Tax audit. Can anything strike fear into battle-hardened business owners and finance departments as these two words? It’s easy to see why. The potential for penalties. The mountain of records needed to be meticulously collected and reviewed. The pressure of knowing it can cost you if you get it wrong.
Businesses striving to mitigate the possibility of an Internal Revenue Service (IRS) audit commonly strongly emphasize adhering to tax laws and regulations. Nevertheless, steering clear of tax audits can prove to be a formidable task in the absence of well-established systems. To gain insight into the internal workings of such companies, it becomes imperative to delve into why evading tax audits can be daunting without the appropriate systems. Here are some of the factors contributing to this challenge:
Why is navigating sales tax regulations challenging for businesses?
Maneuvering through the intricacies of sales tax regulations is a challenging feat. Sales tax laws can be convoluted, with significant variations from one jurisdiction to another.
And that’s just the tip of the iceberg.
Different tax rates
To maintain compliance, a business taxpayer must navigate the diverse tax rates imposed by various states and local jurisdictions. These rates may fluctuate based on the specific product or service being offered, and even within a single state, different localities may enforce distinct tax rates. As a result, accurately calculating gross sales and collecting the appropriate sales tax amount is challenging for businesses.
Nexus complication
Adherence to nexus regulations is essential to prevent sales tax audit penalties and safeguard the long-term viability of the business. However, establishing whether a company has nexus (necessitating the collection and remittance of sales tax) can take time and effort. That’s because nexus criteria differ from state to state and can be triggered by other factors, including total sales volume or transaction count.
Local sales tax laws
In addition to state sales tax laws, local jurisdictions often have regulations, compounding the complexity of staying compliant. Local sales tax rates vary widely, and it’s up to every enterprise to collect and remit the proper sales tax amount for each locality.
Compliance costs and uncertainty
Staying compliant with sales tax regulations can be costly and time-consuming, especially if you sell online or have a presence in multiple states. The complexity of sales tax laws and their frequent changes is another reason companies can find themselves staring at a “Notice of Sales Tax Audit.”
Adapting your sales tax software to your unique tax requirements
Businesses must ensure their sales tax software or other tools are configured to account for nexus and apply tax rates and exemptions. This might involve setting up rules in the software to automatically apply tax rates and exemptions based on nexus or implementing a system to track and manage exemption certificates for different states. Failing to adapt sales tax software to a business’s unique tax requirements can be the recipe for an IRS audit.
Understanding the vulnerabilities that can trigger a sales tax audit
Tax authorities are particularly vigilant regarding potential irregularities in a company’s tax reporting and compliance. They closely scrutinize financial records, inconsistencies, and discrepancies, often looking for patterns that may suggest underreporting or evasion of sales tax obligations. Understanding and addressing these red flags proactively is crucial for businesses to maintain tax compliance and financial integrity.
So, what are the red flags in a company that can draw the attention of tax authorities? Here are some of the most common:
Reporting inconsistencies
Inconsistent reporting, such as discrepancies between sales tax returns, bank statements, and IRS reports, can trigger an audit. Other inconsistencies include inaccurate figures, mismatched data, or reporting irregularities across different periods.
Unusual tax payment fluctuations
A sudden spike or drop in tax payments, especially without a reasonable explanation, can raise suspicion and warrant further investigation by tax authorities. Erratic shifts, particularly when they lack a clear and justifiable cause, can often lead to heightened scrutiny, making it essential for businesses to maintain transparent and well-documented financial records to address any questions.
Unusual financials
If a business’s finances look very different from its competitors, it may raise concerns for tax authorities regarding potential anomalies or discrepancies in financial statements. This scrutiny can lead to a more comprehensive review by a state tax auditor, who will meticulously analyze the business’s financial records and tax returns to verify the accuracy and compliance of its financial reporting.
Past audits
Businesses that have been audited in the past are more likely to be audited again, especially if issues or discrepancies were uncovered.
Customers or vendor audits
When one of your customers or vendors is being audited, it can become a catalyst for your own audit. This could happen if your company’s name arises during their examination, especially in cases like a customer’s use tax audit where non-payment is discovered. This situation could lead tax authorities to take notice of your company, potentially prompting them to launch an audit for further investigation.
Failure to register in a state where your business is conducting sales
Neglecting to register your business in a state where it operates can be viewed as non-compliance and potentially lead tax authorities to launch an audit to verify proper registration and tax collection. It’s crucial for businesses to confirm their correct registration in every state with nexus and to collect and keep appropriate taxes and remit sales tax accordingly.
The step-by-step guide to a sales tax audit
How does a sales tax audit work? Understanding the operational procedures of state agencies that conduct these audits can make it easier to navigate most audits with precision and efficiency.
Step 1: Notification
The sales tax audit process typically commences with a state tax agency notification informing the business of its selection for a sales tax audit. It provides specific details, including the audit’s purpose, the scope of the audit period, the documents required, and the assigned auditor.
There is typically a statutory waiting period before the due date when the audit officially begins, during which the state cannot initiate the audit. Taking advantage of this grace period is advisable, as it allows time to organize your records.
Step 2: Pre-audit planning
Auditors often conduct a pre-audit diagnostic before the on-site visit, reviewing sales tax returns, bank statements, and records for compliance insight. Before the audit begins, businesses can perform this procedure proactively by comparing tax returns, analyzing tax payments on assets, and reviewing expense accounts.
Step 3: Audit period
This is the timeframe auditors will need to assess a business’s sales tax compliance. This period is essential for auditors and the company under review, as it sets the audit schedules and boundaries for the examination.
Step 4: Document requests
During the audit, auditors request various documents and electronic records from the business. These documents may include sales tax returns, general ledgers, charts of accounts, sales journals, sales summaries, sales invoices, sales records, purchase invoices, and exemption certificates. The auditor may also request additional documents, such as contracts, marketing materials, and shipping records. Providing accurate and timely access to these records is crucial.
Step 5: On-site visit
If necessary, the state auditors or audit manager will conduct an on-site visit to the business. During this visit, they may physically inspect records, inventory, and other relevant items. This step allows auditors to gather additional evidence and insights.
Step 6: Audit findings
Once auditors complete their examination, they compile their findings. This includes a detailed report of any discrepancies, errors, or areas of non-compliance identified during the audit. The business is typically provided with these findings for review. If differences or mistakes are found, they may issue an assessment for additional taxes, penalties, and interest.
Step 7: Resolution
After the final assessment and audit findings have been issued, businesses can work with the tax professional or the state tax agency to resolve any issues. This may involve adjustments to tax liabilities, paying any owed taxes, and implementing corrective measures to ensure future compliance. If the enterprise disagrees with the auditor’s findings, they can appeal the audit results themselves.
The Complyt sales tax audit checklist
Systematic methods of preparation are critical when it comes to sales tax audits. Being well-organized and having accurate records at your fingertips can significantly reduce stress and potential risks.
To help companies prepare for potential audits and streamline the process, we’ve created a checklist that covers essential areas businesses should focus on to prepare thoroughly.
Financial records
- Sales tax returns: Ensure all returns are accurately filed, complete, and up-to-date. Maintain copies of filed returns for each reporting period
- General Ledgers: Keep organized general ledger records, including charts of accounts, sales journals, and sales summaries
- Transaction documentation: Maintain detailed transaction records, including sales and purchase invoices, with complete documentation of sales tax collected or paid
Compliance documents
- Exemption certificates: Keep copies of exemption certificates for tax-exempt sales, ensuring they are valid and up-to-date
- Nexus documentation: Maintain records indicating your business’s nexus in each jurisdiction, including physical presence, economic nexus, or other relevant factors
- Tax policies: Document internal tax policies and procedures that outline how your business handles sales tax compliance
General documentation
- Business licenses: Ensure your business has the required permissions and permits to operate in each jurisdiction where you do business
- Organizational documents: Maintain administrative records, such as articles of incorporation, partnership agreements, or LLC operating agreements
- Employee records: Keep records related to employees, payroll, and relevant HR documents
- Communication records: Maintain communication records with tax authorities, including audit notices, correspondence, and responses
Organizational tips
- Data accessibility: Organize and centralize your financial and tax-related data to facilitate quick access during an audit
- Retention policy: Implement a record retention policy to ensure compliance with document retention requirements and reduce clutter
- Training records: Keep employee training related to sales tax compliance and record-keeping
Implementing robust financial systems: Your backbone of compliance
Robust financial systems are essential for compliance with various regulations, including sales tax, income tax, and securities law. These systems help businesses track their financial transactions, identify potential risks, keep capital assets, and meet compliance obligations.
Complyt can assist businesses in implementing best practice monitoring practices and reporting strategies to enhance financial compliance in the following ways.
Leverage fintech tools
Complyt integrates seamlessly with various fintech tools and financial systems. It can automate regulatory reporting by accurately calculating sales tax rates based on customer locations and transaction details. This integration ensures that mitigating non-compliance risks is an inherent part of an organization’s financial operations.
Create a specific data strategy
Complyt is built to gather, store, and analyze vital sales tax data, keeping tabs on transactions, tax rates, sales, and use tax compliance info. It also offers real-time tax rate updates and detailed sales tax breakdowns for each transaction, aiding businesses in shaping a targeted data strategy for financial compliance.
Automate compliance
Complyt reduces the likelihood of human error linked to manual compliance procedures and guarantees that businesses stay current with evolving tax regulations. It simplifies sales tax operations by automating calculations, sales tax return filings, and tax remittances to the appropriate authorities in just a few clicks.
Implement robust security measures
The platform employs stringent security controls, including encryption, access controls, and regular security updates. These measures focus on safeguarding your financial systems and data, protecting sensitive financial information, and ensuring compliance with data privacy regulations.
Never sweat a sales audit again with Complyt
Book a demo and find out how we can help you prepare your audit defense and stay on the right side of the IRS.
FAQ:
What is a sales tax audit?
A sales tax audit examines your tax return to verify that your income and deductions are accurate. It determines whether a business has adequately collected, reported, and paid the proper amount of sales tax owed to the state for taxable transactions.
How does a sales tax audit work?
The audit process is an intensive examination of a company’s financial and accounting records to ensure compliance with state and local sales tax regulations. The auditor’s objective is to verify that the appropriate sales tax amount has been collected, reported, and remitted to the government. Any discrepancies or errors uncovered during the audit can result in hefty fines, penalties, and even legal consequences, depending on the severity of the violations.
What businesses are most at risk of sales tax audit?
- High sales volume: Businesses with high sales volumes, especially those dealing with a significant number of cash transactions, may attract more attention from tax authorities
- Complex transactions: Companies involved in complex transactions, such as online sales across multiple states or international sales, can be at higher risk due to the complexity of sales tax rules and rates
- Frequent tax filings: Frequent errors or late filings of sales tax returns may raise red flags and increase the likelihood of an audit
- Industry type: Certain industries, such as restaurants, retailers, and construction, often face higher scrutiny because of the nature of their transactions and tax collection responsibilities
- Tip reporting: Businesses that rely on tips, such as restaurants and bars, must accurately report and remit sales tax on tips. Inaccurate tip reporting can lead to audits
- Exemption certificates: Companies that frequently deal with customers claiming tax exemptions (e.g., nonprofit organizations) must ensure they have proper documentation and processes to verify exemption status
Location: The state where a business operates can also impact its audit risk, as different states have varying sales tax rules and enforcement priorities
