As state tax audits grow more aggressive and complex, businesses are increasingly exposed to nuanced issues that can have wide-reaching implications—across entities, jurisdictions, and years. From income tax conformity to sales tax base expansion, the rules are evolving rapidly, and many states are leveraging novel interpretations, third-party auditors, and expansive audit techniques to uncover revenue.

Below are ten key state tax audit topics that companies need to be proactively managing—whether they’re preparing for an audit, responding to a notice, or reassessing their compliance framework.

1. Forced Combination and Intercompany Transactions

States continue to challenge the use of separate-entity reporting structures, particularly when intercompany royalty, service, or financing arrangements are involved. Through discretionary authority or specific statutes, states may require forced combination of affiliates if they determine the structure distorts income.

Auditors increasingly scrutinize:

• Procurement companies

• IP-holding entities

• Shared service or management companies

Taxpayers should prepare robust transfer pricing documentation and understand whether the state permits or requires combined reporting.

2. Embedded Royalties and Nexus Expansion

Several states have asserted that royalty payments to an out-of-state affiliate—especially one owning trademarks or intangible property used in the state—create nexus for the recipient entity. These so-called “embedded royalties” can result in unexpected filing obligations and assessments, even where the affiliate has no physical presence.

Companies licensing IP internally must evaluate:

• Whether royalty streams are “sourced” to the market state

• Whether economic presence standards trigger nexus

• Whether constitutional nexus exists under Wayfair-type analyses

3. Section 163(j) and Other Federal Conformity Challenges

As states struggle with whether and how to conform to federal tax law, businesses face increased audit risk related to partial or inconsistent conformity with the Internal Revenue Code—especially concerning IRC § 163(j) (interest deduction limitations), GILTI, and FDII.

California, for example, selectively conforms to certain provisions but departs from others, creating mismatch between federal and state tax bases. Other states decouple from specific provisions entirely.

Taxpayers must:

• Track conformity by jurisdiction and year

• Adjust provision calculations to reflect state differences

• Maintain reconciliations and supporting documentation for disallowed deductions

4. Apportionment and Market-Based Sourcing Pitfalls

States are increasingly auditing the sales factor and applying strict or novel interpretations of market-based sourcing rules, especially for service providers, licensees, and digital businesses.

Common audit targets include:

• Sourcing receipts based on customer location vs. benefit received

• “Matching principle” disputes where income and expenses are misaligned

• Partnership receipts with unclear sourcing methodologies

Audit exposure increases when states disagree on sourcing method, leading to double taxation or conflicting inclusion of revenue in multiple states’ numerators.

5. Research & Development (R&D) Credit Audits

Although intended as incentives, R&D tax credits are a recurring audit hotspot. States challenge both eligibility and expense allocation—especially when research is performed by affiliates, contractors, or in locations different from where the credit is claimed.

Audit risks include:

• Disallowance of expenses for services not directly linked to qualified activities

• Claims unsupported by project-level documentation

• Denial of credits due to improper apportionment or filing positions

States may also limit the carryforward or refundability of credits, particularly where budgetary concerns drive enforcement.

6. Taxation of Digital Products and Advertising Services

States are pushing the boundaries of how they define and tax digital products, especially in the context of streaming, SaaS, and advertising platforms. Taxpayers often face assessments when states assert that:

• SaaS equals tangible personal property

• Hosting or access equals a taxable lease

• Digital ad spend or analytics tools constitute taxable services

States like Texas and Washington apply expansive interpretations of data processing and marketplace rules, while others like Maryland have proposed targeted digital advertising taxes.

7. Tariffs and the Sales Tax Base

Some states assert that federal tariffs imposed on imported goods should be included in the sales tax base, raising the purchase price subject to sales or use tax.

Audit issues can arise from:

• Import documentation discrepancies

• Bundling of tariffs into total contract price

• Lack of clarity on invoicing or chargebacks

Because there is little clear guidance on how tariffs interact with sales tax, auditors may pursue aggressive positions, especially where the taxpayer failed to separately state or document the tariff charges.

8. Local Tax Audits and Home-Rule Jurisdictions

Audits by local jurisdictions—particularly in home-rule cities and counties—have become increasingly common. These audits may involve gross receipts taxes, local sales and use taxes, or special levies, and are often subject to different rules than state-level audits.

Taxpayers often face challenges related to:

• Filing obligations across thousands of localities

• Nexus assertions by city or municipal authorities

• Inconsistent definitions of taxable services or goods

A key risk is failing to register or file where a delivery address or remote employee creates jurisdictional exposure.

9. Third-Party Auditors and Contingency Fee Risk

More states are outsourcing audits to third-party firms, often paid on a contingency or success-fee basis. These firms may have incentives to:

• Push novel or expansive interpretations

• Over-assess liabilities

• Disregard informal settlements or state-specific practices

Taxpayers should carefully document auditor interactions and ask:

• Is this firm contracted directly with the state?

• Are there rules limiting the scope of delegation?

• Are auditor requests consistent with state law and administrative code?

Engaging counsel early and documenting positions contemporaneously can reduce the risk of aggressive assessments sticking.

10. Audit Process Integrity and Administrative Appeals

Finally, many audit controversies arise not from substantive legal issues, but from flawed administrative processes, such as:

• Missed deadlines for issuing notices or conducting conferences

• Lack of clarity around assessment adjustments or methodologies

• Unresponsive or rotating audit teams

• Limited or closed-off administrative appeal routes

Taxpayers should insist on:

• Written positions with clear rationale

• Timely protest and appeal procedures

• Preservation of due process rights, including discovery and independent review

Where states push for fast-track settlements or discourage appeals, businesses should document everything and consider escalating procedural disputes to higher-level forums or courts.

Conclusion: A Proactive Approach to SALT Audits

State and local tax audits are becoming more frequent, more aggressive, and more complex. The issues outlined above represent just a sample of the audit areas businesses must prepare for—with increasing emphasis on documentation, sourcing, intercompany arrangements, and digital services.

Businesses should:

• Establish robust pre-audit readiness protocols

• Maintain centralized documentation on multistate positions

• Monitor conformity developments and regulatory changes

• Involve legal and accounting teams early—ideally before an audit begins

Ultimately, preparation, consistency, and communication are the best defenses against a costly audit surprise.

© 2025 Jeanette Moffa. All Rights Reserved.