What is a sales tax audit?

A sales tax audit is an examination of a company's financial records and taxability determinations by tax authorities to ensure that the information filed on their sales tax return is reported in full and in accordance with applicable tax law. 

There are several different types of tax audits that SaaS businesses may be subject to:

• Desk audit vs. Field audit: Audits can be carried out remotely, in a desk audit, or in-person at your place of business, in a field audit.
• Targeted review vs. Comprehensive audit: Audits can be focused on specific tax issues (i.e. Personal Property Lease Transaction Tax) or time periods, referred to as a targeted review; or can be focused on your broader tax footprint (i.e. State Income Tax, Franchise Tax, Gross Receipts Tax, Sales and Use Tax, Property Tax), referred to as a comprehensive audit.

The audit process: What to expect

The sales tax audit process will typically begin by a tax authority sending an official letter to the business under review via email or through the tax authorities filing portal. This letter will detail the auditor contact information, next steps for scheduling an initial meeting, and the period under scope for the audit.

Sales tax audits can vary in length for SaaS businesses. Desk audits can be completed in as little as 3-6 months, while field audits can take up to a year and comprehensive audits up to 18 months. SaaS businesses can support an efficient audit process by cooperating with the auditing authorities and providing requested documentation in a timely manner. 

While traditional enterprise software businesses may have relatively low transaction volume, PLG-focused SaaS teams often process many transactions during a given period. When conducting an audit, authorities may choose to review all transactions during a specific time period, review a random selection of transactions, or review samples of different sizes–a process referred to as stratified sampling. 

Once auditors have completed their examination, they will deliver their preliminary assessment in an official letter, detailing proposed tax adjustments as well as supporting methodology. The business under audit will be given a specified time period, usually 30-60 days, to review the preliminary assessment and respond. Upon the business’s response, the auditors will deliver their final assessment, which includes a formal notice of the amount of tax due as well as payment deadlines per state. While the preliminary assessment findings are negotiable, the final assessment is a legally binding result. 

SaaS businesses have several appeal rights after receiving their final audit assessment. They can file an administrative appeal with the tax agency conducting the audit, or a judicial appeal with state tax courts under which they’ve been reviewed. The appeal process can not only be lengthy and expensive, but can also impact brand reputation and employee morale, so it’s important for SaaS businesses to weigh the benefits of an appeal before proceeding. 

Common areas of scrutiny for SaaS companies

There are several aspects of SaaS companies’ financial operations that are often scrutinized by sales tax authorities. 

Product classification under different state tax laws

Different states tax software transactions in different ways, resulting in varying taxation across a SaaS business’s customer base. Texas, for example, classifies SaaS as taxable data processing, and therefore taxes only 80% of the charge. New York, on the other hand, considers SaaS a taxable remotely accessed software and taxes 100% of the charge. Auditors will often examine whether SaaS businesses have correctly classified their products and collected and paid the correct amount of tax. 

Product bundling

Many SaaS businesses, particularly those selling enterprise solutions, bundle product licensing and professional services into a single offering. Although this combination sets new customers up for success, it creates a lot of complexity for finance teams. Many states tax software and service products in different ways, requiring SaaS businesses to deconstruct a purchase and pay the correct amount of tax on each category. Tax authorities will often examine whether SaaS businesses have paid software and services tax correctly depending on state laws. 

Nexus

Nexus is a connection between a business and state sufficient to trigger tax collection obligations. A business can establish a nexus in a state through physical presence, such as by having employees or offices in the state, or by economic activity, either by exceeding a threshold amount (typically between $100K - $500K) or making a specified number of sales in the state within a given time period (typically 12 months). As nexus rules vary from state to state, auditors may review business records to ensure that the business was registered to begin collection and remittance in accordance with state law.

Tax exemption certificate management

Certain businesses, such as software resellers, government agencies, and nonprofits, may transact with a SaaS business without paying sales tax. In such cases, the seller (SaaS business) must collect and store tax exemption certificates. Tax exemption certificate expiration varies by state—most are valid for 3-4 years, while some states like Florida require annual renewal. For these reasons, auditors will often review tax exemption certificates on record to ensure all tax exemptions are documented and valid. If SaaS businesses do not have certificates on record for any transactions, they are liable for the uncollected tax. 

Some states allow larger businesses to self assess their tax liability and pay use tax on their purchases in lieu of paying sales tax to their vendors. If one of your customers has such an arrangement with the state, it is considered best practice to retain a copy of their permit. In some states, you can verify the validity of such a permit on the state website.

Without the proper processes and systems in place, managing tax operations for a growing SaaS business can become very complex. Let’s walk through three steps you can take to tighten your tax operations and prepare your processes should you have to undergo a sales tax audit. 

How to prepare for a sales tax audit

Like many things in SaaS, successfully preparing for a tax audit requires a combination of establishing the right processes and organizing the right personnel.

Practice like it’s game day

SaaS businesses benefit by establishing reliable tax processes systematically, treating audit preparation as an ongoing process rather than a reactive measure. Specifically, ensure that you’re tracking tax nexus thresholds across states, maintaining detailed transaction logs, and including digital copies of all invoices. Be sure to document your tax determination logic, as well as user access logs and connectivity of tax systems. It’s best practice to work with a tax advisor to ensure that your products are correctly categorized so that they’re properly taxed.

Complete sales tax account reconciliations on at least a quarterly basis to ensure you’re collecting and remitting tax on all revenue streams in all applicable jurisdictions. While laborious and tedious, these reconciliations are often key for spotting irregularities in tax collection and/or remittance. It’s best practice for SaaS businesses to organize these materials as if an audit could occur at any time. 

Simplify your tax processes with modern tooling

Tax exposure can become significantly more complex as SaaS businesses grow. Even early stage startups benefit tremendously from leveraging modern tooling to optimize their tax processes. Sales tax compliance software makes it easier for teams to track tax rate updates across jurisdictions, product taxability, nexus tracking, and more. Record keeping systems organize important files such as digital invoices, exemption certificates, and transaction records. Furthermore, compliance monitoring solutions provide reporting on tax obligations, filing deadlines, nexus threshold tracking, and compliance risk so that Finance and Accounting teams can manage their compliance from a single dashboard. 

Create an audit response team

As your tax exposure grows, it’s beneficial to establish an audit response team that’s prepared for a potential audit. Internally, this might include stakeholders from Finance leadership, accounting, IT, RevOps, and Product Management. Externally, begin building relationships with tax attorneys, sales tax consultants, and tax software providers in case you do need their support for a sales tax audit. Finally, it’s best practice to identify a response team lead to own communications between stakeholders. 

While audits may be inevitable as your business grows, proper preparation significantly reduces financial risk and operational disruption. Taking these steps today will not only protect your company from costly penalties but also provide peace of mind as you focus on scaling your core business.