Navigating Sales Tax Audits: A Guide for E-commerce Businesses

Dec 4, 2023 | Compliance, Sales Tax

Everything e-commerce sellers need to know if being audited for sales tax

Being hit with a sales tax audit notice can induce panic for e-commerce businesses. Yet these audits are becoming more common as states look to close tax gaps and ensure compliance. 

It doesn’t help that since the 2018 South Dakota v. Wayfair decision, sales tax nexus (where you’re required to collect) has become more complicated. And the fact that states rely on sales tax to pay for budget items like schools, roads and public safety means they are more motivated than ever to ensure they are collecting every penny due. 

But don’t despair. A sales tax audit doesn’t necessarily mean disaster.  With the right strategy, and expert help, you can emerge unscathed. 

Let’s dig into the whys of sales tax audits and what you can do if you receive the dreaded audit letter. 

Why do states perform sales tax audits?

States initiate a sales tax audit when they suspect that a business is not fully sales tax compliant. This can mean anything from they suspect your business does business in the state without a valid sales tax registration to thinking that your registered business isn’t fully compliant. 

Some reasons for audit include: 

  • Filing mistakes like late returns, incorrect tax rate calculations, or inconsistencies in your sales tax reporting.
  • Operating in a high-risk industry or one with complex sales tax rules.
  • Tips from disgruntled staff or customers about potential non-compliance.
  • You were named as a vendor or associate in another business’s audit.
  • Random chance or company growth catching the state’s attention.

An audit notification often feels unfair and arbitrary to an e-commerce seller doing their best to comply in the increasingly complex world of sales tax. From the state’s point of view, they sense an irregularity and are trying to confirm that your business is in compliance. 

And here’s another dirty little secret. Though not spelled out, it’s understood that sales tax auditors will bring in a multiple of their salary every year in interest and penalties from audits. This makes them hungry to catch businesses in the act, and that’s why it’s so important to take an audit seriously. 

What are some common sales tax mistakes that lead to an audit?

As you can see from the reasons for an audit we listed above, audits are sometimes arbitrary and unavoidable. But unfortunately, sometimes a business’s own actions lead to an audit. 

These are the mistakes you need to look out for when handling sales tax.

  • Failing to file sales tax on time – A pattern of late or missing filings may trigger a warning that a business isn’t taking sales tax compliance seriously.
  • Sales tax returns include mistakes – Mistakes or poor/sloppy sales tax returns send the signal that a business may not be collecting and filing correctly.
  • Failing to follow filing and payment requirements – Many states have specific requirements, such as a requirement to file and/or pay electronically if you are paying a certain amount in sales tax. This varies by state. Repeatedly ignoring state requirements can lead not only to fines but to an audit.
  • Not following item-level tax exemption rules – If, for example, you sell grocery items in a state where groceries are not taxable but you always charge the full tax rate on your items, the state might flag that you are not in compliance. (Yes, that’s even if the state is getting more money out of you and your customers than they’d normally receive!)
  • Failing to report consumer use tax – Retailers are allowed to buy items for resale without paying sales tax. However, if they end up not selling any of those items they are required to pay consumer’s use tax to the state for any items on which they did not pay sales tax. Few businesses have no consumer’s use tax due, so if you repeatedly fail to report this amount, this may raise an auditor’s suspicion. 

How to Survive a Sales Tax Audit

Never fear! Audits are common, and your business can and will get through this process.

Before the Audit

If you are being audited, consult a sales tax professional immediately. This should be your first step, even before responding to the audit letter. Your sales tax expert will advise you on how to respond to initial information requests (i.e. audit letters), and how to proceed from there. In best case scenarios, a sales tax expert can help you get the audit dismissed. If you’ve received an audit notification, contact us at HOST immediately before doing anything else.

Your sales tax pro will also help you get your sales tax in order for the audit. This will include determining any sales tax liability you may have, and getting your sales tax compliance in order–from collecting all resale certificates, to ensuring all of your sales tax filings are up-to-date. It’s vital to know your own sales tax liability, otherwise you may accept the auditor’s (incorrect or inflated) estimate. 

Your sales tax advisor will also help you ensure that you don’t accidentally send the wrong (i.e. too much) information to the auditor. It can be tempting, especially when you’re certain you’ve done nothing wrong, to open up all of your books to the auditor. This is a mistake. Only provide the information the auditor asks for. Providing anything beyond what the auditor asked for may inadvertently give the auditor more leverage.

Also, decline to sign any waivers that only benefit the auditor. Before even arriving on-site, your auditor may ask that you sign a statute of limitations waiver giving them more time to look into your case. Your sales tax pro will likely advise that you decline this, except in the case where you need more time to produce the information the auditor needs. Otherwise, there’s no reason to freely give the auditor more time to look into your business. 

What to do During a Sales Tax Audit

In fortunate cases, you and your sales tax expert will solve the auditor’s questions with correspondence. Some states even send out periodic “fishing” letters to multiple sales tax permit holders, even if they have no reason to suspect you of wrongdoing. 

But in other cases, the auditor will decide that your business deserves closer scrutiny. 

Here are our recommendations for dealing with a sales tax auditor. In this case, they will likely visit your place of employment. With your sales tax pro’s help, this can also be relatively painless. 

  • Isolate the auditor – Be friendly and cooperative–you are both just doing your job–but do not allow the auditor free access to your workspace. Just like with accidentally sharing too much information, allowing the auditor to observe your business can open up further avenues for their inquiry.  
  • Provide required information, but nothing more – It’s important to reiterate this. Do not accidentally allow the auditor to find more liabilities!
  • Ask for it in writing – An audit is an “them against you” situation. Rather than relying on memory or honesty, ask for all instructions in writing. Then…
  • Keep (written) track of every interaction with the auditor – Make note of every document you give the auditor, and every other interaction. This could become critical later when it comes time to resolve the audit.
  • Be careful what you sign – On that same note, it isn’t the auditor’s responsibility to explain what you might be signing. Always consult your sales tax pro before signing any documents. 
  • Be timely and meet all deadlines – Being organized and on-time gives the auditor less chance to find fault with your sales tax compliance. 
  • Be wary of sampling methods – Unless your business is very small, your auditor will not go over every single transaction. Instead they either choose a period of time (block sampling) or randomly sample transactions from your business. In general, and especially for e-commerce businesses who may make a great deal of their annual profit in just one quarter, random sampling is preferred. With block sampling, the auditor may choose a block that contains Black Friday and Cyber Monday (BFCM) and extrapolate that your sales are that robust every month. This can lead to inflated fines and penalties at the end of the audit. 

What to do After a Sales Tax Audit

After the auditor finishes, you’ll shortly receive a Notice of Assessment with the written results of the audit. In most cases, there will be some type of fine or penalty. 

  • Apply for a penalty waiver – It never hurts to try and abate some fines and penalties. Just note that some states require certain penalties by law.
  • Protest the audit – If you feel the audit was unfair, you can protest. Just note that some states have short deadlines (such as 30 days) after the conclusion of the audit for you to protest. Also, sometimes protesting is unhelpful, especially when the results of the audit are crystal clear and you did have some irregularities in your sales tax compliance. 

Your sales tax pro will be able to advise you on next steps after an audit is complete. 

How to Prevent Future Sales Tax Audits 

Whether some actions on your business’s part (such as habitual late filing or incorrect sales tax returns) triggered the audit, or you were caught up in a sweep that you could not have prevented, an audit is a shot across the bow indicating that you need to get strict about sales tax compliance. 

Once the stress of the audit has ended, it’s time to ensure air-tight sales tax compliance. Here are our main tips:

  • File and pay sales tax on time and keep up with resale certificates – Getting and staying sales tax compliant is vital for any business. Contact HOST about handling your sales tax compliance. 
  • Ensure you are collecting the right amount of sales tax from all customers on all sales channels – You can read more about ensuring you are collecting the right amount of sales tax here.
  • Keep up with sales tax news – Sometimes trade publications can give an early warning that your industry or a product category in which you sell is coming under scrutiny from states. No time to keep up? Keep up with the HOST blog instead.  

Do you have questions about a sales tax audit? Have you received a dreaded audit letter? Contact HOST today.