How to Survive (and Thrive In) a State Sales and Use Tax Audit (2024)

As the critical Wayfair decision from 2018 continues to unfold in terms of its implications, sales and use tax audits have skyrocketed as states look to recapture critical revenues. If your business is selected for a sales and use tax audit, understanding the process will help you minimize any potential pain. There also may even be opportunities to recoup overpayments.

How Do State Auditors Select a Business for a Sales and Use Tax Audit?

States have the right to audit taxes they administer. While it may seem like a personal reflection on your business practices or integrity, that’s not always the case. A state could be focused on a certain industry in which they are seeing significant liability on audits, or you just got “lucky” being selected. Or perhaps one of your customers or vendors was audited, and your selection is a result of the trickle-down or “audit referral” system, which generates more revenue for the state.

Then again, there are missteps that could flag an audit. You may have filed your sales tax return incorrectly, or reported high amounts of tax exempt sales in relation to total sales, in which case an auditor may want to see your exemption certificates on file. If you are unregistered with a state and they find out, you can likely expect an audit.

How Will I Be Notified of an Upcoming Sales and Use Tax Audit?

You will receive a letter in the mail or a phone call notifying you of the audit. Even when receiving a paper letter, it’s important to make sure it is legitimate. The letter should outline the following items:

Can I Request to Change the Start Date of My State Sales and Use Tax Audit?

The start date of your audit will be stated in your notification letter. If this date does not work, you can in fact negotiate the start date. However, you don’t want to extend it too long. Interest will continue to accrue until the audit is completed and the liability is paid. Also, if you try to push an audit out too far into the future, the auditor may suggest to extend the audit period they are reviewing.

If you do negotiate a later start date, the state will want you to sign a waiver to keep the older periods in the audit open. Waivers could actually benefit you in some cases, so playing hardball with the auditor on this point may not always be a good practice. Plus, being flexible and maintaining a good relationship with the auditor is never a bad move.

How Do I Prepare for a State Sales and Use Tax Audit?

The best preparation for a state sales and use tax audit is to start early! File your returns accurately and comprehensively in the three to four years leading up to the audit. Since, of course, you never know when an audit could occur, filing appropriately throughout the course of your business is the best approach.

Other long-term ways to prepare include:

Keep up with tax law changes as they occur. It’s important to ensure you are not paying the wrong amount because the law has changed and you weren’t aware.
Build relationships with other internal departments at your company. The more you know what your IT, supply chain, accounts payable and other key departments are doing, the more you will understand whether or not they are complying from a tax perspective. If they aren’t, you can assist them in fixing the issue — rather than finding out about it during the audit.

Once notified but prior to commencing the audit:

Be sure information can be readily pulled for the entire audit period.
Pull all documents the auditor requested.
Review documents before giving them to the auditor. This step is very important. These will be the core documents from which the auditor will sample and evaluate your business. They must be accurate. Also, providing clean documents will enhance your credibility with the auditor.

What Should I Expect When Our State Sales and Use Tax Audit Begins?

Your auditor will request the following for the audit period in question:

Copies of sales tax and/or use tax returns
Support workpapers for those returns to perform the reconciliation
Detailed general ledger and trial balance, from which they will draw samples
Invoices, specifically to check the tax being paid

If you are a manufacturer, the auditor will likely also want a tour of your plant. Best practice is to have your plant manager give you the tour before the auditor comes on board. They can run you through the entire plant so you can confirm what is being purchased, how it’s being used, etc. It will also give you a full understanding of the operations and what is truly taxable or non-taxable in the plant. Then you will be prepared to have the tour with the auditor and answer questions confidently.

Audit Sampling

Sampling is a core element to understanding the audit. Sampling is the process through which your auditor will draw a conclusion about all of your sales and use tax activities, based on a relatively small slice or view of them. So it’s important that sample is representative of your entire business.

The auditor will likely sample certain transactions in one of two ways:

Block average sample. This type of sample is commonly used, in which the auditor will pick certain months of activity to review within the audit period. They can pick two months within each year or six months within the last year of the audit period. However, you need to be careful as to which months they are reviewing, especially if your business is seasonal, in which you have “high” and “low” months of activity.
Statistical sample. This is when the auditor chooses a sample within the entire audit period. They stratify it by dollar range and choose a certain number of invoices per strata. Then they review in detail all capital or fixed assets from the sample.

Note that you will be asked to sign a sample agreement, which says you agree with, and cannot appeal, the type of sample the auditor plans on using. So be sure both parties are in agreement prior to signing. Regardless of the method used, confirm with the auditor which accounts will be included in the sample, and be sure you agree it is representative of your business activity.

Keys for a Successful Sales and Use Tax Audit

Know your business, particularly the ins and outs of any acquisitions/disposals/mergers within the audit period.
Gain credibility with the auditor from the beginning.
Meet/communicate with your auditor regularly.
Do not ignore auditor requests or deadlines.
Review prior audits, before the new audit begins, to have an idea of previous weaknesses/areas where the auditor may look first.
Provide the auditor with items according to the audit timeline to ensure the audit is completed efficiently. Don’t let it drag.
Provide all, and only, the information requested by the auditor.
Always review schedules of taxable items provided by the auditor to ensure you agree and to minimize liability.
Always reconcile information before sending to the auditor.
Know which exemptions pertain to you in your industry to assist in negotiating liability reductions.
Document key elements of the current audit so you can fix the issues going forward.
The process of going through an audit is also a great time to catch any mistakes that may work in your favor, so review for overpayments to offset liability. While the auditor is looking at taxability, you and your tax advisers can determine if you overpaid and deserve a refund.
You can appeal the audit outcome if you do not agree with the auditor’s assessment. Specialized tax professionals can provide audit defense representation.

Commonly Missed Overpayments

As alluded to above, it’s possible to not only mistakenly pay too little tax, but you can also mistakenly pay too much tax — for which you are legally entitled a refund. Below offers an initial list of potential refund review areas for which your business may qualify:

Call Centers. There is a commonly missed sales tax exemption for the purchase of telecommunication services to function as a call center, often used in marketing, sales, customer service, tech support, etc.
Direct Marketing (Warehousing). If you’re a distributor and you’ve bought inventory to sell, you could qualify for exemptions in the warehouse. Anything that touches or impacts your inventory could be exempt: forklifts, software, forklift repair, etc.
Manufacturing. From the beginning of your manufacturing process to the end, items/areas such as equipment, repairs to exempt equip, etc. could have available exemptions.
Multiple Points of Use. This applies to software and hits home with many businesses. Some states, such as Ohio, tax software, but many don’t. So, for example, if your corporate headquarters is in Ohio and you have multiple locations and employees throughout various states, you could be paying Ohio tax rates on software for users in states where there is no such tax obligation.
Pollution Control. This is a frequently missed exemption for manufacturers, especially on sales and use tax audits. Pollution control equipment needs to be certified to qualify for the exemption, but it often can be certified retroactively. In Ohio for example, you can go back four years and file an application with the Ohio Department of Taxation to have the Ohio EPA review the equipment to have it certified for either water, air or noise pollution control.
Utilities. Particularly if you are in manufacturing, there are key utility exemptions to consider. For example, if your equipment is powered by gas, that gas may not be taxable. A utility study may be helpful in determining how much gas, or another utility, is used in your manufacturing process to see if you qualify for any exemptions.

From how you are selected and notified, to preparing and working through a sales and use tax audit, understanding the process and leaning on your tax advisers for assistance can make an audit less painful and may even uncover new opportunities. As the state and local tax landscape continues to evolve, related audits will continue to be a staple in the state toolbox for continued revenue generation.

Contact Nick Longo or a member of your service team to discuss this topic further.

Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circ*mstances and current law with your professional advisers.