How to contest and defend sales tax audits

When to contest an audit, how to prepare, and more.

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Sales tax audits may be an unfortunate fact of corporate life, but not all audits are the same. After a sales tax audit is completed and a company is finally delivered a notice of proposed assessment by the state, the company must decide one of two things: whether to contest the audit findings or simply pay the assessment and move on.

Both options require another set of decisions. Contesting the audit means going through a complex decision tree, the steps of which are detailed below. And even if a company decides to pay an assessment and get on with business, it must decide whether to fix the issue that led to the audit in the first place, or agree to disagree and fight the issue again in the next audit.

Neither decision is simple. But contesting the audit does require immediate action.

According to Bobby Bui, a state and local tax (SALT) attorney who now serves as the Director of Business Development for excise and sales tax in the oil, gas, and chemical industries at Thomson Reuters, the decision to contest an audit should be based on an assessment of the likelihood of winning, the benefit of the win (measured in both dollars and future impact of precedent set), and whether the cost of defending the audit exceeds the benefit of the win (which may be uncertain as well).

“There are generally two issues that drive a sales tax audit assessment,” Bobby says. “The first is a documentation issue, such as missing invoices or contracts to prove whether tax was due and properly assessed or owed. The second is missing customer an exemption certificate to prove a transaction was exempt, which is a tax-technical position taken by the taxpayer on a transaction that the state disagrees with and seeks to assess.”

When should you contest an audit? 

To justify contesting a sales tax audit over documentation issues, Bobby says a company must first believe it has the invoice(s) or exemption certificate(s) to prove to auditors that their assessment is invalid. And even if this documentation is available, he says, before contesting the audit the company should consider the effort and cost necessary to defend their position.

For tax-technical positions, Bobby advises companies to analyze their underlying position with advisors and conduct a more in-depth analysis of the impact of a win or loss. There may be more than just the dollars at stake, after all, especially if a current assessment may impact future transactions.

According to Bobby, before contesting a sales tax audit, some general factors to consider are: 

• The likelihood of success: Do you have the necessary documentation? And if so, is it sufficient to ensure victory?

• Cost-benefit analysis: Considering advisory and legal fees, internal costs (time, money, effort), and other ancillary expenses to contest the audit, is the reward going to outweigh those costs? If so, by how much?

• Other business factors: Would losing jeopardize some other area of the business? Government contractor bids in that jurisdiction, for example, or other areas beyond tax where perfect compliance is a must-have qualification for doing business?

• Negative publicity: Might contesting the audit result in bad publicity that affects other areas of the business or tarnishes the company’s reputation? And does that potential cost outweigh the value of the audit liability in question?

• Future impact: Would a negative decision now set a bad precedent and have worse repercussions in future audits and/or future capital projects?*

*For example, Bobby says: “Suppose you bought one compressor in the 2022-23 tax year and that is the only issue auditors are concerned about, so the dollar amount of the assessment is small. But suppose you bought 1,000 compressors in 2024, and you know auditors will raise the same tax issue in the future. In that case, you might decide to defend a single position even if the amount is small, because you know that if you let it go and the decision goes against you, it could come back to haunt you.”

How should you prepare for an audit defense? 

If after weighing these considerations the company decides to contest a sales tax audit, the tax team is typically tasked with preparing the company’s defense. Though in truth, Bobby says, tax teams should start preparing the company’s defense as soon as they are informed of the audit.

“The moment you get notified of an audit, you should start preparing—both for the audit itself and contesting it—because you have to assume that the assessment is going to be negative,” he says.

Preparing for a sales tax audit defense means: 

• gathering all the necessary documentation (invoices, exemption certificates, tax memos, workpapers, etc.)
• reconciling the company’s accounts, balances, etc.
• determining what information is missing and how to find it

By the time the auditors arrive, Bobby says, the tax team should already know what issue(s) the auditors are concerned about, whether the information they are looking for is really missing (and if not, where it may be), and whether the company can credibly defend its position.

How can automation help in an audit defense? 

After a few meetings with auditors, the tax team will know what information auditors have requested and have a good sense of what key issues may arise in the audit. At this point, the tax team should also have a good feel for how strong the company’s defense is (for example, availability of documentation, validity of tax positions, errors, etc.).

At this stage of the process, there is typically a period of information-sharing back and forth, Bobby says, during which auditors request information to clarify questions. Both the data-gathering and data-sharing stages of the sales tax audit process are where automated tax technology and robust tools for tax analysis can really help.

“The right technology and IT infrastructure allows you to provide data to auditors in a quick and timely manner,” Bobby explains. Furthermore, he adds, “being able to respond to auditors with structured, standardized reports—as opposed to reports that are manually cobbled together—builds a lot of trust and confidence in both the process and the data. It also builds confidence in the tax department, because the data isn’t being manipulated, it’s a push-button report that’s coming from a single source connected to the ERP system, which is the source of truth for everything.”

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A faster, more accurate audit process 

So, for example, if an auditor is concerned about a single transaction that occurred three years ago, a capable tax engine should be able to pinpoint that transaction, and also show the logic upon which the decision was made. If the company can show that their tax system has already flagged the issue and corrected it, “that kind of proof is very persuasive,” Bobby says. Such proof can convince auditors that they don’t need to scour through a company’s entire transaction history for similar occurrences of the same issue, Bobby says, “because given the same set of facts, an automated solution will make the same tax decision—so if you trust the data and the process, why test other transactions?”

The ability to quickly answer questions for auditors and access data when it is requested also results in a faster audit, Bobby says, saving time and money.

“Automation makes responding to audit requests a much quicker process, not only because the speed of data-gathering and reporting is so much faster, but because the auditor can look at the process and the software and be confident that the information you are providing them is accurate and trustworthy.”

What if a sales tax audit needs to be appealed? 

Sometimes, the issue under audit cannot be resolved and must be addressed by an administrative board or, worst-case, in court. In such cases, Bobby says, members of the tax team typically take a supporting role to the legal team, providing relevant data, affidavits, and testimony.

Here again, an automated tax system’s ability to isolate relevant data and provide fast, accurate reports helps speed up the litigation process and, if outside legal counsel is being used, reduce their billable hours. Likewise, if the company is employing outside advisors to assist with the audit defense, an automated tax engine “can help streamline the whole process and reduce the need for extra advisory support,” Bobby says.

Win or lose the audit, there is more work to do 

Finally, even if a company wins an audit appeal, the tax team’s work is not finished. Upon winning an appeal, Bobby says, the tax team should go back and make sure the state’s assessment is correct and, if money is due back to the company, that everyone agrees on the final amount.

After the close of any audit, Bobby also advises companies to review their tax policy and, if warranted, make any necessary changes. He also advises companies to update configurations in their tax engine so that the processing of future transactions is consistent with the agreed-upon audit findings.

And if an appeal is lost? “Losing means going back to the original cost-benefit analysis to decide if continuing to fight is worth it,” Bobby says. “It’s only going to get more expensive the farther you move down that chain, because then you have to re-do the work and re-litigate the entire case.”

Implementing sales tax technology such as ONESOURCE Determination in your tech stack can save time and make preparing for an audit defense much easier. Automating indirect tax processes takes the risk out of the equation by driving greater efficiency and giving numbers you can count on.

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