Sam Brotman, JD, LLM, MBA September 7, 2016 11 min read

CDTFA Audits, Pt 1: What Is an Audit and How Are Companies Selected?


Sam Brotman, JD, LLM, MBA

Owner and Director of Legal
Brotman Law

what is an audit and how are companies selected

This post in one in a four-part series explaining how the California Department of Tax and Fee Administration (CDTFA) performs its audit function, what to expect from an audit, how to prepare for it, and what happens when the audit is complete.

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The California Department of Tax and Fee Administration (CDTFA) administrates, enforces, and collects sales and use tax for the State of California. Its purview includes performing audits of businesses to ensure compliance or because a company is under suspicion of tax fraud or negligence. The audit is meant to confirm whether a business has reported and paid the correct amount of sales tax to the state.

The goal of the audit is to:

  • Discover oversight or fraud
  • Promote compliance with state tax law
  • Increase revenue for the state
  • Apply penalties when taxes are found to be owed

Furthermore, the CDTFA shares its information with the Franchise Tax Board (FTB), the Employee Development Department (EDD), and the IRS. Audits, investigations, and adverse consequences from these agencies may be triggered by this shared information.

When Can an Audit Occur?

A sales tax audit occurs when the CDTFA suspects a business’s reported sales have been understated. Typically, records cannot be verified by a direct audit approach, meaning the CDTFA cannot match everything a business reports to it and the other agencies.

When the CDTFA cannot verify through direct audit, it will perform a “mark-up” audit. A mark-up is the amount added to the cost of a good or service to obtain sales tax from the buyer. It is a percentage of the gross profits divided by the cost of goods sold.

A mark-up audit is often used to prove materially misstated or fraudulent accounting, especially for cash-intensive businesses. Auditors are trained to spot illegal programs that periodically make a certain amount of sales and cost of goods disappear from a point of sale system while simultaneously informing an owner how much cash to skim illegally from the POS to make things even.

Auditors will also approach a vendor to compare the dollar amount of goods sold to the business under audit matches what the business’s cost of goods sold account for the same period.

How Are Companies Selected for Audit?

Certainly, a random audit can be scheduled. The CDTFA does state that it will audit nearly 1% of active master accounts each year. However, more often there is a definite trigger that tells the CDTFA when an audit is in order.

The CDTFA looks at these factors to identify potential audit targets:

  • Industry involved
  • Past audit history
  • Amount of total sales tax reported
  • Amount of exempt sales reported
  • Ratio of exempt sales to total sales
  • Where the business is located

A large company with a high sales volume or that reports a high amount of exempt sales are more often targeted than those with smaller sales volumes or no exempt sales. If the ratio of exempt sales to total sales is out of line for the industry, that can trigger an audit, too.

Common Audit Triggers

Failing to Report Sales and Use Tax

This one is pretty obvious, and it isn't that hard for the CDTFA to find out. If you have a website or phone number for your business but are not in the CDTFA’s system, or if you are paying payroll tax or other tax in California but have not registered for sales and use tax, you have a big reg target on your back.

Any time you are selling goods in the State of California or purchasing goods from out of state and bringing them into California (even if it is just passing through) without paying sales or use tax, you can be audited.

If you or your vendors are audited by the CDTFA, it can trigger follow-up investigations by other agencies. Even if you are located outside the state, if you sell anything in California, or it makes a stop in California while being shipped elsewhere, you may be assessed a tax and could be targeted for audit.

Consistently Reporting or Filing Your Taxes Late

If you have a history of failing to report, file, or pay sales tax, the CDTFA becomes suspicious of your bookkeeping practices. It also understands that if you are struggling to pay the tax, there is an incentive to under-report sales as well.

Reporting Substantial Exempt Sales

As mentioned above, reports of exempt sales cause the spotlight to head your way. The rules and regulations governing exempt sales are complicated, and there is a high tendency towards misunderstandings and mistakes. The CDTFA looks for innocent oversights and negligence as well as willful fraud.

To reiterate, if you are in the business of exempt sales, the CDTFA will likely audit you.

You Have Been Audited in the Past

This is especially true if you have been audited in the past for a specific issue that you have not yet cleared up. If you have been audited once, you are likely to be audited again. If you have not fixed the problem, you will be charged again until the CDTFA is satisfied you are doing things right.

One of Your Vendors Was Audited

This is called “audit by association.” A few paragraphs ago we said an audit at one of your vendors could trigger an audit of your business. If you learn that one of your vendors or suppliers is being audited, do not be surprised to find an audit letter addressed to you in the near future.

Large companies get audited regularly, and these can trigger “whipsaw audits” on all its clients. This is how smaller businesses that previously flew under the radar attract notice.

Your Business Had a Major Change

If you acquired a business, opened a new location, or closed one, the CDTFA may become interested in your sales tax record. It also pays attention to when there is a sudden increase or decrease in sales. This is why new businesses may be at risk for an audit.

Your Industry Is Known For Substantial Non-Compliance

Some industries just have a reputation for sales tax non-compliance, especially businesses dealing in cash:

  • Bars
  • Restaurants
  • Grocery stores
  • Gas stations
  • Liquor stores

Cash is easily "lost" or hidden, but the CDTFA wants every bit of it recorded and reported.

Audits are common for industries that tend not to adhere to sales and use tax law as a matter of course. There may be a lack of internal controls, or the requirements are not understood. This often happens with exempt sales and reporting consumer's use tax.

An audit is nobody's idea of fun, but it happens. Sometimes, the reason for the audit is out of your control. Sometimes you just made a mistake. If you are in a cash intensive industry or have been audited before, you can take it as a given that you will be audited at some point.

Be sure to read the next post that explains how audits are announced, the records that may be requested, and other details surrounding the next segment of the audit process.

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Last updated: September 24, 2022

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Sam Brotman, JD, LLM, MBA

Owner and Director of Legal
Brotman Law



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