Jun 2, 2021 • 9 minute read
Direct Audits – What to know
If you're a small business, there's a chance you will be audited. While an audit can be time consuming and labor intensive, it doesn't have to be. This article outlines what to expect when being audited and provides helpful hints so that you can get through the audit as smoothly as possible and reduce your potential liability.

Direct Audits – What to know

Retailers with new obligations to collect sales taxes (State Sales Taxes – Where to collect) worry about their potential liability if they collect the wrong tax amount. They are concerned about their audit risk and are looking for ways to lessen their potential exposure. This exposure can differ significantly depending on the laws of the individual states you are collecting for, your sales or other activities in that state, and how you decide to meet your collection obligation (Streamlined Sales Tax Audits – Extra Help For The Merchant).

In states where you do not have a physical presence, using TaxCloud can substantially reduce your audit risk. We do all the collection and remittances for you, so the states will be looking to us to make sure your returns are accurate and complete on your remote sales.

In states where you have a store or other physical presence the state may select you for an on-site audit, which may or may not cover all the taxes in the state. The notes below can help you ace an on-site audit.

Sales Tax is Complicated- Rules, taxability, rates, definitions, exemptions, and forms vary tremendously across the sales tax states. And while the Streamlined Sales Tax states have made significant simplifications and standardizations, they are still far from uniform. If you are selected for an audit by a state where you have a physical presence, you will do yourself a favor by learning how that state’s sales tax regimen generally applies to your business in advance of the audit. At the end of this blog are some resources you can use for that purpose.

Being Selected for Audit- Being selected for an audit does not feel like winning the lottery. But it does not have to be the fear inspiring event and messy, time crunching distraction some small businesses experience. With some advance preparation and the correct frame of mind your business can come through an audit unscathed.

Be Prepared- The best time to prepare for an audit is during the ordinary course of your business operations, not after you get a letter telling you your business has been selected. Yes, it will take some of the time you could devote to other activities for your business. But preparing for (and learning from) an audit will also help you keep your business records in order and give you insurance and assurance you have the processes and controls in place to be fully compliant with sales tax laws and regulations for the future.

Why Me? – It is not worth worrying too much about why your business was selected for audit. Every state has its own methods and reasons for audit selection, but they often include regular audit cycles for some businesses, targeting by industry where past audits show compliance could be improved, checks on compliance with recent changes to nexus or other statutes, and (usually) a certain number of random audits just to keep everybody honest.

Entrance Conference- On site audits usually start with an entrance conference. The auditor will discuss the process with you and how they plan to proceed. Be sure to ask any questions about any aspect of the process you do not understand. Where, when, and how the auditor will work will be covered. Be clear on who you have designated to assist the auditor besides yourself and introduce them. It is entirely appropriate for other employees to respond to an auditor’s question by saying “Let me get Sally or Joe to help you with that.”

The Auditor Is Not Your friend. She Is Not Your Enemy Either- The auditor is a professional employed by the state with an important job to do. The auditor is making sure the laws regarding taxes are properly implemented, and that businesses are complying with their obligations under state law to collect and remit the correct amount of tax. But it is true that people drawn to careers in audit generally like order, numbers that match where they should, and for people and businesses to follow the rules. That’s just their nature. You may be focused on the creative aspects of your business, but the auditor is going to be focused on your business records. That being said, most auditors are reasonable people, and they will not ding you for the occasional minor error in record keeping.

Work Space and Treatment- Be courteous. To the extent you can, provide a quiet, orderly space away from your business operations. The combination of a decent working space and readily accessible records will make the audit go more quickly, eliminating frustrations for the auditor, and minimizing the time you have to spend on the audit and away from improving your bottom line. Most states have restrictions on what an auditor can accept while at your business. The safest bet is to stick to offering water and coffee. Soft drinks or other treats are fine if they are freely available to all your employees. Do not be offended if the auditor refuses everything. Don’t offer to take them to lunch, even if you would do so for other visitors to your company.

General Business Documents- The auditor may want to see your general ledger and journal entries, bank statements, federal tax returns, and any other state or local tax returns. Having these ready when she walks through the door will get you off to a quick and smooth start, and help establish a good relationship, which can be very useful in the rest of the audit.

When the auditor asks for additional documents, supply them as quickly as you reasonably can. Don’t be afraid to ask questions. It’s important for you to understand the reasons documents are being requested. Understanding what is going on in the audit will enable you to be responsive, and occasionally suggest better or more representative alternatives to the request.

Sales and Use Tax Documents- The auditor will want to see sales tax returns, use tax returns, invoices for both sales and purchases, resale certificates, exemption certificates, and shipping records. But she may not want to see all of them. Have them organized so you can readily pull what she needs and wants to see. Have a process in place to make sure exemption and resale certificates are properly executed and stored. Make sure the product descriptions on your invoices are specific enough for the auditor to be certain of what was sold (e.g. Was Goldfinger a book, a DVD, a soundtrack, or a download?).

Sampling- It’s pretty unlikely an auditor is going to want to look at every sales tax record you have. She is likely to use various sampling methods in order to arrive at an approximation of any liability and to expedite completion of the audit. This can be a good thing and save everyone time if the sampling results in an accurate representation of your overall sales, exempt sales, sales for resale, and merchandise retained for your own business use, and overall liability. It can, of course, be a bad thing if the result is not a good representation, potentially leaving you with more liability than you actually have. Discuss any sampling with your auditor in advance. It’s easier to prevent a non-representative sample than it is to correct one after the auditor has done the work. Make sure you understand what the auditor is looking for.

Make sure the auditor understands the nature of your business. If your business is highly seasonal, that needs to be reflected in the sampling. If it is not, that needs to be reflected in the sampling. If you have more sales for resale during some periods, and more direct retail sales in others, that needs to be reflected in the sampling. If you sell major equipment during certain months and not in others, that needs to be fairly represented. You may want to consult with your accountant or other tax professional and have them assist you with any discussions about sampling.

The auditor may want to specifically examine transactions over a certain dollar threshold and apply sampling to the remainder of your transactions. This is usually a good idea if you have occasional big ticket sales because it tends to avoid distortions that could otherwise result from a flawed sample. You may want to suggest this if the auditor doesn’t.

Statute of Limitations Waiver- It is common for an auditor to ask you to extend the statute of limitations by signing a waiver for a specific period, especially if the audit will occur near the limitation. With a signed waiver the auditor does not have to rush the audit to avoid missing a tax year and will be less likely to include items that could have been resolved with some discussion. You will probably have more time to pull records and prepare for the audit. However, any interest on liability will continue to accrue. Make sure the waiver is both reasonable and for a limited period of time. You don’t need to sign a waiver a year in advance and you don’t want to keep the statute of limitations open indefinitely.

Materiality- If errors in your records are minor and involve negligible amounts an auditor may have the ability to not assess your business for them and provide future reporting instructions instead. Rest assured though, if you come up for audit again and the future reporting instructions have not been followed, you will be assessed.

Penalties and Interest- When your audit is complete you will owe interest on any unpaid taxes. You may also be assessed a penalty on any unpaid taxes. Auditors sometimes have the ability to waive penalties, and will often do so if they find the errors understandable and not a result of negligence. It doesn’t hurt to ask. Interest is a different story. Most states will not allow an auditor to waive interest.

Exit Conference- The auditor will explain what was found and the nature of the assessment, if any. You may be asked to accept the finding to avoid further interest and penalties. That’s fine if you fully understand and agree with the changes, but if you need more time or want to consult an advisor, you have the right to do so. Make sure you fully understand your appeal rights and what deadlines you have.

How to appeal an audit assessment- As noted above, it’s very important to understand your appeal rights. The specific requirements and deadlines vary greatly from state to state. States typically require a written protest within a relatively short period of time. It is important that you understand the specific deadlines and requirements of your state. Calendar the deadline as soon as you get the audit report. You could lose your appeal rights if you do not file a written protest by the deadline that meets the state’s requirements.

Next Time- You may be tempted to quickly put the audit behind you once you’ve been given the results, especially if they were not too bad. This is exactly the time to set yourself up for a successful audit the next time around with this or any other state. Note any problems that were discovered in your records and figure out ways to improve your business practices to avoid them. And then implement those improvements. Generally speaking, any improvements you make that will help you in audit will also help you in documenting and understanding your own business.

Audit Resources- Depending on the nature and size of your business, and how complicated the state tax laws are in the state auditing your business, you may need to do more or less research on your compliance. Below are some of the resources you can use.

Individual States- Many states have publications geared to a general understanding of particular tax topics. Contact the state that plans to audit you for general information about how their sales tax works, and for any specific questions you may have based on your business and clientele.

Streamlined Sales Tax Governing Board- The 24 member states supply information about taxability and administrative practices in easily accessible matrices. You can access this information at here.

Tax Professionals- If you anticipate your sales tax audit will be pretty straightforward and you are prepared for it you probably don’t need to incur the expense of having an accountant or other tax professional assist you with the audit. If you anticipate your audit could be a complicated and sizable undertaking you need assistance with, then having a tax professional assist you during the process may make the most sense for you, especially if your time is more valuable spent elsewhere.

TaxCloud- If you are a TaxCloud client we may be able to assist you. While we do not provide accounting or legal services and therefore can’t officially represent you in an audit, we can provide auditors with the data they need in electronic format in a timely and organized manner. And the fact that you are using our services means there won’t be many errors to find in the first place.