Navigating the complexities of a state tax audit can be daunting for both businesses and individuals. Unlike federal IRS audits, state tax audits come with unique challenges that vary by state and tax type. Understanding these distinctions is crucial to achieving a favorable outcome.

A state tax audit is a review of your filings by the state’s Department of Revenue or Tax Authority to ensure compliance with state tax laws. Typically, you’ll receive a formal notification specifying the tax years under review and the required documentation. The process may involve submitting detailed records or even hosting auditors at your business—which is a bad idea.

Given the complexities, responding quickly and accurately to any audit notice is important. Consulting a tax expert or attorney can help you prepare, protect your interests, and ensure an efficient resolution.

In this blog, we’ll cover what you need to know about state tax audits, including key differences compared to IRS examinations, common triggers, and the value of professional guidance.

How Does a State Audit Differ from a Federal IRS one?

State tax audits focus on ensuring compliance with state-specific tax laws, which can vary significantly from federal tax codes and regulations.

The states are well equipped to target different types of state and local taxes because these agencies are often more narrowly focused on specific tax types: income, sales, excise, payroll, employment, tourist development,  franchise, and property taxes, depending on the state you live in.

Here are some key differences:

• Tax Jurisdiction: State audits are conducted by the state’s tax authority in accordance with state law, applying different procedures compared to the IRS. Each state has its own tax code and enforcement priorities, which can lead to variations in audit procedures and focus areas.  Having representation by a tax attorney familiar with state law and procedure is imperative because navigating the administrative process effectively often leads to an effective outcome.
• Audit Triggers: States focus on different audit triggers such as residency, nexus issues, use tax reporting, and income sourcing. In addition, states with no income tax might be more aggressive in auditing sales tax compliance.
• Tax Types: As mentioned above, there are various tax types and may have to respond differently depending on the focus of the state tax auditor.

Understanding these differences is crucial because there are exchange of information agreements between the IRS and the state taxing agencies so that an adjustment by one agency often triggers a proposed adjustment by the other.

What Triggers a State Audit?

Understanding what triggers a state tax audit is essential for addressing current examinations and avoiding them in the future. State tax agencies often flag certain behaviors or discrepancies that can lead to an audit. By recognizing these triggers, you can take proactive steps to ensure compliance and minimize the risk of future audits.

Common triggers include:

• Failing to Record All Income: States compare your income reported on federal and state tax returns. Significant discrepancies, particularly underreporting, can raise red flags. This is especially true for businesses with cash transactions or individuals with multiple income sources.
• Nexus Issues: If your business operates in multiple states, you may establish a nexus—a connection that creates tax obligations in another state. Failing to comply with these obligations can lead to an audit. With the rise of e-commerce and remote work, nexus issues have become increasingly complex and scrutinized.
• Failing to Report Use Tax: Many states require businesses to report and pay use tax on out-of-state purchases where sales tax wasn’t charged. This is an area of growing focus for many states, especially with the increase in online shopping.
• Operating a business as a Sole Proprietor: Sole proprietors often face scrutiny due to the way they report their activities and are therefore more targeted and prone to detectable errors and omissions.  In addition, it is often more likely that the business owner might commingle personal and business expense items and attract focused attention.
• Misreported Data: Common mistakes such as math errors, incomplete forms, excessive deductions, or late filings can also prompt state authorities to examine them more closely, particularly if they occur across multiple years.

By seeking professional tax assistance and understanding these triggers, you can implement more accurate record-keeping practices and stay informed about tax obligations in all operating states. This proactive approach reduces the likelihood of an audit and helps ensure that your tax filings are accurate and compliant.

Common State Audit Types:

• Sales Tax Audits: Focus on accurate reporting and remittance of sales tax. Auditors may examine point-of-sale systems, invoices, and exemption certificates, looking for unreported sales, incorrectly applied exemptions, and failure to collect tax on taxable items.
• Payroll Tax Audits: Verify correct withholding and payment of payroll taxes. Audits may Involve reviewing employee classifications (W-2 vs. 1099), benefit calculations, and timely remittance of withheld taxes.
• Income Tax Audits: Ensure income tax filings accurately reflect earnings and deductions. For businesses, audits may involve scrutinizing allocation and apportionment methods, especially for companies operating in multiple states, and the proper application of inventory costing methods, as well as a variety of other issues depending on the industry in which the taxpayer operates.
• Franchise Tax Audits: Check compliance with state-specific franchise tax requirements. These often involve complex calculations based on business activity, structure, and sometimes the value of assets within the state.

A tax professional proficient in handling the type of state tax audit involved is crucial for proper preparation and response. Generally, state audits fall into two categories: desk audits, which are conducted remotely and focus on specific issues like discrepancies, and field audits, which are more comprehensive and involve on-site reviews.

When notified of a state tax audit, please contact a tax professional immediately.  Frequently, when a tax attorney first enters the picture, the taxpayer has already caused irreversible damage and limited the chance for a great result.

If the taxpayer disputes the audit findings or audit results, there are administrative appeal rights that the taxpayer must pursue. The appeals process varies by state but typically involves presenting your case to an administrative law judge or tax appeal board. This is where professional representation is necessary to craft compelling arguments based on tax law and precedent.

The Combined Benefits of Tax Controversy and Tax Compliance Experts

Facing a state tax audit can be overwhelming, but you can navigate the process effectively with the right support. The Tax Workout Group (TWG) specializes in tax controversy and tax compliance, offering a comprehensive approach to resolving state tax audits. Our team of state tax experts can assist in every stage of the audit process, from audit representation to advocating in appeals to litigating in court and even eliminating the state tax claim in bankruptcy if all else fails.   Our team leverages expert knowledge of state-specific tax laws and audit procedures to help minimize your liabilities and protect your interests.

If you’re facing a state tax audit or need guidance managing your state tax obligations, don’t go it alone, reach out to the Tax Workout Group today for expert advice and representation to ensure the best possible outcome for your audit.