Overview
State sales and use tax audits are administrative reviews by state tax agencies to verify that a business collected and remitted the correct amount of sales and use tax. Unlike federal income tax audits handled by the IRS, sales and use tax is administered by states and localities, so rules and enforcement priorities vary widely. High‑risk items commonly include missing registrations, unreported remote sales after Wayfair, and recurring discrepancies between bank deposits and reported sales.
(For the impact of Wayfair on remote sellers, see: Nexus and Sales Tax for Remote Sellers After Wayfair.)
How state audits typically work
- Notice: States usually begin with a written notice. It may be a random contact, a desk audit request for specific documents, or notification that a field audit will occur.
- Scope: Auditors commonly review 3–5 years of transactions, but some states have longer audit look‑back periods or unlimited assessment windows for fraud (check your state rules) (see state guidance: https://www.tax.ny.gov/).
- Records requested: sales journals, point‑of‑sale (POS) summaries, exemption certificates, resale certificates, bank statements, credit card settlement reports, purchase invoices for use tax, and tax return filings.
- Findings and resolution: If the auditor finds tax due, the state will issue assessments including tax, interest, and penalties. Many states offer appeal routes and, in some cases, voluntary disclosure agreements (VDAs) or penalty abatement for first‑time compliance efforts.
Authoritative references
- South Dakota v. Wayfair, Inc., 138 S. Ct. 2080 (2018) established that states may require out‑of‑state sellers to collect sales tax based on economic nexus. (Court decision: https://www.supremecourt.gov/opinions/17pdf/17-494_6k47.pdf)
- State tax agencies set rules and audit policies; examples include New York State Department of Taxation & Finance (https://www.tax.ny.gov/).
- Small Business Administration (SBA) provides guidance on sales tax responsibilities for small businesses (https://www.sba.gov/).
Common audit triggers (detailed)
- Third‑party reporting mismatches
- Credit card processors, payment platforms (PayPal, Stripe), and marketplace facilitators often report gross receipts or settlements to states and the IRS. If those reports don’t match the amounts you reported on your sales tax returns, it will flag an inquiry. Reconcile your merchant statements to your POS and returns monthly.
- Nexus changes and remote sales
- After the 2018 Wayfair decision, economic nexus thresholds (e.g., $100,000 in sales or 200 transactions in a state) trigger registration and collection obligations in many states. Sellers who grow into new states or use third‑party marketplaces without updating registrations often attract audits. See FinHelp’s guide on nexus and remote sales for specifics: Nexus and Sales Tax for Remote Sellers After Wayfair.
- Large refund requests or frequent credits
- Repeated large refund or credit requests can signal incorrect initial collection or abuse of exemptions. States may audit to verify the legitimacy of refunds and the supporting documentation.
- Inconsistent taxability treatment
- Misapplying exemptions (e.g., claiming resale, manufacturing, or nonprofit exemptions without proper certificates) draws scrutiny. Services vs. tangible goods vary by state; inconsistent treatment across returns can trigger review. For guidance on product and service taxability, see FinHelp’s resources: Sales Tax Basics for Online Sellers and Small Businesses.
- High cash sales or industries with large cash components
- Restaurants, bars, salons, and other cash‑heavy businesses are statistically more likely to be audited because of the historical risk of underreporting.
- Sudden revenue changes or anomalies
- A dramatic increase or drop in reported sales inconsistent with industry trends or your location’s foot traffic can trigger a review. States use benchmarking tools and third‑party data to spot outliers.
- Marketplace facilitator and marketplace seller issues
- Marketplace facilitator rules (where the marketplace collects and remits tax) reduce some seller exposure but can create mismatches if a seller reports sales the marketplace already remitted. Keep reconciliations and check FinHelp’s guide: Marketplace Facilitator Rules: Who Collects and Remits Sales Tax?.
- Poor or incomplete records
- Missing exemption certificates, inconsistent POS data, and disorganized bookkeeping make audits longer and increase the chance of assessments. Maintain a single reliable source of truth for transactions.
- Complaints, whistleblowers, or vendor reporting
- Vendors, ex‑employees, or competitors sometimes notify state agencies about suspected noncompliance. Vendor invoices that show taxable purchases where no use tax was paid can spark an audit.
- Random selection or targeted industry sweeps
- Some audits are random; others are part of targeted programs (e.g., states reviewing remote sellers in a fast‑growing category).
Industry-specific examples (what auditors look for)
- Retail: Reconcile POS sales vs. supplier shipments and bank deposits. Itemized sales tax by Sku and returned merchandise processing are common focus areas.
- Restaurants and food services: Distinguish taxable prepared food from nontaxable grocery items and track dine‑in vs. takeout rules that vary by state.
- E‑commerce: Match marketplace reports, shipping addresses, and nexus thresholds to determine where tax should have been collected.
- Services: Many states tax specific services (e.g., repair, installation); incorrect classification of a taxable service as non‑taxable is a frequent error.
Real‑world examples (anonymized)
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Retail client: A brick‑and‑mortar store was audited after state analysts noted sales gross receipts materially higher than typical stores in the same ZIP code. The business had not tracked customer returns properly, inflating taxable sales. The audit resulted in additional tax and interest.
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Restaurant client: Unreconciled cash reports vs. credit card deposits led to an audit that found underreported taxable receipts. Proper POS reconciliation and daily cash tapes would have reduced exposure.
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Online seller: An e‑commerce merchant expanded sales into multiple states but did not register for sales tax in several jurisdictions after crossing economic nexus thresholds. That triggered a multistate audit and assessments across several states.
Practical steps to reduce audit risk (checklist)
- Register and file where you have nexus. Revisit nexus after product launches, advertising in new states, or growth of remote sales (Wayfair effect).
- Reconcile merchant processor settlements, POS reports, and bank statements monthly.
- Keep valid resale and exemption certificates organized and digitized. Retain exemptions for the period required by the state (commonly 3–5 years).
- Implement consistent taxability rules in your invoicing and product catalog. Document the reason for any exemption or non‑taxable sale.
- Use software to automate tax calculation and returns. Tax engines reduce calculation errors and help maintain nexus tracking across states.
- Conduct periodic internal self‑audits focused on high‑risk periods (holiday season, promotions, large refunds).
- Train staff on how to handle cash sales, returns, and exemption documentation.
If you receive an audit notice: immediate steps
- Don’t panic. Read the notice carefully and note deadlines.
- Contact a qualified state sales tax advisor or attorney if the potential exposure is material. In my practice I’ve seen timely professional involvement reduce penalties and negotiate look‑back periods.
- Gather the requested records in an organized fashion: sales journals, POS reports, bank statements, exemption certificates, purchase invoices, and filed returns.
- Consider limited scope cooperation: provide requested records in a controlled environment or via secure portal; insist on scope letters to limit the fiscal years under review when possible.
- Negotiate if appropriate: many states will accept reasonable documentation, and some offer penalty abatements for first‑time failures or voluntary disclosures.
Typical penalties and look‑back periods
- Look‑back periods commonly range from 3–5 years, but exceptions exist for fraud or willful failure to collect. Check your state’s statute of limitations. (Example: New York guidance: https://www.tax.ny.gov/.)
- Penalties vary by state and can include late filing penalties, failure‑to‑collect penalties, and interest. Some states assess civil fraud penalties for deliberate evasion.
When to consider voluntary disclosure agreements (VDAs)
If you discover uncollected tax in a new state, a VDA with that state’s tax authority can limit look‑back periods and penalties. VDAs are state‑specific — speak with a practitioner experienced in multistate sales tax to evaluate options.
Documentation best practices
- Retain original exemption and resale certificates, vendor invoices, and POS summaries in both paper and secure electronic format.
- Keep a clear audit trail for returns and credits: link the original sale, the return transaction, and any credit memos.
- Time‑stamp and centralize records; use a consistent naming convention and a secure cloud backup.
Conclusion and final tips
Audits are stressful but manageable with preparation. The most common triggers are reconcilable — third‑party reporting mismatches, nexus changes after Wayfair, inconsistent taxability, poor recordkeeping, and industry risk patterns. Practical controls (monthly reconciliations, digitized exemption certificates, automated tax engines, and periodic self‑audits) greatly reduce exposure.
For more on sales tax fundamentals and managing remote sales, see these FinHelp resources:
- Nexus guidance: Nexus and Sales Tax for Remote Sellers After Wayfair
- Sales tax basics: Sales Tax Basics for Online Sellers and Small Businesses
- Marketplace rules: Marketplace Facilitator Rules: Who Collects and Remits Sales Tax?
Professional disclaimer
This article is educational and does not constitute legal or tax advice. State sales and use tax rules differ by jurisdiction and change frequently. Consult a qualified state sales tax advisor or attorney for decisions about your specific situation.
Author note
In my 15+ years advising small businesses, the cases that avoid audits are those that invest in reconciliations and clear exemption management. If you don’t already, start monthly reconciliations and a searchable exemption certificate repository — it will save time and money if you ever face an audit.
Sources
- South Dakota v. Wayfair, Inc., 138 S. Ct. 2080 (2018). https://www.supremecourt.gov/opinions/17pdf/17-494_6k47.pdf
- New York State Department of Taxation & Finance: audit and statute guidance. https://www.tax.ny.gov/
- Small Business Administration: Sales Tax overview. https://www.sba.gov/
- FinHelp glossaries linked above for additional how‑tos and state‑specific guidance.
