Q: A small business recently learned that they should be collecting sales tax on the portion of their revenue that they previously thought was not taxable (labor and delivery). They immediately updated their sales tax process going forward but what should they do with prior periods? Should they accept the risk and wait and see if they get audited? What do you commonly see done in these situations?
A: The appropriate course of action depends largely on the small business's financial situation, the amount of the liability, and the owner's risk tolerance. If the business has the resources to pay the delinquent sales tax, or if the liability amount is relatively small, voluntarily declaring and settling the liability is typically the best option. This approach provides peace of mind, eliminating the worry of future penalties, interest, or audits.
For businesses that lack the ability to pay or are willing to accept the risk, waiting to see if an audit occurs is an alternative. However, it’s important to assess the potential liability, including penalties and interest, and consider setting aside a reserve to cover the payment in case the tax authorities initiate an inquiry. One critical factor to consider is the extent of the correction. If the change in reported sales and sales tax from prior periods to the present is significant, it may raise a red flag with the tax authorities, potentially increasing the likelihood of an audit.
In terms of common practices, it’s a mixed approach based on the liability size, risk tolerance, and financial capacity. This is what we typically see:
- For smaller liabilities, most business owners choose to settle.
- For larger liabilities, about 20% opt to pay, assuming they have the financial ability, while 80% take the risk of not paying. Of that 80%, approximately 50% are unable to pay, and 30% have the means but are willing to take on the risk.