Most Illinois tax professionals can tell at a glance whether a small business is at risk for an Illinois sales tax audit. Here are some of the reasons.

There have been ongoing changes in the work people do and the way in which they do it, which have been brought to the forefront do to changing technology. Covid, of course accelerated all of this, pushing us off of an edge into the world of “work from home” and dramatically changing the way people did their jobs before most of us had a chance to adjust. None of this was lost on the State of Illinois Department of Revenue, an agency which had already been an early entry into getting their auditors “out in front of the screen”, with many audits being performed in substantial part from remote locations. The changes in technology and in the manner in which much work is done has, if anything, only enhanced the State of Illinois Department of Revenue’s ability to enforce the tax law. This includes not only State tax law, but also includes certain Federal tax law based on agreements with the Federal Government to include issues which had previously been the exclusive audit territory of the Internal Revenue Service.

The State of Illinois has created a very efficient system of tax compliance and enforcement, to process returns and payments, as well as to resolve questions that come up in the course of doing the processing. The system includes direct audits of business which are subject to Illinois taxes as necessary to maintain compliance. During the pandemic, State auditors generally did not perform on-site audits, audits in which they travel to the business location and review business records in-person, as they did pre-pandemic. Instead, the State had its personnel conduct audits away from the business locations, generally using e-mail to conduct the audits from the State auditor’s home.

During that time, the State of Illinois Department of Revenue is doing an excellent (if painful) job, in comparison to most other taxing authorities, of making sure that their employees were able to work from home by making sure their auditors have the equipment, the programs, the authority and the guidance to do the work from home.

At the present time (post-pandemic) the State will and does regularly conduct audits in which auditors travel to business locations and review records. Now, however, the State auditors use technology, including information from third party sources more than ever. In addition, a large amount of the work which used to be performed at the office of the business or accountant is being performed by the auditor from an offsite location. At the present time, the overall experience with the State of Illinois is that it has become more capable and more aggressive in enforcing the law than it had been in the past. This increase in aggression may be the result of efforts to make up for time lost during the pandemic. In these conditions, you may find that your business becomes the subject of a State of Illinois audit, and when that happens, chances are that the subject of that audit will be Illinois Sales and Use Tax.

The State of Illinois provides an indication of how it selects businesses returns for audit on it’s website (at random, by referral, by nature of business, by past audit history, and by tax issue). While I don’t doubt that the State selects businesses for audit under each of the categories listed, based on a lot of experience in assisting businesses through audits and their repercussions, like many tax attorneys, I have my own lists of ways in which I believe the State selects returns for audit. I propose that State of Illinois business returns are most commonly selected for audit for one of the following three reason:

1. The tax return does not make sense in for the type of business operated or the location from which the business operates.

2. The figures in some tax returns filed by the business do not agree with other tax returns filed by the same business for the same year and on the same subject.

3. The State has information received from third parties and with the tax returns filed by the business do not make sense in light of that information.

Regarding business whose tax returns do not make sense for the type of business or the area in which they operate, businesses of the same type tend to produce similar financial statements. As a result, businesses such as retail sales companies, restaurants, automobile or equipment sales companies and other entities, may all be expected to have financial statements that are similar to other businesses of the same type, generally surprisingly similar.

It is true that businesses can be operated in an entirely differently manner from their competitors or have entirely different results of operation. Each business has its own operating techniques and the level of profitability can vary greatly from one business to the next. There can be “superstar” businesses which have very profitable operations and “low performing” business which don’t do as well. However, tax personnel know, that most businesses of the same type operate in substantially in the same manner, with consistent results for businesses of the same type. Outliers are, by definition, the exception to the rule.

A tax returns where the cost of the payroll, product, food, material or other expenses are not in proportion to sales, or in proportion to the figures reported by similar businesses of the same type in other categories, can be considered to have a “red flag” telling the Department of Revenue that a business is not reporting its income or expenses properly. The Department of Revenue actually uses “rules of thumb” to gauge whether a business is properly reporting its sales. An example is that in regard to sales of food, without knowing anything else about a business, the an auditor would expect to see the gross receipts generated from food sold at a restaurant to be at least three times as much as the amount that is expended on food purchases. A similar rule of thumb would be in effect for liquor, however, in that regard, the three times rule would be the minimum amount the State would expect to be generated.

Another example of a tax returns which “do not make sense” are tax returns which show consistent yearly losses, sometimes very high losses, without showing equally substantially contribution to the business by the owner or investors. Why exactly would any business owner continue, year after year, to operate a business which always loses money? This is a question which the State of Illinois frequently determines is worth looking into.

A category of audit which is not mentioned on the State website but which generates audits is where a business files returns, such as sales tax returns where the total sales reported differs significantly form the cumulative sales reported on the related income tax returns filed by the same business for the same period. When this type of an event occurs, it is frequently the Sales tax returns where the income is understated, as that tends to be where the tax savings from understating the income is most apparent to the business owner.

With Sales taxes as high as they are in this State it is understandable that businesses would be tempted to use whatever techniques they can to minimize that cost. Aggressively pursuing this course can result in incongruities which create problems for the business. Business owners should be aware in particular that in this State, it does not require a large understatement of tax due before penalties and personal liabilities come into play. To make matters worse, the State Criminal Law has set a low threshold for violations in this area. At times this low threshold can result in, what appears to be selective enforcement “opportunities” depending on which section of the Department of Revenue first becomes interested in the discrepancies. On many occasions it is a disgruntled person, a spouse, business partner or employee who provides the information which initiates the audit. Audits which originate from information presented to the Criminal Division, unsurprisingly, are more likely to result in the business which initiated the inaccurate returns being subject to criminal enforcement.

The final category I will cover here is where the tax returns filed with the State do not make sense in light of other information available to the State. The state is increasingly receiving reports relevant to the operation of individual businesses from third parties. These reports can be reports from gasoline suppliers, credit card companies or other electronic payment service providers, liquor and food distributors and other entities. To the extent this information is not automatically reported to the State, the information can be and regularly is directly requested from the vendor during the course of an audit. Inconsistencies between information provided by third party vendors and information which ends up on a tax return can be costly for a business and its owners as the State is becoming increasingly able to determine the correctness of returns from information it already has. The failure of a businesses returns to match up to information provided to the State by third parties is an area where there is a built in headache for the tax filer. To paraphrase the line from the “Lucy Show” from years ago, at that point, “you’ve got a lot of explaining to do”.

In any event, if your business becomes the subject of a State audit, is a good idea to get professionals involved in mitigating liabilities at a very early point. Operating a business does not automatically carry with it tax expertise and having a third party handle the matters required by the issues which generate an audit allows business owners to rest more easily and continue to conduct their business, rather than struggle with the complexities of Illinois tax audits.