Understanding your risk for a tax audit can be tricky. While every small business wants to avoid it, it can be hard to find a rhyme or reason in the IRS’s auditing activity. One recent study showed that public companies located near an IRS service office were more likely to face an audit. A subcommittee hearing in Congress in 2016 revealed that small businesses were most likely to face audits by mail.
Regardless of the practices of the IRS, when a small business faces an audit, it’s a huge expense of time and often money. In 2015, the average additional tax bill caused by an audit was nearly $10,000.
But don’t worry. The best way to minimize the stress surrounding tax audits and the risk of an unexpected tax bill is to know the rules and keep your tax records accurate and complete. In this quick guide for small business owners on the best practices for avoiding a sales tax audit, we’ll cover what to do and what not to do to stay compliant.
The average additional tax charge due to an audit is almost $10,000.
1. Register in all states where you have nexus.
For starters you’ll need to be certain you’ve registered to collect sales tax where sales tax is due. That means knowing the nexus rules in any states where you do business. The state where your business is located is a definite requirement. You must register with your home state before collecting sales tax on taxable sales there. The states without state sales tax are Delaware, Montana, Oregon, New Hampshire, and Alaska (though Alaska allows local sales tax).
For the most part, unless your business is located in one of those 5 states, retail sales in your home state are taxable sales. In the restaurant industry, certain exceptions apply in some areas, like to-go orders, cold food items, and bakery items. Consult our state-by-state sales tax guides for more on how food is taxed in your state.
Besides the state tax rate, most states have additional local sales-tax rates as well. So knowing the correct rate is important. Also know that if you have more than one location or make sales in multiple areas, that rate is likely to change from place to place, so be sure that your POS software is set up accurately to collect the right rate.
When you operate more than one location, local tax rates are likely to change.
You can register to collect sales tax online at the state’s Department of Revenue (sometimes called Department of Taxation, Commissioner of Revenue, etc.). In most cases, registration is free, though some states do require a small fee ($10 is common) or a deposit. You can’t collect the tax without registering first. Once you’ve registered, you’ll be issued your state's version of a Retail Sales Certificate, which you’re required to place in a visible location. If you have more than one location, you’ll usually need to register each one separately.
Once you make sales across state lines, whether or not you need to register and collect tax in other states becomes a matter of each state’s definition of nexus. Some states where you make sales will have a threshold number of sales or revenue from sales per year above which nexus is established. Other states won’t require you to register and collect tax without conditions such as inventory held in the state or an affiliate relationship with someone who resides in the state.
2. Understand the changing nature of sales tax nexus.
Since the Supreme Court ruled to overturn the Quil v. North Dakota ruling recently, you can expect laws in many states to change as they expand their definitions of nexus. For more information about the states where you make sales, our state-by-state sales tax guides are a good place to start. Currently, states who have introduced new sales tax legislation as a reaction to the ruling or already had laws in place that they now plan to enforce include:
- New Jersey
States like South Dakota are in a position to act more quickly than others and plan to begin collecting sales tax through online out-of-state sellers who meet their criteria as early as this month.
Some states will begin enforcing new sales-tax rules in July.
3. File your sales tax on time (including prepayments).
Not only do you incur penalties and fees when you don’t file your sales tax by the deadline, you also increase your risk of an eventual audit. When you register your business with a state’s Department of Revenue to collect tax, you’re assigned a filing frequency based on estimated revenue. The majority of small businesses are required to file returns and pay sales tax either quarterly or monthly. Most, but not all, deadlines fall on or around the 20th of the month following the end of the filing period.
Many states offer incentives for filing on time in the form of a discount off your total sales tax liability. The discounts range from .5% to 5% of the total tax liability with maximums in place in some states. Overall, these incentives vary widely. For instance, Arkansas offers a 2% discount with a maximum of $1000 per month, while New York has a 5% discount with a maximum of $200 per quarter. The following states currently offer timely-payment discounts:
- New York
- North Dakota
- South Carolina
- South Dakota
Often the deadline to file falls around the 20th of the month after the filing period ends.
If you believe that you qualify for a different filing frequency than the one you’re assigned initially, you can request a change to your filing frequency in writing. Keeping track of the different filing deadlines in different states if you sell online can be a challenge but is a critical step to staying compliant. After you reach a certain level of sales volume, one of the major bonuses of using an automated sales-tax filing software is knowing that all deadlines are being met and your discounts are secure.
High volume sellers also need to be aware of prepayment requirements. In some states, such as California, you may be required to file quarterly sales tax returns, but prepay the sales tax you owe on a monthly basis ahead of the quarterly filing. For example, if your taxable sales in California average more than $17,000 per month, you must prepay each month’s collected sales tax by the 24th of the following month, and file your returns quarterly.
To further complicate matters in California, the state only requires you to prepay 90% of your monthly tax liability, so you can hold onto some of the cash until the end of the quarter. Again, prepayments, in states that require them, only apply to businesses with a large annual tax liability.
In Georgia, for instance, the figure is over $60,000 in state sales tax liability for the year, and monthly prepayments due are 50% of estimated tax. While in Minnesota, if you owe more than $10,000 in sales tax in a year, you’re required to make one accelerated payment in June. As you can see, state sales tax rules vary enormously, which leads to our 4th way to avoid an unnecessary audit.
Accelerated payments are usually a portion of the total tax liability due.
4. Use software to ensure accuracy in calculations.
Especially if you make sales in multiple states, your sales tax calculations can be complex. Rules vary wildly. And hundreds of different sales tax rates can apply in a single state, depending on the local taxes charged. If you make mobile sales, the correct sales tax rate may change as you change locations. If you sell from multiple locations even within a single state, the rates may vary.
For that reason, using software to collect the tax and ensuring that your online carts or in-person POS systems are set up accurately can go a long way toward avoiding mistakes and getting flagged for an audit. Some business owners make the mistake of assuming that shopping carts and payment software such as Square update automatically when sales tax rates change, but that is not the case.
It’s up to you as a business owner to make changes within your POS systems. Considering that sales tax laws change regularly, it’s a good idea to consult an accountant and have her review your sales tax setup quarterly.
Once you reach a sufficient sales volume, automated tax-filing software will save enormous amounts of time and reduce the possibility of expensive errors.
Look for software with built in audit protection so you'll be covered no matter what.
5. Invest in audit protection.
This is another way to gain peace of mind and reduce the potential cost of an audit. Often tax preparers offer this form of insurance against the financial risk of an unexpected audit. Depending on your sales tax liability and the volume of sales you do, audit protection can be a worthwhile investment.
The investment may not be necessary depending on your software, however, as sales tax software now often comes with its own built-in audit protection. With LumaTax, for instance, any sales tax audits that include returns we filed on your behalf are guaranteed to be handled by our own team of tax experts.
Typical audit red flags
If you own your own business or have self-employed income, you’re already at a greater risk for an audit than the average tax payer when it comes to taxes across the board. Some conditions that seem to bring special scrutiny from the IRS on the whole (not just with sales-tax) include:
- cash-intensive business activities
- excessive deductions
- high-grossing sole-proprietorships
- substantial net losses
Statistically speaking, the IRS does seem to pay special attention to cash-heavy businesses such as restaurants and hair salons and pass-through entities such as S corporations and LLCs, so keep that in mind. Whatever the case, if you’ve built in these best practices when it comes to your sales tax returns, you’ll be ahead of the game and less likely to be adversely affected if an audit should occur.
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