation date as the date you started doing business in the taxing jurisdiction. As a result, tax periods for which you had not started making taxable sales may be erroneously included in the period under audit. You may also find tax periods included which already had statute of limitations expire or periods already closed due to being included in a prior audit. Maintaining good records and cliff notes (for prior audits) will be a big help here.
• Multistate sales information - State and local tax authorities often ask for all business sales broken out by state and local jurisdiction. The natural tendency is to provide a schedule detailing all sales within and without the tax jurisdiction conducting the audit.  However, you are not required to specify which other state and local taxing jurisdictions your sales are attributable to, or outline what other jurisdictions you file and pay tax. This information is outside of the auditor’s scope, so providing a schedule of “total sales outside the state” and “total sales within state” is more than okay.

3. Know your rights; seek external expertise if needed

The audit letter you receive should reference where you can read up on your taxpayer rights. Almost every tax authority posts taxpayer rights and audit procedures (i.e. New York) for your detailed review and consideration. Stay informed. If the scope of the audit seems daunting, seek the help of a tax advisor for audit defense.

4. Consider conducting a self-audit

You know your business better than anyone, including when business began, where it began, and how it began (i.e. purely online vs. hiring employees in state). Review your prior sales tax filings (and supporting data/workpapers) to ensure there are no clear gaps. If there are gaps, reach out to internal teams to get answers so you’re prepared in the event the auditor asks about them. Staying organized (and saving documentation from legacy systems) is particularly helpful here.

5. Review preliminary findings thoroughly

Once you’ve received the auditor's preliminary findings, take the time to review them thoroughly with your audit team before responding. If you decide to dispute any findings, provide supporting documentation and calculations with your response. 

These five best practices can help your team manage the process effectively and minimize potential financial impact. Implementing robust sales tax compliance processes today will be key to successfully manage any future audits and protect your growing business from unnecessary tax risks and penalties.