In today’s state and local tax landscape, it's easy to overlook additional states where you may trigger nexus as well as not have confidence in your understanding of how different jurisdictions tax your products or services. Unfortunately, these oversights often come to light only when a state audit is initiated, and by then, the financial and operational consequences can be significant.

Costs of State Audits and Non-Compliance

The impact of a sales and use tax audit can be felt both financially as well as operationally within any business. Addressing your organization’s sales and use tax compliance process before an audit takes place, allows you to have peace of mind, and minimize the risk associated with the costs associated with sales and use tax audits:

• Assessments – Audit assessments can include tax owed, plus penalties and interest. These penalties can include failure to pay as well as failure to file, and in many states total penalties can be up to 25% of assessed tax. In addition, the state will apply interest to both the tax and penalties due.
• Operational Effort – The time your organization will spend relating to locating records, preparing documents, and communicating with the auditor, will be significant. This will require you to devote your own time or hire third-party advisors to handle the matter.
• Failure to file – In many instances, if a business has failed to file the necessary sales tax returns, this can extend the audit period, increase the potential tax liability, and make it more difficult and time-consuming to retrieve older documentation.
• Collection of Tax – If a business has failed to collect taxes historically, they are put in a difficult position; either absorb the liability or attempt to recoup it from customers.  Both are unpleasant.
• Tax warrants and liens – Unpaid sales and use tax liabilities can result in the state issuing a tax warrant/tax lien against your business, potentially damaging the business’ reputation.
• Liability of Business Owners – Sales tax is a trustee tax (a tax collected by a business from a customer, then paid by the business to the state). If a business fails to pay a sales tax assessment, states may go after the business owners/officers directly for payment of the tax. 

To mitigate these risks, it's critical to stay informed and proactive about your compliance obligations.

Proactive Steps to Strengthen Compliance

There are several steps businesses can take before an audit notice arrives to reduce their exposure and ensure compliance:

1. Review Your Nexus Footprint - If your business has triggered nexus, either physical or economic, but failed to register, the state may look back multiple years during an audit. Conduct a Nexus Analysis to determine where you have filing obligations and assess any past exposure. Where appropriate, consider pursuing a Voluntary Disclosure Agreement (VDA) to limit lookback periods and reduce penalties. Note: VDAs must be completed before an audit notice is received.
2. Understand Your Product Taxability - Sales of tangible personal property are typically taxable, but many states also tax software SaaS, digital goods, and services. Understanding how each state treats your product or service is essential to proper tax calculation and collection.
3. Maintain Records and Manage Exemption Certificates - Implement a reliable system to collect, validate, and store exemption certificates. While many states permit you to gather missing certificates during an audit, those obtained after the fact may be more closely scrutinized and can be disallowed. Auditors also frequently do not accept incomplete certificates, so ensure all required information is completed accurately, including signatures.
4. Verify Proper Reporting  - Sales tax is a trust tax, meaning all collected tax must be accurately reported and remitted. Review your systems to ensure:
   • All taxable sales are reported,
   • Tax rates used are accurate, and

   • No discrepancies exist between what’s collected and what’s reported.

     Example: If your POS system erroneously applies an incorrect tax rate that is greater than the actual tax rate, and the over-collected tax isn’t remitted, some states (e.g., Rhode Island) may expand the audit period.

5. Use Tax - Have a process in place to identify purchases subject to use tax such as supplies, software, and fixed assets used internally. Many businesses overlook use tax, which can become a focus during audits.
6. Prepare for the Audit Process- If you receive an audit notice, engage a tax professional early. Having an expert involved from the beginning can:
   • Streamline communication with auditors,
   • Help manage documentation and sampling methods, and
   • Resolve issues at the auditor level—potentially avoiding costly appeals.

Sales and Use Tax Audit FAQs

1. I received an audit notice, what should I do? 

Contact your tax advisor to plan your response. Begin gathering relevant records such as exemption certificates.

2. What if I am missing exemption certificates? 

Auditors may assess tax on those sales. Reach out to customers to request updated, valid certificates.

3. We just discovered we have economic nexus in a state. Should we register?

First, assess your potential past exposure. If there's historical liability, it may be in your best interest to pursue a VDA before registering, to limit the lookback period and abate penalties.

If you have questions about your sales tax compliance or need help navigating a sales tax audit, our State and Local Tax (SALT) Team is here to assist.