5 High-Risk Industries Targeted by State Sales Tax Compliance Auditors
All state tax agencies have the ability to enforce compliance by auditing businesses conducting taxable sales activity. The decision in Wayfair vs. South Dakota, Inc. provides the states with expanded jurisdiction over those businesses. As a result, businesses and practitioners alike should anticipate sales and use tax audits to increase due to the new economic nexus laws implemented post-Wayfair.
Understandably, getting an audit notice from a state tax authority can be a frightening experience. Businesses should take proactive measures to understand their risk and avoid the possibility of a state sales tax audit. This article discusses the industries most at risk of a state sales tax audit and how businesses can be prepared.Jump To:
- What Is a State Sales Tax Audit?
- What Happens During a State Sales Tax Audit?
- How an Agency Determines Whether to Audit a Business
- 5 Industries Most Likely to Be Targeted by State Tax Auditors
- How a Business Can Avoid State Audits
What Is a State Sales Tax Audit?
A sales tax audit is a state’s evaluation of a business’s financial records to ensure voluntary compliance with sales tax requirements. During a state sales tax audit, the state looks for possible oversights, mistakes, and fraudulent activities.
State agencies generally trigger an audit when they suspect a business is not properly reporting its sales taxable activity. At some point, a state may also want to audit the good faith estimate of taxable transactions prepared as a part of a Voluntary Disclosure Agreement (VDA) or a regularly filed sales and use tax return.
What Happens During a State Sales Tax Audit?
During a state sale tax audit, the business must provide sales and financial records, in addition to any other evidence the auditor asks for. This can include purchase orders, receipts for cash transactions, proof of your annual profits, and more.
Audits can be costly for any business, not only if additional tax is owed, but also in time and resources diverted to the exercise. Businesses that don’t have a good recordkeeping system may have a difficult time simply locating and compiling all this information. And, the direct cost of penalty fees, interest, and unpaid tax can quickly add up.
As a result, businesses should always be proactive in their sales tax compliance and do everything in their power to minimize the risk of an audit.
How an Agency Determines Whether to Audit a Business
Agencies prioritize whether to audit a business using a variety of direct and indirect triggers, any of which would suggest that a business is not meeting its tax obligations. The three top areas an agency examines are:
- Disallowed sales for resale.
A resale business purchases goods and then resells the same goods, for example, a business that sells tires to tire shops. A business that sells goods that will be resold is tax-exempt because the tax will be collected from the purchaser upon resale, provided its customers have a resale certificate. A resale certificate is a signed document that indicates that the purchaser intends to resell the goods and therefore exempt from tax.
The business is responsible for collecting resale certificates on exempt items and keeping them on file. When considering to conduct an audit, state agencies analyze the business’s taxable and exempt sales ratio from its tax return. Then, the state compares the business’s data to decades of industry averages and evaluates whether the business could be non-compliant.
During the course of a sales tax audit, the state will generally also inspect the business’s records to ensure that it properly maintained resale certificates.
- Unreported sales.
If the business hasn’t registered for sales tax state where it has nexus, a state tax authority can still figure out that the business should be paying tax.
- Compare directories of high-volume businesses to state registration databases to verify if each company’s website or phone number is in the state’s tax system. While these directories aren’t publicly available, government agencies gain access through reporting by marketplace facilitators such as Amazon.
- Look at businesses registered to pay payroll tax or other taxes to a state and compare them to companies in their sales tax database. As a reminder, physical presence nexus requires collecting tax for businesses that are selling taxable products. The state can compare NAICS codes to determine if the business is likely required to collect sales tax.
- Cross-reference state business registration records with import and customs records to spot businesses dodging state sales tax obligations.
- Cross-reference tax payments from marketplace facilitators (such as Amazon) on behalf of marketplace sellers (the business) to verify the business is registered in their state.
Auditors also use common sense to identify potential targets for further investigation. For example, an individual auditor may walk into a business and see two cash registers, one for cash and one for credit. This could be a red flag and reason for the auditor to pursue a further inquiry.
- Recorded vs. reported differences
If the business’s ledger reflects different numbers than its state or federal return, that’s a signal that there may be bigger issues at hand. Auditors have statutory authority to access all of the business’s filed records and use tools that flag businesses with mismatched revenue reporting.
5 Industries Most Likely to Be Targeted by State Tax Auditors
Operating in a high-risk industry also dramatically increases audit risk. Simply put, a high-risk industry is any in which businesses sell taxable products across multiple jurisdictions. These sellers have easy access to distribute their offering globally.
Five industries, in particular, are highly vulnerable to exposure. Below, we’ll explain how each industry operates and discuss why they’re particularly high-risk.
Merchandisers, such as big box stores, are retailers and wholesalers of all sizes that sell goods. These businesses can operate in brick-and-mortar storefronts, online, or both. They buy all types of goods from manufacturers, including furniture, clothing and shoes, electronics, and food products, often at discount bulk prices. In turn, they resell these good directly to customers.
Tax requirements become more complex when dealing with multiple product categories, making merchandisers are an easy target for audits. Retailers must properly tax items that fall into various product categories, increasing their likelihood of miscalculating tax from time to time.
Manufacturers take raw materials and turn them into products that can be sold to merchandisers. These businesses can create a wide variety of goods, including apparel, textiles, computers, food, chemicals, and plastics. Some manufacturers sell their own goods and are both manufacturers and merchandisers. Consumers are very familiar with many manufacturers across a variety of categories—including apparel brands, tech brands, and automotive brands.
Manufacturers traditionally sell to distributors and wholesale companies, which in turn resell the product to the retail consumer. To be considered exempt from collecting sales tax, those resellers must retain reseller certificates. Auditors frequently target manufacturers because of the complexity of managing reseller certificates and overall potential for gaps in recordkeeping.
Additionally, many states extend special tax treatment to these businesses in an effort to drive local economic growth. For example, some states offer special exemptions to manufacturers purchasing machinery needed to create their particular product. However, these rules can be easy to overlook or misunderstand, thus creating another audit trigger.
Software companies are organizations that develop, build, and sell software, data, or electronic hardware products. While legislation surrounding tangible goods and services tends to be more cut and dry, tax rules related to software sales are highly nuanced. As a result, it's common for states to target software companies because profit margins are typically healthy, and software tax legislation is handled differently in each state. This naturally creates increased exposure and risk for software companies.
- Cloud Computing Companies
Cloud computing is using off-site systems to help computers store, manage, process, or communicate information. Cloud computing companies can focus on different areas, including data storage and virtual servers. However, there are other types of cloud computing that exist within software as a service (SaaS), infrastructure as a service (IaaS), platform as a service (PaaS), and function as a service (FaaS) platforms.
Here’s how each type of cloud computing works:
- SaaS: Instead of downloading software to a local computer, users access software online (through a website).
- IaaS: Provides essential infrastructure components, such as security tools, servers, and storage, on the cloud.
- PaaS and FaaS: Both of these types of cloud computing are resources developers can use to build applications and execute code more efficiently.
State definitions of how various cloud computing services are taxed are widely varied and often ambiguous. As a result, software companies become another easy target for state auditors.
- Digital Products Companies
A digital product is any software that has users, including social media platforms and streaming services. The popularity of digital products has absolutely exploded in recent years, as the popularity of the subscription-based model continues to rise.
Once again, these categories fall into a gray area of sales tax compliance. Many states do not clearly define and manage taxes related to digital products because the offerings themselves rarely fit the mold. As a result, many companies have triggered economic nexus but don't realize where they have tax obligations, making them low-hanging fruit for state tax authorities.
How a Business Can Avoid State Audits
Many companies have yet to register and remit taxes in states where they've triggered economic nexus. Some underestimate the number of states where they have nexus, and others are unaware of their obligations altogether. Tax authorities know this and are taking advantage of this opportunity to send more nexus inquiry letters, conduct more audits, and recoup unpaid tax revenue for their state.
Tax compliance misrepresentation can range from unintentional negligence to willful fraud. To determine what’s happening, auditors compare primary source data to filed (or missing) sales tax returns. If they find discrepancies on the returns, they are likely to do a more thorough investigation. An auditor may run specific tests to evaluate whether tax is being properly reported or may contact vendors directly to confirm.
Don’t leave sales tax compliance to chance. Instead, prioritize the long-term financial health of your business by assessing your risk and taking action before it’s too late. This no-cost compliance risk assessment tool is a great place to start.Continue reading “Sales and Use Tax Registration”