Sales tax audits are on the rise across the United States, particularly for remote sellers. Since the 2018 South Dakota vs. Wayfair case, many states have become more aggressive in pursuing online retailers, particularly those operating across state borders. In this blog, we will go over how to prepare your business for a sales tax audit and ensure your business is “audit-proof.”
Step 1 – Understanding What Triggers an Audit
Common triggers for audits include, but are not limited to:
- Exceeding economic nexus thresholds and not registering for a sales tax account
- Irregular filing, such as late filings, missed periods, or zero returns in high-volume filing periods
- Missing or invalid resale certificates, such as expired forms, missing signatures, incorrect formats
- States sharing data with other states – States increasingly share data with each other, and if one state begins an audit, others may follow suit.
- Customer complaints – This can happen if a customer is charged the wrong tax and reports it to the state.
- Rapid growth without compliance updates – States monitor online marketplaces, so your business growth can cause them to investigate your business.
Step 2 – Managing Economic Nexus
How you manage economic nexus is a vital part of preparing your defense for a sales tax audit. Economic nexus is something that often blindsides fast-growing and successful businesses, particularly when focused on growth and not compliance. Economic nexus is a rule that determines whether a business must collect and remit sales tax in a state based on its sales activity, through total sales or transaction thresholds, rather than physical presence. ‘Exempt sales’ through marketplaces, like Amazon or Etsy, can also contribute towards reaching economic nexus.
The requirements differ depending on the state. If your business meets a state’s economic nexus threshold you will be required to register your business there for a sales tax account. Not registering once threshold is reached is a major audit red flag.
Therefore, it’s very important to monitor the nexus thresholds. Start by identifying where you commonly ship products and have customers. Track your sales by state, which can be done using software built into e-commerce platforms, like Shopify and BigCommerce, or through online accounting software, like QuickBooks or Xero. This should be reviewed regularly, even after you have prepared your ecommerce business for a sales tax audit.
Step 3 – Registering for Sales Tax Accounts and On-Time Filing
As mentioned above, when economic nexus is reached, you must register for a sales tax account in the state. Registration can be done online through the state’s Department of Revenue website. Preparing for a sales tax audit by ensuring you’re properly registered is how you can establish a defense against triggering an audit, with some states assessing back taxes on sales made since you crossed the threshold. Interest and penalties can be applied to those amounts, making it very costly for your business.
Once you have a sales tax license in a state, you will be legally required to file returns on a monthly, quarterly, or annual basis based on the volume of your transactions or specific rules of that state. This is regardless of whether you’ve made any sales, and even if no tax is due. Staying on top of those deadlines and filing on time is important when preparing for a sales tax audit. That is how to avoid penalties or estimated taxes added to your accounts.
Step 4 – Maintaining Documentation
It is highly important to maintain audit-proof documentation. This includes:
- Valid resale or exemption certificates
- A tracker to know when the exemption certificates expire
- Sales tax registration letters
- Business formation documents
- Federal EIN confirmation letter
- Filed sales tax returns and payment confirmations
- State correspondence, such as notices, renewal reminders, and account information
It isn’t just good practice to prepare for a sales tax audit. It’s how you create a legal safeguard that can protect your business from costly audits, hefty unexpected fines, and disruptions to your operations. You should have an effective system, such as an online drive or dedicated folders on your hard drive, to store the documents above. It’s good practice to also have backup copies and printed copies.
If you have exempt sales, you must also be able to provide a valid resale certificate. This resale certificate must be properly filled out, signed and dated, state-specific, and accepted by that state. It is to be noted as well that some resale certificates have expiration dates, such as the end of the calendar year or three years from the date of issue. These need to be regularly renewed and up to date, especially when you are preparing a solid defense for a sales tax audit of your ecommerce business.
As a wholesaler, it is important to make sure that you are regularly checking the resale certificates that are provided to you by sellers to ensure that they are properly filled out, signed, and applicable for the correct states.
This is all highly important as some of the consequences of poor documentation include retroactive sales tax assessments, penalties, interest on penalties, and sometimes revoked sales tax exemption status.
Step 5 – Consider VDAs
This step in how to prepare for a sales tax audit focuses on VDAs. If you’ve already triggered economic nexus in a state but didn’t realise or register, then don’t panic. You can file a ‘Voluntary Disclosure Agreement’ and come forward voluntarily before an audit begins. This demonstrates your willingness to comply and can help limit how far back a state will assess your sales tax liability, reduce your penalties and interest, and allow you to register without triggering red flags.
This is a proactive approach that can save your business thousands in penalties. It’s always recommended to prepare a VDA before a state initiates an audit, as once a sales tax audit is underway, the option for a VDA isn’t usually available. Working with a tax specialist early can help your business stay on top of the requirements, prevent errors, and save significant time.
How Can RJM Help?
Here at RJM Tax Exemption, we have bespoke software that integrates with Amazon and Shopify to monitor your economic nexus in real time to determine how close you are to passing thresholds. This helps you better prepare a defense for sales tax audits of your ecommerce store. When economic nexus is reached, we can notify you and automatically apply for the necessary sales tax account.
We also offer services checking and verifying sales tax exemption certificates, securely storing your important business documents, and keeping you up to date with the latest state and federal tax regulations. We can help you be ‘audit-ready’ and worry-free year-round, and not just in tax season.
If you have any questions or would like any additional information, please reach out to us.
