Facing a sales tax audit is an intense time for any business. Even if you are sure that your bookkeeping and records are impeccable, the painstaking process of proving your honesty takes up a lot of time and resources, and hosting an auditor as they comb through your books is always a stressful prospect.
Most California businesses will deal with a sales tax audit at some point, and understanding why and when sales tax audits happen and what to expect is the best way to be prepared when your number comes up.
Sales tax audits: the basics
The revenues from sales and use taxes are used for roads, schools, parks, and other vital public programs, and as state budgets are always in need of more funds, it is in California’s interest to pursue the payment of these taxes aggressively. The California State Board of Equalization (BOE) is the government body charged with administering, collecting and enforcing the California tax code. The BOE regularly conducts audits to ensure that businesses are correctly collecting, recording, reporting and paying sales and use tax.
There are many reasons that your business could end up under the scrutiny of a BOE sales tax audit. Businesses where cash transactions make up a large portion of sales are a natural target for an audit, as are companies which deal with a large number of exempt sales. If your industry has a reputation for tax irregularities, it is probably only a matter of time.
These are some of the reasons that grocery store, bars, restaurants, and other businesses in the hospitality sector are frequently audited. Sometimes you can get swept up in the fallout of another audit: if one of your vendors is found in violation of tax law that may set off a cascade of audits. If you have had tax trouble in the past or been late or irregular with your filing or payments, you are inviting the closer attention of the BOE. Businesses which are undergoing big changes (such as the closing or addition of a location) can also be flagged for an audit.
What to expect: first steps
The objective of a sales and tax audit is to find irregularities, oversights, mistakes or evasions in the way your company deals with sales tax. If your business is selected, initial contact will probably be by letter. The audit engagement letter is where the auditor will explain the terms of the audit, ask for a call or a meeting, and lay out a preliminary list of records and documents you will need. It is an important piece of paper as it offers your first opportunity to help your business.
Good preparation and the tone of your first interaction with the auditor are very important, so you should take care to comply with all of the requests in the letter. You will have some flexibility in scheduling the audit, and can ask for a reasonable amount of time to collect the required materials. Two or three weeks is standard. If you need more time you may be required to sign waivers.
A Waiver of Limitation is a document which will extend legal requirements if the auditor finds additional tax liabilities owed. The BOE usually works with a Statue of Limitations: a three year limit within which they must investigate and charge delinquent taxes in your tax return. This waiver extends that time limit.
A Waiver of Credit Interest is a document which will absolve the BOE of interest owed if the auditor finds a refund or credit owed to you.
It is in your interest to have a tax attorney review your case before you sign a waiver or other document which could affect your rights in the audit.
No longer in business?
If you have closed your business recently, you can still be audited, and the BOE has been known to attempt to assess liability against as many people as possible. Anyone who may have been involved in dealing with sales tax in the business can find themselves held responsible and required to prove their innocence. In this case it is particularly important to have good advice from a tax professional before the audit begins.
Preparing for the audit
After you have agreed on a time and a place for the audit, your next step is to collect and review the documents requested for the time period designated in the letter of engagement. That list is only the starting point, so you can expect further records to be required as the audit progresses. It is good practice to prepare the most common records reviewed in audits of this type:
- general ledger
- sales and use tax returns and worksheets
- state and federal income tax returns
- sales invoices
- purchase invoices
- till receipts
- property tax statements
- documentation supporting exempt sales, such as resale certificates or freight bills
The auditor may be working on your premises, in which case you are expected to provide them with a space to work, a desk, good lighting and an electrical outlet. If they are working at their field office, you will be responsible for bringing the record to them (you will be given a receipt.) It pays to be professional and accommodating in your relationship with the auditor, but remember that you are not required to volunteer information that has not been requested.
What are they looking for?
The auditor will be looking for innocent errors and oversights as well as for evidence of willful misrepresentations and evasions. There are several stages to an audit, beginning with preliminary tests and proceeding to more detailed examinations as indicated by the findings. Basic comparisons of books with tax returns are a usual first step, followed by more sophisticated statistical samplings and markup tests.
In some industries, undercover investigations may be used: for example, “pour tests” in restaurants and bars are sometimes conducted to ensure that the measures of alcohol reported by the business are truly representative.
After the audit: what now?
Once the auditor has finished their investigations, there will be an exit meeting where the findings are reviewed, and the auditor will prepare a Report of Field Audit or a Report of Investigation. This is the point at which you can raise any disagreements with the assessment. If you want to protest the results of the audit, you will be given some time to collect evidence to support your case, which you will need to present to the auditor. After the official report is filed, you’ll later receive A Notice of Determination (billing), which will outline the taxes and/or fees you owe or A Notice of Refund.
If the BOE owes you a refund, they will first check to make sure that you do not have any other outstanding tax liabilities with any state agency. If you do, the refund will be applied to that tax debt. If you do not, they will issue a refund warrant usually within four to eight weeks of the Report of field audit. If you do have a sales tax liability assessed against you and do not plan to appeal, you will need to pay the amount due within 30 days of the assessment.
If you fail to pay within that time period, you will be charged a penalty of 10% of the amount owed. Interest is also charged on the amount owed: the interest rates vary. Persistent failure to pay will expose you to aggressive collection actions by the BOE such as liens, levies or seizure of property and assets.
If you still disagree with the findings, you will need to file an appeal (“petition for redetermination”) within that 30 day period. The BOE has a long appeals process, and at each stage you will be required to make your case. In an audit situation, the reality is that you are generally assumed guilty until proven innocent.
This is why having a professional tax representative is so important. While there is no need to take an adversarial attitude towards the BOE, the reality is that you are up against a huge organization with the full force of the law on its side and a vested interest in proving you wrong. It is no easy task to navigate through all the rules, regulations, and mountains of paperwork to ensure that the audit is conducted properly and fairly.
The advice and oversight of a trained tax attorney can simplify the process. You need someone who understands the intricacies of the California tax code inside and out, and who can analyze and assess the complex statistical methods and general procedures of an audit with a practiced eye
A good tax attorney will work alongside the auditor to oversee each stage of the audit, addressing issues as they arise. Once the work of the audit is finished, your attorney is there to help you if you need to fight unfair audit results. They will prepare presentations, file documents on your behalf, and deal with every step of the appeals process. If you can trust that you are in the hands of an experienced professional with your best interest at heart, much of the stress of a sales tax audit can be relieved.
At various stages during the appeals process, you will have opportunities to reach a settlement or an Offer in Compromise where the BOE agrees to accept payment of less than the amount you actually owe. Negotiating these deals is best done with your tax attorney by your side.
Whatever the outcome of your audit, you’ll want to do everything you can to avoid going through another audit in the future. Putting extra controls in place, tightening up operations, and reviewing your books at regular intervals are best practices which can keep your business on the good side of the BOE. If you are ever in doubt about your compliance with California tax law, a consultation with a qualified tax attorney can give you renewed confidence and peace of mind.