How to Minimize the Risk and Pain of the Dreaded Sales Tax Audit

Mar 04, 2014 11:06 PM  By

Want to avoid a sales tax audit? Don’t open a business. If you already have a business, this is not an option.

So first, accept that every state conducts audits of registered companies and individuals on a random sample basis, and there is no way to guarantee that they won’t choose you.   That does not mean that they targeted your business or think you did something wrong. Rather, random audits are a statistical method of keeping a finger on the pulse, very similar to how the IRS conducts random sampling audits of individual tax payers.

Second, be aware that auditors will also contact your business if something doesn’t ‘smell’ right. Perhaps you’ve claimed a large number of exempt sales in an industry where exempt sales are uncommon. Maybe you made an unexplained and large number of (honest) errors during the filing process and now the state thinks you owe money. Either way, auditors will rely heavily on their gut instinct developed from years of experience, but ultimately they have to operate based on documented evidence.

If an auditor contacts your business, you need the ability to present supporting documentation that will defuse their suspicions from the outset. Being forthcoming and providing all of the information that they requested in a timely manner will not only establish the documentation you need to support your position but will also go a long way to calm any suspicion that you are hiding something. Your professionalism will connote that you are following their rules and that their time would be better spent auditing someone else.

Instead of living in fear of auditors, you can take preventative steps to maybe not to avoid but at least to minimize the time, expense and stress of inquiries and help assure that a simple inquiry does not escalate into a full blown audit.

Most entrepreneurs launch into business thinking about growth, not easing the pain of an audit. Unfortunately for the go-getters, audit related remedies cannot be taken retroactively. Unless you exercise caution as the business launches, you might be too late once the State comes knocking on the door. The following pointers will help you minimize the risk and pain of the dreaded sales tax audit.

1.        Audit Trail

Beginning with your first sale, meticulously document an ‘audit trail.’ Assume that an auditor will eventually want to look at each sale and see how you calculated sales tax. This is especially important if you have exempt sales, which are red flags to auditors who will want to see exemption certificates, information about the buyer and other documentation about the basis for the exemption. Remember: if you don’t have this documentation, you will be on the hook for the back taxes, fines and penalties.  The auditor will not wait to see if you can collect the taxes from the buyer. Chances are you will need to make the whole payment out of your own pocket.

2.       Filing Record

For every sales tax filing, you need to collect proof that you filed the return and paid the right amount of money, and you need proof of when the return was filed and when the payment cleared.  Most business owners will typically print their return, cut a check, put a stamp on the envelope and consider their filing obligation complete. Without the proper supporting documentation, you will not be able to respond to an assessment that your filing was late. This will lead you into trouble in the event of an audit.

What can you use to support your position?  Remember, more often than not, the processing of your return is performed in a disjointed manner.  Just picture a situation where the state receives a tax return and one person opens the envelope, a second person processes the return and a third person processes the payment. What happens if one of these people, such as the person processing the check, is out sick, on vacation or simply backed up? Let’s say your check is not processed until later in the month.  Many states have a standing process in which assessments are automatically generated if a certain day in the month is reached and filing elements are missing.  In a situation like this, you will receive an assessment, and you will be on the defensive, having to show that you filed on time and sent in payment.

You can help your position by having a Certificate of Mailing to demonstrate that you mailed your return on time. You can also help your position by having a copy of the check and proof of when the payment posted from your account to the correct tax agency.

3.       Working with Auditors

You could file on time, have a Certificate of Mailing and have proof of payment but still get a call from the state because an auditor sees something strange in your return. The most important thing you need to do is treat the auditors with respect, professionalism and courtesy.  While you may view their requests as a distraction from running a business, this in and upon itself will not make the auditor go away.  The auditor is in a similar position. They are focusing on their business, which is protecting the state from tax avoiders.  Respond to their requests in a timely manner. Provide supporting information. Answer all their questions. If you followed the above steps from day one, responding to the auditor and providing them all they want will be quick and painless. It will also increase the chances that they will go away.

Remember that auditors will respond in a reasonable manner if they think that you are helping them do their job. They understand that there could be mistakes or disagreements in your sales tax filings, but they are less likely to penalize you if you’ve been transparent and help them understand that these were honest mistakes.

On the other hand, if you challenge or belittle the auditor (even by simply not responding in a timely manner), they’re more likely to escalate the process to a full audit—and once they do so, they will in all likelihood find something amiss, providing further grounds for hefty fines and penalties.

If you’re evasive or untimely, the auditors will suspect that you might be hiding something and press harder. First, they will request follow up information, and if you continue to provide unsatisfactory materials with a delay or an attitude, you’re painting a bulls-eye on your business, even if you did nothing wrong. Don’t be evasive.  The auditors by their nature are curious people, so they will continue digging until they receive a satisfactory answer.

By taking the preventative measures outlined above and by treating auditors with professionalism and courtesy, you will mitigate the risks associated with an audit, including the time and cost you will spend defending against one.  Keep in mind that the way you document your sales will determine how much time, money and peace of mind an audit drains. If your filing records are stuffed in shoeboxes, you might have to spend four to five hours tracking down documentation. Whether you have a physical system or rely on a software solution, you need a good record-keeping system that will make finding, retrieving and sending documents quick and painless.

Jonathan Barsade is CEO of Exactor, a developer of end to end solutions for secure sales tax record keeping and compliance.