When I was a Senior Tax Auditor for the State of California, the number one question business owners would ask me was, “Why did I get selected for an audit?’  

The answer to that question is rarely straightforward. Below I’ll describe the most common red flags that can lead to a small business audit—and what you can do to reduce your risk of getting one.

The surprising truth about audit risk

This may come as a shock to some business owners, but you’re far more likely to be audited by your state than the IRS.

Why? Cash-strapped states bring in ridiculous amounts of money by collecting taxes—so they want to make sure businesses are paying up.

How much money are we talking about here? Well, a lot.

Take a look at these stats from the US Census Bureau:

2017 State Sales Tax Collected Graph
In 2017, the U.S. collected $452.8 billion in sales tax. This chart shows the top ten sales tax revenue generators, out of the 45 states that currently collect state sales tax.

When you see how much money comes from sales tax, it makes it easy to see why states spend time and effort collecting all the tax revenue they’re owed.

State government audit departments are the enforcement arm that makes sure businesses follow all sales and use tax laws. Every year, audit agencies across the country uncover billions of dollars in uncollected state revenue in the form of underreported and ‘misplaced’ tax.

Now we’re back to the question: Why would one business be chosen for a state audit over another one? Or in other words, how do I know if my business is likely to get audited?

Thanks to the years I spent conducting audits, I know which errors most frequently capture the attention of state tax authorities. Here they are:

6 things that might trigger a small business audit

1. Compliance issues uncovered during another audit

You may be thinking, “Wait, I can get audited for something unrelated to my business?” Yep. A lot of audits are triggered by documentation found in completely unrelated cases.

For example, state agencies frequently audit/investigate compliance for:

  • Income tax
  • Sales tax
  • Unemployment claims
  • Workers’ compensation
  • Other industry-specific issues

Auditors examine sales invoices, purchase invoices, general ledgers, contracts, bill of ladings and many other common business documents. Often times, this paperwork identifies outside vendors or customers that don’t correctly comply.

This ultimately leads auditors to take a closer loo.

2. Handling lots of cash

Businesses that do lots of cash transactions are at higher risk of being audited. It’s plain and simple; cash is hard to track and trace!

Here’s a tip: if your business deals with lots of cash payments, be mindful of your register setup. It’s well known among tax auditors that businesses that are intentionally misreporting taxable transactions often use one cash register to process credit cards and another register for cash.

If an auditor sees this setup, it will likely give them pause.

3. Disgruntled employee issues

If you have consistent staffing issues, take them seriously. Disgruntled staff members frequently call the state employee tip hotline to report their employers for violations. Many times these calls are ex-employees lashing out. And while the tip given may not be true, they still increase your odds of an audit.

Employee tip hotlines are fertile grounds for state income, sales tax, payroll, state disability, unemployment, and workers’ comp auditors as well.

4. Operating a business in a high-risk industry

There are several high-risk industries that state audit departments tend to focus on. That’s because historically, these types of businesses have a higher rate of compliance errors.   

Noncompliance by NAICS Industry Class Graph - California Least Compliant Industries
Data from the California BOE’s annual review reveals that retail and food services take the top two spots on California’s least compliant list.

Restaurants and retail are regularly found at the top of most ‘least compliant industry’ lists. This is primarily because both of these industries have many factors that can easily lead to reporting errors.

For example, restaurants have to deal with complex variations in tax law for on-premise consumption, to-go orders, deliveries, hot-prepared food, cold food, and surcharges. Retail establishments are faced with calculating tax on a broad range of products that can be purchased over-the-counter or shipped.

Retailers also have many special deductions, exemptions, and sales tax holidays to contend with. Additionally, both of these industries are known to deal with lots of cash and high employee turnover.

5. Having a high ratio of exempt sales to total sales

Industries with a high volume of exempt sales (or sales that are not considered taxable) are at a greater risk for an audit. The same thing goes for businesses with sudden large increases in the number of exempt sales they report.

On the flip side, a significant drop in taxable sales can also be a red flag for auditors, as can frequent refund and large tax credit claims.

So why are exempt sales so tricky to navigate?

Compliance means business owners have to follow complex rules. Plus, exempt sales require extra documentation. This results in frequent recordkeeping errors, which can be a big issue since the burden of proof always falls on you, the taxpayer.

Accurate recordkeeping and careful attention to detail are key to avoiding audit triggers when it comes to exempt sale compliance.

6. Neglecting to pay use tax on out-of-state vendor purchases

Most taxpayers fail to pay use tax on eligible out-of-state purchases when the seller neglects to charge tax at the time of the transaction. This common mistake has led many state tax audit departments to use software programs that review tax returns for reported use tax figures.

If you file a sales and use tax return on behalf of your business and the use tax line on your form always has a zero on it, you may be inviting an audit.

Use tax rules are complex and have many variations. In fact, failure to pay use tax is the top area of noncompliance for California businesses owners.

Audit risk reduction checklist for small business owners

Now that you understand what most commonly triggers an audit, let’s talk about what you can do to reduce your audit risk.

Make good recordkeeping a habit from day one

Get smart software with cloud access, back up data often (a good accounting software will help), and keep ALL your receipts. 

Know your tax responsibilities and abide by the rules

Make an effort to understand your responsibilities and adhere to them. Hire a small business accountant to assist in this effort.

 Know where you have sales tax obligations, aka nexus

Study up on your sales tax obligations for each state you do business with or in. Don’t forget about economic nexus, which occurs when a business reaches a specific sales threshold (usually $100K) within a taxing jurisdiction.

 Stay up-to-date on regulations everywhere you owe

State and local tax rates vary, and laws change frequently. To avoid compliance issues, verify that your tax settings are correct in any software you use to manage your business (i.e. payroll software, accounting software, ecommerce platforms, and POS systems). Then, run regular updates if needed.

 Keep the team happy

Disgruntled employees are bad for business and morale. Not to mention, when someone’s annoyed with your business, they probably won’t hesitate to report any issues they see to the state.

A lot of these anonymous calls happen when employees leave. Do your best to avoid this scenario by learning how to amicably part ways if you have to terminate an employee.

Consider outsourcing sales tax compliance

Whether you opt to hire a business accountant or spring for sales tax software, both of these options will help you take compliance worries off your plate.

Key takeaways

As a former Senior Tax Auditor, I know that most small business owners do their best to be compliant. In fact, I’ve found that most mistakes are unintentional. Sales and use tax laws are far from simple, and it’s difficult to explain all of these things in layman’s terms.

But here’s the gist: Do your best to stay organized and avoid common audit triggers by using the checklist provided. These two things will help you avoid the attention of your state auditor (who very well might’ve been me at one point).

Need help with sales tax compliance? Learn how LumaTax can help your business

Robert Schulte Robert Schulte is a former California Senior Tax Auditor who was responsible for auditing the largest corporations in the state. His innovative computer auditing techniques resulted in more accurate audit results for the state and led him to start three sales tax software companies.
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