Why state audits happen (brief overview)
State tax agencies look for discrepancies, patterns, or anomalies that suggest taxes were underpaid, credits or exemptions were claimed improperly, or statutory filing requirements weren’t met. Many audits start from automated data matches, third-party information (1099s, W-2s), or spikes and inconsistencies in reported income or deductions. State auditors focus on collection-sensitive areas such as sales and use tax, payroll and employment taxes, income reporting, and nexus/registration issues (state-specific rules about doing business in a state).
I’ve worked with dozens of small business owners and independent contractors over 15+ years and I regularly see the same avoidable mistakes trigger costly state reviews. This guide explains the most common triggers, real-world examples, documentation to keep, and practical steps to reduce audit risk.
Top compliance mistakes that commonly trigger state audits
Below are the most frequent errors state auditors flag, with short explanations and what to do instead.
- Failing to collect or remit sales tax (or remitting late)
- Why it triggers an audit: Sales tax collection is time-sensitive and easy to detect through returns or audit programs; states aggressively pursue unpaid sales tax plus interest and penalties. Many audits start from late or missing returns.
- What to do: Register for sales tax in states where you have nexus, file on time, and reconcile point-of-sale (POS) records against returns monthly. Keep exemption certificates for every exempt sale.
- Misclassifying workers (employees vs. independent contractors)
- Why it triggers an audit: Misclassification affects withholding, unemployment insurance, and employer payroll tax liabilities. States often cross-check W-2s and 1099s and may audit payroll tax filings.
- What to do: Use state and IRS guidelines to classify workers correctly. Maintain written contracts, time records, and proof of control (how work is directed and supervised).
- Underreporting income or mismatches with third-party forms
- Why it triggers an audit: States obtain 1099 and W-2 data and perform automated matches. Income omitted from returns that appears on third-party forms creates a fast audit trigger.
- What to do: Reconcile bank deposits, 1099s, and accounting records each quarter. If you receive a corrected 1099, amend promptly.
- Claiming aggressive or unsupported deductions and credits
- Why it triggers an audit: Deductions that don’t align with the business type or revenue raise red flags. Large, unusual, or late-year deductions invite scrutiny.
- What to do: Keep receipts, invoices, and clear business purpose memos. Apply conservative judgment to ambiguous items and document your decision.
- Poor or missing documentation
- Why it triggers an audit: Lack of receipts, contracts, invoices, or canceled checks prevents substantiation of deductions and credits. States commonly disallow items without supporting records.
- What to do: Keep organized digital and paper copies for the recommended retention periods (see below). Use cloud accounting and scan receipts promptly.
- Not registering or filing in states where you have nexus
- Why it triggers an audit: Businesses with economic presence (sales thresholds, physical presence, or marketplace activity) that fail to register often attract compliance checks.
- What to do: Review state nexus rules (they vary by state) and register where required. Consider marketplace facilitator rules for online sales.
- Inaccurate payroll tax deposits and filings
- Why it triggers an audit: Missing or late Form 941, state unemployment filings, or deposit errors show up in state reconciliations and can lead to employment tax audits.
- What to do: Reconcile payroll registers, ensure timely deposits, and retain timesheets, payroll reports, and proof of tax deposits.
- Refund or credit claims that spike without explanation
- Why it triggers an audit: Sudden, large refund requests (sales tax credits, income tax credits) often prompt state reviews to verify legitimacy.
- What to do: Document the business reason, supporting invoices, and any prior approvals. For sales tax refunds, collect exemption certificates and procurement records.
- Mixing personal and business expenses
- Why it triggers an audit: Personal expenses taken as business deductions are a frequent audit finding and may lead to disallowance and penalties.
- What to do: Use separate bank accounts and cards for business. Maintain clear expense policies and contemporaneous records.
- Not responding to notices or missing deadlines
- Why it triggers an audit: Ignoring state notices or failing to file requested documents elevates scrutiny and can lead to default assessments.
- What to do: Treat all state correspondence as time-sensitive. If you can’t meet a deadline, contact the agency or hire representation immediately.
Real-world examples and brief case studies
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Sales tax remittances: A retail client I advised missed quarterly sales tax filings after switching POS systems. The state issued assessments for unpaid tax plus penalties. The business avoided criminal exposure by cooperating, but paid back taxes and penalties that could have been minimized with timely reconciliation and voluntary disclosure.
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Worker classification: A landscaping company labeled long-term helpers as contractors. A state unemployment audit reclassified them as employees, creating back payroll tax liabilities and penalties. Correcting classifications and maintaining detailed time sheets helped the company enroll in a payment plan.
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Unsupported deductions: A sole proprietor claimed sizable home-office and travel expenses with no contemporaneous records. The auditor disallowed deductions, resulting in additional tax, interest, and loss of trust with the state revenue agency.
Documentation checklist (state audit essentials)
Use this checklist to prepare before an audit or to reduce audit risk:
- Sales tax: registers/POS reports, sales tax returns, exemption certificates, reseller permits, shipping records, point-of-sale receipts, and vendor invoices.
- Payroll: payroll registers, Forms 941 and state equivalents, deposit receipts, W-2s/1099s, timesheets, contracts, and worker classification documents.
- Income & deductions: general ledger, bank and merchant statements, invoices, receipts, canceled checks, loan agreements, and proof of business purpose.
- Nexus & registration: business registrations, certificates of authority, marketplace facilitator reports, and correspondence with state tax agencies.
Keep these records in a structured, indexed format (by date and tax period). Scanned copies should be readable PDFs with filenames that make reconciliation straightforward.
How states select returns for audit (brief)
State agencies use automated systems to match third-party information, analyze trends, and flag outliers. Common selection mechanisms include:
- Data matching with 1099s/W-2s and federal returns.
- Anomalies in gross receipts vs. industry averages.
- High-volume refund filings or irregular credit claims.
- Information from whistleblowers, other agencies, or random sampling programs.
For multistate businesses, differences between state and federal treatments (nexus, apportionment) can create selection triggers. See our article on [State vs. Federal Audits: Key Differences and Coordination](
