State & Local Tax Blog

How to Conduct a Reverse Sales Tax Audit

The word “audit” has a negative connotation for most business owners. But because of recent sales tax developments, many online sellers are taking a proactive approach to their compliance by conducting audits of their own. In this post we break down the benefits of a reverse audit and how to conduct one.

What’s a Reverse Sales Tax Audit?

A sales tax audit is a review by an auditor from a state department of revenue to assess if a business properly collected, remitted and paid sales tax. If the state finds you’ve failed to meet these obligations, then the state will require you to pay owed taxes, penalties and interest.

A reverse audit is exactly what it sounds like: an audit by the taxpayer and their accountants of their sales tax compliance to identify and recover overpayments. Unlike a traditional audit, the goal of a reverse audit is to save you money.

Reverse audits have been commonplace for decades. Manufacturers often use this tactic to recoup sales tax from vendors and states, as sales tax can get messy in that stage of the supply chain.

But massive changes to sales tax in recent years have made them more relevant than ever. With legislation changing constantly and states auditing with unprecedented intensity, many online sellers are starting to see the benefits of taking a proactive approach to their compliance.

What Are the Benefits of a Reverse Audit?

While there are a number of benefits to conducting a reverse audit, the biggest one is pretty obvious: it saves you money. A lot of money.

Hundreds of thousands of dollars are up for grabs. Seven-figure savings are possible.

But beyond the obvious financial incentive, there’s another great reason to conduct a reverse audit. You get to review your finances on your own terms and timeline.

An audit is a stressful, time-intensive process that’s designed to create revenue for the state and expenses for the taxpayer. You can – and should – fight an audit by bringing up exemptions to offset penalties. But it’s much easier to do so through an independent review that’s designed to improve the financial standing of your business.

How Do I  Conduct a Reverse Audit?

Identify Your Nexus

Before you can reduce your taxability, you’ll need to know precisely where you have sales tax nexus.

Nexus is a link or connection to a state that allows that state to impose a sales tax responsibility upon you. There are two types of nexus:

  • Physical nexus is when your business has a physical presence in a particular state.
  • Economic nexus gives states the right to force out-of-state sellers to collect and remit sales and use tax if they meet or exceed a state’s economic threshold.

Conducting a nexus review involves looking at every state where your business has made sales to see if you meet either of these criteria. After the nexus review, you’ll know exactly what your nexus footprint was and in which states you had a responsibility to collect tax.

Once you’ve completed a clear assessment of your tax responsibility, you’ll have a strong foundation to mitigate your sales tax responsibility and address any issues.

Determine if What You Sell Is Taxable

After conducting a nexus review, you should then look at the products you’re selling and evaluate if the items were taxable.

Depending on your industry, you might find that a portion of your sales are not taxable. For example, in some states the sale of supplements and nutrition products are either non-taxable or taxed at a reduced rate. The sale of apparel and skin care products might also be non-taxable.

Identify Exemptions

Sometimes, one of the parties involved in a transaction won’t have to pay sales tax on a taxable product or service. This is known as a sales tax exemption. Exemptions reduce the amount of tax a business is required to collect and remit.

There are two main types of exemptions you should look for.

First, if you’re a wholesaler, some transactions are tax-free if you collect and save the right exemption certificates. This moves the taxability of the product from the middle of the supply chain to the end consumer.

Second, if you sell to exempt groups – like schools, non-profits and government agencies – you won’t have to collect and remit sales tax on those transactions.

Identify Who’s Responsible for Collecting the Taxes

After a taxability review, reducing the exposure for uncollected taxes, you should then look for transactions where your business wasn’t actually responsible for collecting the tax.

On every taxable transaction, someone is liable for collecting and remitting sales tax. On most transactions, this responsibility falls on the seller. But in states with marketplace facilitator laws, facilitators are responsible for collecting sales tax on every transaction.

If you look through your sales and identify every marketplace transaction that occurred in states with marketplace facilitator laws, you can shift all the responsibility for these transactions to the facilitators.

Conclusion

If your business collects and remits state sales tax, there’s a good change you could recover overpayments or out-of-pocket expenses by taking a closer look at your compliance. For online sellers looking to improve the financial standing of their business, reverse audits provide a favorable and manageable process for doing so.

Need help conducting a reverse audit? We’re here to help. Fill out our short What’s Next questionnaire to get in touch for a free 45-minute consultation.

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