Can I go to jail for errors on my sales tax return?
Yes, you can. If the CDTFA 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 CDTFA 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.
What is the Difference Between Sales and Use Tax?
Sales tax applies to in-state transactions. If you have a store in California that is selling merchandise to a California customer, that is a transaction where sales tax is applied.
Use tax is a counterpoint to sales tax. For example, if I buy a car in Arizona, I can ship it to California because California is not charging me sales tax on that transaction because it is not occurring within the state. Instead, they charge me a use tax.
Use tax is the tax that I pay for importing goods into California. In situations where there is no sales tax, I pay use tax.
How do sales audits and use tax audits differ? Sales tax audits are focused on taxable sales. They are focused on looking at total sales and figuring out of all those total sales which ones are taxable, how much the tax should be charged on those sales, and then looking at the tax that should have been charged and the tax that was paid in reconciling those amounts.
Use tax audits focus on purchases, what was purchased, what was specifically purchased from out-of-state, if there is a use tax obligation and where it was due.
In looking at the two types of audits, even though they are very similar and even though they both involve purchases, they are very different animals and need to be addressed accordingly.
Is it a good idea to meet with your sales tax auditor?
Yes, 100 percent. Go meet your sales tax auditors, spend as much time as possible with them and drive them completely crazy. In all seriousness, the way that we have had the most success in the firm is by face-to-face contact. The more time you spend with these auditors as individuals, the more you get to know them, the more they will like you and the more latitude they will give you.
People naturally do business with people. Once you get to know, like, and trust somebody, then you start to develop a relationship with them. One of the big reasons we are successful is because we deal with these cases over and over and over and over and over again.
We deal with the same people repeatedly. I might not know every auditor in the San Diego office of the CDTFA but I know a ton of them. It is really important and we have developed that relationship because of face-to-face contact and because an auditor or manager who I am having a disagreement with is not going to take an unreasonable position.
They know they have to see me again and again and again and again and again. It is not like we are going to take a hard line on this case and hope this person never shows up again because there is a level of contact and a level of familiarity.
If you decide to represent yourself in the CDTFA audit — which I do not recommend — but if you do, you want to have as much contact and as much touch point with your auditor as possible. You are not going to be able to influence them or buy them dinner, or bribe them under that table, but just having that familiarity, developing trust and developing rapport is a very important strategic tactic.
I would absolutely recommend that you go and meet with your sales tax auditor. I would not recommend that you bring them into your business, though. I recommend that you actually go to see the TFA. The meetings will be a lot shorter. You will get the time to interact with them in the conference room, you can walk them through your documents, and you just give them a much better presentation by doing that.
What are the types of penalties that I can face in a CDTFA sales tax audit?
Sales tax audits have different types of penalties. Some penalties are more severe and some people 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, a client did not turn over all the sales tax that they collected and they 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.
What is a Dual Determination?
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.
Is it possible to settle with your sales tax auditor?
Unfortunately, playing, "Let's make a deal with the auditor,”' is not really possible. It is not possible to just throw out a number, maybe $25,000 to make the auditor go away. However, in the context of any sales tax audit, there is a certain amount of horse-trading that happens in order to get to a result.
From the CDTFA's perspective, they would rather close the audit as agreed than have you as an un-agreed audit going into appeals. The more cases they close at the audit level, the less likely they have to do any work and the less resources they have to allocate. Those resources at the CDTFA are precious.
Now, the CDTFA is not going to lie down for you in an audit. Towards the close of the audit, if you can make a presentation to the auditor that you will agree to the audit if they reduce X, Y, and Z, the auditor may be more than likely to cut you a break in exchange for getting an agreed-upon audit.
That is a card that you should play only at an appropriate time.
Again, the CDFA is not just going to give you a flat discount, but if there is an issue that could go either way, the auditor may be more likely to bend to you in order to resolve the audit and bring it to a conclusion.
Understanding where these issues are and how to present them strategically is a little bit of an art, but by doing that, you can significantly cut your liability and attain the best result for yourself as possible.
What do I do if there is a really serious error on my tax returns and I get audited?
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 I 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.
What is a managed audit? Is it a good idea?
A managed audit is when you sit down with the auditor and agree to basically perform a self-audit. A managed audit formulates a plan that is a contract and it is found under CDTFA Form 526.
A managed audit can be a good idea in certain situations because what you are doing is essentially filling out the auditor's work papers for them. You submit the work papers to the auditor along with some documentation for them to verify and if everything turns out okay, then the auditor will bless the audit.
In doing a managed audit, you have the potential to cut your interest rate in half. That can be pretty good savings depending on how much your liability is. However, the savings in terms of the interest can be outweighed by the length of time and the resources it takes to complete the audit.
Managed audits take a lot of work and if a client lacks the internal resources to do the audit for the auditor, it can be a huge waste of time, cost and energy.
The managed audit decisions should only be made with a tax representative in terms of discussing the strategy for the audit. Agreeing to a managed audit is a significant burden and can be a huge amount of work, so the decision should not be made lightly.
If you do the managed audit properly and you fill it out and turn it in and it reduces the amount of time that the auditor takes to look at the audit, you can set yourself up for success in certain situations.
What is a markup test?
In the context of a sales audit, a markup test is kind of what it sounds like. A markup test is a test to determine the markup in the aggregate of taxable products that are being sold.
Take a restaurant, for example, the auditor will look at all the menu items, and they will have somebody break out food costs and say, "Okay, if you are selling burritos, tell me all the ingredients that go into the burrito and give me an estimate of how much it cost you to make that, and then let us see what your markup is."
Markup tests are really dangerous because markup tests generally vary across different products.
A restaurant selling beer can have a certain markup. A restaurant that is serving shots coming out of a bottle is going to have a higher markup on liquor than with beer. In trying to take an average of those two things, it is really difficult to get an appropriate average markup.
We try to avoid markup tests whenever possible. If we have to go through them, we will try to limit the scope of the markup test to make it as easy as possible on the client and to make sure that the results that we are getting are really consistent
Markup tests are very common, particularly in retail settings, with restaurants, and with a variety of other businesses. They really should be avoided at all costs.