Five Things to Do Before a Sales Tax Audit

Sales and use tax audits can be painful, especially for small and mid-sized businesses. For the unprepared, these audits shed light on areas of noncompliance and, more often than not, end with an assessment. Here are five proactive tips to ease the pain before you receive the dreaded audit notification:

1. Have a use tax accrual system in place. Remember that laptop you bought on the Internet? When the vendor does not charge sales tax, many businesses recognize that this creates use tax liability. Despite this knowledge, many businesses fail to establish a use tax accrual system that consistently self-assesses on untaxed purchases. Not only is the failure to remit use tax a huge red flag that could trigger an audit, it almost certainly ensures that untaxed items will be picked up by an auditor leading to assessments, including potential penalty and interest.
2. ​Understand what you are selling.Does your service agreement license software? Are you a contractor operating under lump sum and time and materials contracts? Did you just sell a warranty? Companies can know their product inside and out and still not understand the sales tax implications of what they are selling. This can lead to significant pain when a company has to pay sales tax on multiple years of sales during an audit. This sales tax could have been collected from your customer at the time of the sale, but efforts to collect it long after the fact are often futile.
3. Review your nexus exposure. Are you storing inventory in State A? What about that sales person making trips to State B? Did you drive a delivery truck into State C? Sales tax collection responsibilities are triggered by establishing nexus (i.e., a sufficient physical presence) in a state. When companies ignore their nexus exposure, they are taking a big gamble. If they get caught, the failure to file returns in a state could mean that there is no statute of limitations applied to a state’s review (that 3-year audit period just turned into a 10-year audit period). Companies can reduce their risk by constantly keeping an eye on their nexus creating activities, and considering voluntary disclosure agreements for states with significant exposure.
4. Collect properly completed exemption certificates at the time of the transaction.If you are selling a taxable product in a state where you have nexus, you need to either collect sales tax or obtain a properly completed exemption certificate. Sales tax audits often boil down to how good the documentation is, with exemption certificates often being the most important. Even if an auditor is kind enough to give you time to go back to customers to get a certificate, there is no guarantee that you will be able to track them down. Take a look at your exempt customers and make sure you have an exemption certificate on file. While you are at it, make sure that the certificate is signed and properly completed.
5. Apply exemptions correctly. Sales tax is a huge cost that is largely shouldered by businesses. Understanding exemptions for certain purchases (manufacturing, transportation, and R&D equipment are examples that are commonly exempted) can result in huge savings for companies. On the other hand, applying exemptions too broadly can result in significant exposure. Companies often fall into the trap of thinking exemptions are more generous than they actually are.