Before going any further in the process, we should address the risks associated with a California Department of Tax and Fee Administration audit. By far, the biggest mistake that we see taxpayers make and the biggest area of risk that they have is the dangerous assumption that because they "did not do anything wrong in the sales tax audit, they do not have anything to fear.”
That statement conveys a fundamental misunderstanding in the way that sales tax audits work. As a reminder, the auditors are looking for mistakes in how the taxpayer filed their sales tax returns and, in the amount of tax that they paid. So, the auditors are devoting a significant amount of time and energy to going through all of your data and verifying your taxable sales. The reality of the situation is that even if you do not feel like you made a mistake, the auditor may find some.
The auditor does not have to find “actual mistakes.” Sales tax auditors can and do often make “estimated assessments” using statistical samples applied to a larger population of data.
The main problem with a sales tax audit is the amount of data that may need to be dealt with during the course of the audit (over a three year period) and a conflict between the limited amount of time that the auditor has to work the case file with the amount of data. Take a business with 100 average daily sales. Over a year, that business has more than 36,000 transactions and over the standard three-year audit period, you are dealing with more than 100,000 transactions. No California state auditor has the amount of time to deal with that large of a transaction volume.
The auditors combat this problem by resorting to statistical sampling. Out of a more than 1000 days for a three-year period, auditors will lean on 2-3 days of test data and apply that to the population. Whether or not you hold a PhD in statistics, I think that you will agree that for the California sales tax auditors to take .2% of an audit period and to treat that as reflective of a business’s sales for an entire three -year period is a complete stretch. Think of all the things that have happened to your business in three years. Is it fair to say that you are the same that you were three years ago?
Here is the problem in a mathematical sense. Let’s say the auditor’s average sales over a 2-3 period is $30 off from the true average of your sales over the same three-year period. $30 is not a whole lot. However, times that amount by the 1095 day audit period and you are left with a $32,850 in tax due and owing (not to mention all the penalties and interest you are accumulating.
Under California Department of Tax and Fee Administration audit guidelines, sales tax auditors may resort to these “indirect” methods of testing. When the auditor goes to indirect methods of testing, they are using statistical samples to arrive at what the proper conclusion is. However, the problem is that statistics are nothing short of educated guesswork and the problem is that when the state guesses, it usually guesses wrong.
California Department of Tax and Fee Administration auditors tend to go after low-hanging fruit. The auditor is not going to dive into a lot of very complicated things. They are going to go after quick wins. A lot of the quick wins happen when they apply indirect methods of testing.
The flipside is that the auditor is going to put the burden on the taxpayer to produce documents to refute the auditor's conclusion. You should not be guilty until proven innocent in a sales tax audit but sometimes, that is how it goes with a sales tax audit. Once the auditor has come to a conclusion in your case, it can be very, very hard to disprove.
Unlike other forms of audits, serious errors in sales tax audits are usually pretty easily discoverable. One of the biggest mistakes that people make is they under-report their sales tax returns, but their federal income tax returns show the true amount of sales.
The auditors take, what we call, big five data: your sales tax returns, your federal income tax returns, your internal accounting, your bank statements and your 1099-Ks, and they will line up all that data together. That is a pretty good indicator out the gate of whether or not there is a discrepancy or whether or not your reported taxable sales are accurate.
Anyway, this is a big problem because it is very easy to see serious errors right away. The first thing you need to do is understand how serious the error is and whether or not there was any intent behind it. If there was intent and you potentially fraudulently filed the sales tax return, that is a different issue.
If there is a serious error and it is isolated to one particular quarter, you are better off highlighting it for the auditor and isolating the error rather than letting them turn a molehill into a mountain and go through the entire audit with the expectation that that error is going to continue.
The best thing that you can do with errors is either, A) admit them to the auditor flat-out, or B) do damage control, and mitigate the issue as much as possible. By mitigating the issue, you are going to reduce your liability and you are going to shorten the life of the sales tax audit and the error is not going to seem that serious when in question.
Yes, you can. If the California Department of Tax and Fee Administration thinks you are willfully under-reporting sales tax and/or fraudulently filing returns, you can and will receive a criminal referral. One of the biggest jobs that we have at the beginning of an audit, is when somebody comes to me and says, "I have under-reported on my sales tax and now I am getting caught," is to mitigate any evidence that there was any willful conduct on behalf of the client.
The goal with any potential criminal matter is to keep it civil and to minimize the damage as much as possible. You can trigger a CDTFA fraud referral based off of that, but also, even if you are not going to go to jail for the errors that you caused on the sales tax returns, you have to be mindful of penalties.
The CDTFA has a very rigid penalty scheme, particularly with respect to fraud penalties and sales tax that was collected but never paid to the state.
In addition to worrying about going to jail, you need to be worried about the escalating liability, because an escalating liability, once it gets into collections, can create a huge problem for the taxpayer.
While you are in the examination phase of a California Department of Tax and Fee Administration audit, you want to make sure you can make the biggest adjustments possible and eliminate any notion that there was any willfulness behind your actions.
Sales tax audits have different types of civil penalties. Some penalties are more severe and some penalties are less severe. Generally, penalties will range anywhere from 10-50 percent, but the biggest kicker with sales tax penalties is that sales tax penalties can stack on top of one another.
For example, let’s say that a client did not turn over all the sales tax that they collected and they also failed to file a return. This client could be looking at a 40 percent penalty for the failure to turn over sales tax and a 10 percent penalty for each return that was not filed. As you can see, this can stack up pretty quickly and it leads to a lot of problems in the context of the audit.
Usually, the CDTFA will reduce the penalties down to a manageable level. For example, if you have 12 quarters of sales tax returns that you did not turn in, they are not going to hit you with a 120 percent penalty. Still, sales tax penalties are pretty severe. The CDTFA often leans towards the stronger end of the penalties, at least at the district level.
When we handle a sales tax audit, one of the biggest areas for negotiation, is what the ultimate penalty structure is going to be for the client. We push on behalf of our clients for zero or very low penalties. This is contrary to a lot of the behavior that you see in a sales tax audit, but if you play your cards right, you can mitigate penalties or avoid them entirely.
For a more detailed discussion on penalties in a sales tax audit, please visit our complete guide to sales tax penalties.
A dual determination happens when you have a situation with a business, that either accrues payroll tax liability or sales tax liability. When you have a payroll tax or sales tax liability with a business, the state or the IRS can hold the officers of the company personally responsible if they did not pay those taxes.
There are certain taxes that we refer to as trust fund taxes. Those are monies that are held in trust for the benefit of somebody else. A common example of this has to do with payroll taxes.
When you do not pay payroll taxes, there is a portion of those payroll taxes that are the employer’s responsibility but there is also a portion which is the employee’s responsibility. The government can hold you responsible for the employee’s portion of those taxes,
What a dual determination really hinges on is who is responsible for the nonpayment of taxes, whether they had knowledge of or were aware of the fact that taxes were not getting paid and whether they could have done something to pay those taxes.
Generally speaking, if you are aware of a liability and you chose to pay other creditors that were not the government, they are going to hold you liable for that.
The dual determination process is a very strategic one because when you have a situation where you have multiple officers, the state or the feds tend to cast a pretty wide net. They will just loop everybody up and they do not care who they assess because it is just more avenues for them to attack and try and get money out of it.
When you have a situation where you are going to have unpaid payroll taxes or unpaid sales taxes, you want to plan this out strategically.
We actually start planning these things out at the beginning of a collections case when we walk into a situation and realize that there is a business with multiple years of unpaid tax liability or even multiple quarters of unpaid payroll taxes. We will start looking at the analysis from what is going to happen if this goes forward and there is a dual determination. Who is the responsible officer? How are we going to get them out of this?
When we negotiate a strategy for paying off payroll taxes, we think about the consequences to the individuals that may or may not happen later. By the way, we do this during audits. We do this for a variety of processes when you have a business and there is the potential for the officers to be held responsible for the taxes.
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