This post is the second 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.
The first post of this series explained the role of the CDTFA and the goals of a sales tax audit. It includes when an audit can occur, how companies are selected for audit, and common audit triggers.
This post takes up how the audit is conducted, what records are requested, and the type of tests auditors use to verify tax filings.
How the Audit Is Conducted
The audit is announced through an “audit engagement letter” that tells you the terms of the audit, provides you a preliminary list of documents to gather, and a request to contact the auditor.
Do not worry; you will have plenty of time to consult a tax professional and to get your documentation together.
The State of California does not have a fixed structure for conducting audits. An auditor is authorized to use a range of methods to find any necessary information. A records review is always performed, but the auditor may also use:
- Covert observations
The auditor looks for two things:
- Taxable sales that were not properly taxed
- Taxable purchases that were not taxed
Looking at taxable sales that were not properly taxed is considered the "sales tax" portion of the audit; the auditor is trying to find instances where you did not charge tax, or you charged the wrong rate. In the case of taxable purchases that were not taxed, the auditor is checking for the “use tax” charges. If you purchase business-related goods or services online or from an out-of-state supplier, you are required to pay tax on that transaction.
Typically Requested Documents and Records
Auditors may ask for a wide variety of documents from the tax years under investigation. The list can include:
- Sales and tax returns and worksheets
- General ledgers
- Sales invoices
- Purchase invoices
- Property tax statements
- Till receipts
They may also request documents to support exempt sales, such as resale certificates. At any time in the audit process, the auditor can ask for more information or documents, including bank statements and depreciation schedules.
How Auditors Find Mistakes
Auditors generally find discrepancies by comparing total sales recorded in your books to the total sales reported in your sales and income tax returns. However, they have other ways to find out if you made a mistake.
They can observe your business and apply certain tests or procedures to make sure the sales and amount of sales tax is properly reported. Processes include:
- Statistical sampling
- Analysis of transactions
- Markup analysis
- Credit card percentage tests
If you own a bar or restaurant, an auditor may even perform a “pour-over” test while undercover to confirm appropriate amounts are being dispensed.
Auditors can also choose to contact your vendors directly for information.
California Sales Tax Audit Procedures and Techniques
The entire purpose of the audit is to ensure taxes are correctly calculated and reported. Through preliminary testing and looking at areas where taxes are commonly misplaced, the CDTFA may find an indication that an audit is not warranted. Auditors check for the accuracy and completeness of your records, whether the markup on the cost of goods is adequate, and whether the people preparing the tax returns understand tax laws and the rules and regulations for your particular business.
Reasonable amounts are determined by the type of business you have, the nature of the premises, its location within the community, and other clues to your tax situation. Auditors also look at whether the amount of tax you report varies significantly when taxing periods are compared and whether you have a good record of preparing and filing your taxes correctly.
Auditors can request any record or document, but they must explain why the document is being requested. It is your right to know. On the other hand, if you refuse to produce the records, the CDTFA can subpoena you. If you request to record the audit on audio or video, you are likely to be turned down. However, if it is allowed, the CDTFA will issue a subpoena for those records as well.
Audits Based on Verification or Accumulation of Taxable Differences
Auditors may decide to use verification of taxable differences rather than base the audit on total sales and claimed deduction basis. This method is preferred when records are available, but the verification of gross receipts or deductions is unnecessary due to the low number of transactions.
It may also be used when the taxpayer reported taxable measure is based on a listing of transactions, the capitalization of tax reimbursements, or by markup of taxable purchases.
A comparison between recorded and gross sales can disclose a number of discrepancies:
- Sales, gross receipts, fuel use
- A month in which a department or branch was not included in reported totals
- Classes of transactions or use that are erroneously considered non-taxable by the taxpayer
Audit Verification Methods
The accuracy of lists and tapes of taxable items is verified by determining if you failed to tax any items that should have been taxed and by verifying that all the items you charged tax on were indeed taxable.
Postings and computations are verified as well. Auditors check your math on:
- Any taxes charged on customer invoices
- The posting of tax charges to a sales journal,
- Clerical accuracy of footings and posting of tax charges to a tax accrual account
- Your tax charge conversions to taxable measures.
An auditor will never knock on your door without warning. You should receive an audit engagement letter with a list of records you need to present for a sales and use tax audit, and you will be given enough time to gather them and to consult a tax professional to help you with the audit.
Many different records can be requested, but the auditor must explain the purpose of the request. However, if you refuse to produce the record, you can be subpoenaed. Discrepancies are found through comparisons of total recorded sales, and total sales reported as well as other methods as needed.
The next post in the series takes up how to prepare for an audit, including how to communicate with the auditor and providing access to staff.