Why Sales Tax Audits Have Increased—and What You Need to Know

Over the past few years, sales tax audits have increased, and for many businesses, this trend shows no signs of slowing down. Understanding why these audits are becoming more common, what’s behind the rise, and how your business can best prepare is essential for staying compliant and avoiding costly penalties. Read more below.

The Catalyst: Wayfair and the Establishment of Economic Nexus

The 2018 South Dakota v. Wayfair Supreme Court decision changed everything. Before Wayfair, most states could only require businesses to collect sales tax if they had a physical presence (like a storefront, warehouse, or employees) in the state. But Wayfair introduced the concept of economic nexus, allowing states to mandate that out-of-state businesses collect sales tax based on their revenue or the number of transactions within the state.

The impact was immediate and widespread. Virtually overnight, thousands of businesses, especially e-commerce companies, were required to comply with new rules, leading to an explosion in sales tax compliance obligations. However, this created a significant compliance challenge for businesses, and it didn’t take long for states to see potential for increased revenue through both new collections and heightened enforcement—namely, audits.

How Economic Nexus Has Evolved—and What It Means for Businesses Today

In the years since Wayfair, many states have refined their sales tax rules even further, adding layers of complexity that make it easy for businesses to accidentally fall out of compliance. Here’s how:

• Product Exemptions: Economic nexus brought to light a range of state-specific exemptions, leading to confusion, particularly for businesses selling a variety of products across multiple states. For instance, some states exempt certain food items or software from sales tax, while others don’t. Keeping up with these variances is no small feat and can make compliance a moving target.
• Changed Thresholds: Every state with economic nexus has established its own revenue or transaction threshold, often updating these thresholds to reflect state budgets or shifts in the marketplace. While most thresholds range from $100,000 to $500,000 in revenue, they aren’t uniform, and businesses with a national customer base are required to track and comply with each state’s rules individually.

These factors combined make compliance a challenge, and states have responded by initiating more audits, often targeting businesses that they suspect may not be adhering to these complex requirements.

Why Audits Are on the Rise

Sales tax audits are on the rise for several key reasons, and understanding them can help your business anticipate and, ideally, avoid an audit.

1. Increased Revenue Scrutiny by States: As states continue to recover from budget gaps, especially in the wake of the pandemic, many are intensifying their focus on sales tax revenue. This increased focus translates into more audits, particularly targeting small and medium-sized businesses that may not have the resources to manage the complexities of multi-state compliance.
2. State-Driven Data and Automation: To keep pace with these changes, states are increasingly using data analytics to spot discrepancies in sales tax filings. Automated systems can quickly flag potential non-compliance, making it easier for states to initiate audits based on discrepancies rather than waiting for larger red flags.
3. Compliance Questionnaires as Audit Triggers: Many states now send out compliance questionnaires, probing businesses about their sales activity in the state. While these questionnaires may seem harmless, if a business fails to respond accurately or promptly, it can inadvertently trigger an audit. Some businesses ignore these questionnaires, thinking they are low-risk, but that’s a big mistake—compliance questionnaires are increasingly becoming an initial step in the audit process.

The Impact on Small and Medium Businesses (SMBs)

While audits can be burdensome for any business, they are particularly challenging for SMBs, which may lack the in-house resources or expertise needed to navigate complex compliance issues. Here are some of the ways sales tax audits are affecting SMBs:

• High Cost and Resource Strain: Sales tax audits can be costly in terms of both time and money. SMBs are often stretched thin, and dealing with an audit can mean diverting resources away from critical areas of the business. In some cases, SMBs even find themselves hiring external tax advisors to manage audits, leading to unforeseen expenses.
• Uncertain Appeal Processes: With states experiencing lengthy timelines for audits, many businesses choose to appeal initial findings, especially if they believe the audit contained errors or oversights. However, appeals add to the uncertainty and can extend the resolution process even further, often at additional cost to the business.

How to Protect Your Business from Sales Tax Audits

Understanding why sales tax audits are on the rise is the first step; the next is taking proactive measures to protect your business. Here are a few actionable tips:

1. Stay Informed on Nexus Laws: Economic nexus thresholds, product exemptions, and other state-specific rules change frequently. Designate someone in your organization to stay current on sales tax regulations or work with a service like TaxValet to ensure you’re up to date.
2. Respond Promptly to Compliance Questionnaires: If you receive a compliance questionnaire from a state, take it seriously. Respond accurately and promptly to avoid raising red flags that could trigger an audit.
3. Document Everything: Proper documentation is your best defense in the event of an audit. Keep thorough records of your sales, exemptions, and tax remittances for each state. This includes transaction data, invoices, and any supporting documentation for product exemptions.

Why Sales Tax Automation Software Isn’t Enough

While sales tax automation software can streamline the process of calculating and remitting sales tax, it’s not a silver bullet for achieving full compliance. Automation tools often focus on calculations alone, without accounting for complex state-specific nuances like varying product exemptions, thresholds, and periodic changes to nexus laws. Relying on automation alone can leave gaps that increase your audit risk.

Moreover, sales tax compliance requires regular updates and human oversight to ensure that your business is accurately reporting sales across different jurisdictions. Without expert support, businesses can still fall out of compliance due to misinterpretation of state rules or insufficient documentation practices. For a deeper look at why automation alone isn’t enough, you can read more about it in our post on the limitations of sales tax automation software.

Safeguard Your Business from Sales Tax Audits with TaxValet

Sales tax audits are becoming an increasingly common aspect of doing business, especially in the wake of economic nexus laws. But with the right approach, your business can reduce its audit risk and navigate compliance with greater confidence. 

If you’re concerned about sales tax compliance or want to explore ways to reduce your audit risk, TaxValet is here to help. Our team of experts specialize in sales tax compliance, so you can focus on growing your business, knowing your sales tax obligations are in good hands.

Reach out now for your free sales tax plan.