State and local tax audits are becoming more frequent, targeted, and complex. As states expand enforcement efforts and rely more heavily on data-driven tools, organizations face heightened scrutiny across a broader range of tax types and filing obligations than they did just a few years ago.
The challenge isn’t just responding when an audit begins. It’s understanding where exposure may exist, strengthening documentation before questions arise and the audit notice is received by taking practical steps to improve readiness across the full audit and dispute cycle. A proactive approach can help reduce risk, improve outcomes, and limit disruption to the business.
A changing state audit environment
States are taking a more aggressive and increasingly sophisticated approach to identifying audit targets. In many cases, audit selection is no longer driven solely by what appears on a tax return. States are comparing information across agencies and using nontax data points, such as permits, payroll registrations, and other filings, to identify organizations that may have additional filing or payment obligations.
That broader view is contributing to a more expansive audit landscape, especially in higher-revenue areas such as income and franchise tax, gross receipts tax, and sales and use tax. For business leaders, the implication is clear: state audit risk may arise from more places than expected, and long-standing assumptions about where an organization does or doesn’t have exposure may deserve a fresh look.
What to expect during the audit process
A state tax audit typically begins with a notice that outlines the tax type under review and the periods covered, which often span three to four years. From there, auditors generally request detailed records, including sales data, payroll records, fixed asset information, and other supporting documentation needed to evaluate the organization’s compliance position.
Where states are focusing audit attention
Income and franchise tax
For income and franchise tax audits, states are often focused on nexus determinations, apportionment, the validity of deductions, or specific state modifications. Service companies may face added complexity around sourcing methodologies, particularly where market-based sourcing and cost-of-performance rules produce different outcomes across jurisdictions. Organizations should also pay close attention to throwback or throw out rules, state conformity to federal tax changes, and decisions not to file in states where the business may now have economic or physical nexus.
Gross receipts tax
Gross receipts taxes (GRT) can create exposure in states that don’t fit the traditional income tax model. Businesses may overlook GRT filings because they often fall outside the traditional income tax compliance framework. Audit activity in this area often centers on sourcing, nexus, and the composition of the tax base. For organizations with multiple legal entities or changing ownership structures, group reporting rules can add another layer of complexity.
Sales and use tax
Sales and use tax continues to be one of the most common and consequential audit areas. States typically review if tax was collected and remitted, the accrual of use tax on purchases, exemption certificates for customers/transactions treated as nontaxable, and whether the organization has established nexus under either physical presence or economic threshold standards. Taxability can also vary significantly by state and, in some cases, by locality, making it important to revisit how products and services are classified as the business evolves.
Further, sampling is an important part of the sales and use tax process, particularly for organizations with high transaction volume. Sampling allows auditors to review a subset of transactions and apply the resulting error rate across a broader population. Sampling can be done using different methods and populations, so it’s critical to understand each of these before agreeing to sampling. It’s also important to remember that for transactions which are treated as tax-exempt, the burden of proof often rests with the taxpayer to prove the transaction is nontaxable. For evidence that a transaction is exempt or nontaxable, organizations may need to provide specific documentation, such as an exemption certificate.
Additional areas of audit risk
Audit exposure isn’t limited to traditional tax returns. Unclaimed property, employee withholding, pass-through withholding, unemployment insurance, and workers’ compensation-related obligations can all create risk. These areas may be especially important for organizations with remote employees, multistate operations, or legacy accounts that were never properly closed. In some cases, the lookback periods and penalties associated with these issues can be significant.
How organizations can mitigate audit risk
Reducing audit risk starts with identifying potential exposure early. As organizations expand into new markets, add new services, hire employees in additional states, or modify their operating structures, their state tax footprint can change quickly. Periodic reviews can help leadership understand where obligations may exist before a notice arrives.
A nexus study can help determine where the organization may be subject to tax based on its activities, people, and revenue footprint. A taxability study can provide clarity on whether specific products or services are taxable and highlight differences between states. Together, these assessments can support more consistent compliance and reduce uncertainty when positions are challenged.
Documentation and internal controls also matter. Maintaining exemption certificates, preserving supporting documentation, and ensuring key tax processes don’t reside with only one employee can make a meaningful difference during an audit. Organizations are often in a stronger position when records are organized, responsibilities are clear, and supporting documentation and tax accounts are accessible.
A consistent use tax policy can also help improve purchase-side compliance, particularly for larger invoices and fixed asset purchases. While this process can be difficult to manage, it’s often one of the clearest opportunities to reduce unexpected audit adjustments.
When historic exposure already exists, a voluntary disclosure agreement (VDA) may provide a path to resolve liabilities proactively. Through a VDA, taxpayers can file three or four years of returns and pay the tax due (plus interest), and in exchange the state will waive tax for periods prior to the lookback period and waive penalties for the filed taxes. Certain states may require additional years of returns as VDA terms are different from state to state. This allows organizations to address issues and move forward with a clearer compliance strategy.
Key takeaways for business leaders
- State tax audits are becoming more frequent, data-driven, and expansive, increasing risk across a broader range of tax types and obligations.
- Audit exposure often extends beyond tax returns, as states use cross-agency data and nontax filings to identify compliance gaps.
- Organizations must be prepared to substantiate positions with detailed documentation, as the burden of proof typically rests with the taxpayer.
- Key audit focus areas include income/franchise, gross receipts, and sales and use taxes, with additional risk in areas like unclaimed property and payroll-related obligations.
- A proactive approach — through nexus studies, taxability assessments, and strong internal controls — can help reduce risk and improve audit outcomes.
