What Auditors Really Want: How to Document Sales and Use Tax Transactions Before an Audit Starts
The outcome of many sales and use tax audits is determined long before the auditor arrives. It is determined by the quality of the company's documentation.
One of the most common comments I hear from business owners during an audit is: "We know the transaction was exempt, but we can't find the paperwork."
Unfortunately, knowing something happened and proving it happened are two very different things.
When I review audits, I rarely see businesses lose because they intentionally violated the law. More often, they lose because they cannot adequately support what they reported on their tax returns.
Every Tax Return Is a Statement of Fact
When a taxpayer files a return, they are asserting that the information reported is true, correct, and complete. The purpose of an audit is to gather evidence supporting or challenging those assertions.
An audit is much more than determining whether company records "match" the tax return. Auditors are expected to gather and analyze evidence to determine whether the law was applied correctly.
That's an important distinction. Just because a transaction appears on your general ledger does not automatically mean the tax treatment was correct. You need documentation that explains what occurred and why the tax treatment was appropriate.
The Two Words That Matter Most: Relevant and Reliable
Evidence must be both relevant and reliable. Relevant evidence relates directly to the issue being examined. Reliable evidence comes from trustworthy sources and can withstand scrutiny.
Many companies provide documents that are relevant but not particularly reliable. For example: an employee email explaining why tax was not charged; a spreadsheet created after receiving an audit notice; a written statement describing what management believes happened.
These documents may be relevant, but auditors are trained to seek stronger support whenever possible. The strongest evidence is generally documentation created during the normal course of business, at the time the transaction occurred. Documents created when the return was originally prepared are generally more reliable than documentation created after the audit begins.
Why Exemption Certificates Matter So Much
Nothing illustrates relevant and reliable evidence better than exemption certificates. If you make exempt sales, your exemption certificate is often the single most important document supporting the non-taxed transaction.
During audits, I frequently encounter situations where the certificate is missing, incomplete, was obtained after the audit started, or does not match the customer or transaction.
An auditor does not simply accept a statement that "the customer was exempt." They want documentation proving it. The best time to obtain supporting documentation is when the sale occurs, not years later when memories have faded and employees have changed.
Auditors Are Trained to Look Beyond Verbal Explanations
Auditors will be cautious about accepting verbal or written assertions in place of actual evidence. Statements such as "We've always done it that way," "Our accountant told us it was exempt," "I remember that customer being tax-exempt," or "The vendor said tax wasn't required" are rarely sufficient on their own.
Those explanations may provide context. They are not evidence.
If you're relying on a tax position, you should maintain documentation supporting that position, including contracts, invoices, exemption certificates, purchase records, correspondence, and tax research when appropriate.
The Seven Ways Auditors Gather Evidence
There are seven common evidence-gathering techniques used during audits: inspection, observation, inquiry, confirmation, recalculation, reperformance, and analytical procedures.
- Inspect contracts, invoices, and exemption certificates.
- Observe manufacturing or business operations.
- Interview employees.
- Confirm information with banks, customers, or other third parties.
- Recalculate tax computations.
- Reperform processes independently.
- Analyze financial relationships and trends.
This means documentation should not merely exist. It should also be consistent across multiple sources. For example, if a company claims a manufacturing exemption, auditors may review invoices, tour the facility, interview personnel, and inspect production equipment. If the documentation and observations tell different stories, questions arise quickly.
Documentation Should Tell a Complete Story
Evidence should help prove a fact without requiring assumptions. When documenting sales and use tax transactions, ask yourself: Would someone unfamiliar with this transaction understand why tax was or was not charged? If the answer is no, you probably need additional support.
For significant transactions, your file should answer:
- Who was involved?
- What was sold or purchased?
- When did it occur?
- Where was it delivered or used?
- Why was the tax treatment applied?
That's often the difference between a smooth audit and a painful one.
Be Prepared Before the Department Asks
Instead of waiting until an audit begins, proactively identify the documents necessary to support your tax positions. If you cannot easily produce supporting documentation today, an auditor will likely have the same challenge tomorrow.
- Exempt sales
- Manufacturing exemptions
- Resale purchases
- Promotional giveaways
- Drop shipments
- Multi-state transactions
- Use tax accruals
- Software and technology purchases
The Bottom Line
Audits are evidence-driven. Auditors are trained to evaluate whether evidence is relevant, reliable, and sufficient to support a taxpayer's position.
The organizations that navigate audits most successfully are not necessarily the ones that never make mistakes. They are the ones that maintain organized, contemporaneous, and well-supported records that clearly explain their tax decisions.
When documentation exists and tells a consistent story, audits typically proceed much more smoothly. When it doesn't, even a technically correct tax position can become an expensive assessment.
"Good documentation doesn't just support compliance. It is often your best audit defense."
— Holly Hoffman
Is Your Documentation Audit-Ready?
Holly Hoffman is a former WI Dept. of Revenue auditor and the owner of Sales Tax Advisory Network, LLC. She helps businesses identify documentation gaps before an auditor does.