One of the most common targets in a California sales tax audit is sales for resale. Sales for resale is the most common deduction claimed by California taxpayers and one of the most common targets of the California Department of Tax and Fee Administration (CDTFA).
California Department of Tax and Fee Administration sales tax auditors are especially careful in examining accounting methods used by taxpayers and use various procedures to verify amounts.
Often, California taxpayers will estimate this deduction and will get tripped up in a sales tax audit when the California Department of Tax and Fee Administration auditor uses their verification procedures.
Normally, there are two ways that a CDTFA auditor will verify sales for resale. First, if the claimed deduction consists of relatively few items so that all transactions can be examined in a reasonable amount of time, the California sales tax auditor will audit every item in detail.
Consequently, if sales for resale are numerous and of a reasonably similar unit value, the verification will be made on a test or sample basis.
The auditor will develop perimeters for their test, such as a time period and a method for screening data. This test will then be imputed to the rest of the audit period. California sales tax audits for sales for resale generally are broken down into three classification categories:
- Detailed audit — lists of claimed sales for resale available
- Detailed audit — lists of claimed sales for resale not available
- Audit on test basis
California Procedures for Detailed Sales Tax Audits Where Resale Data is Available
In the case of a detailed audit, and when a list of claimed resales is available, claimed resales will be summarized by months or by quarters in accordance with the taxpayer’s listings and records. The taxpayer’s detailed schedules will be used as a basis for the verification.
The auditor will examine sales invoices and other documentary evidence of the non-taxability of the sales, such as resale certificates, purchase orders, correspondence, or contracts. The nature of transactions and the type and number of items purchased will be scrutinized to determine whether resale certificates appear to have been taken in good faith.
All sales questioned by the auditor for any reason will be listed on a subsidiary schedule. A copy of this schedule will be given to the taxpayer as an aid in attempting to support the exempt status of the questioned items.
A reasonable period of time must be given to the taxpayer to obtain this information before closing the audit. If a list of claimed resales is not available, then the auditor will request the taxpayer to prepare a detailed listing of all claimed sales for resale and the taxpayer must be allowed a reasonable amount of time to do so.
If questioned resales are not supported by the taxpayer to the auditor’s satisfaction during a California sales tax audit, then those sales will be disallowed.
One special item of note: sales to Mexican merchants for resale are allowable if certain requirements are met. For example, a Mexican Merchant Identification Card must be valid and not expired at the time of the sale and the merchandise purchased for resale must be related to the special business classification codes on the card.
California Sales Tax Audits: Everything You Need to Know
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. 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 California Department of Tax and Fee Administration (CDTFA) is the government body charged with administering, collecting and enforcing the California tax code.
The CDTFA 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 CDTFA 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 stores, 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 CDTFA. 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 CDTFA usually works with a Statute 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 CDTFA 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 CDTFA 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 a 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 CDTFA 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 percent of the amount owed. Interest is also charged on the amount owed and the interest rates vary. Persistent failure to pay will expose you to aggressive collection actions by the CDTFA 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 CDTFA 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 CDTFA, 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 CDTFA 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 CDTFA.
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.
Sales Tax Audits: An Overview
A sales tax audit has key differences from a regular audit. First, the scope of the audit looks at a business’s gross receipts and various ways of measuring gross receipts.
The businesses that are most frequently subject to sales tax audit include bars, restaurants, retail stores, manufacturers, wholesalers, services businesses that sell goods and a variety of others.
Throughout their years of practice, sales tax auditors have developed ways of determining gross receipts that are innovative and industry-specific. For example, if the business audited were a coin-operated laundromat, the California Department of Tax and Fee Administration may measure water consumption levels for the business against the number of washing machines it has.
Pour tests are common for restaurants and bars (the amount of alcohol used to make each drink) and inventory audits are common for other types of businesses.
The CDTFA sometimes feels that these methods are more telling than a standard gross receipts test. In addition, the CDTFA will normally ask for a substantial amount of documents in testing and verifying gross receipts during a sales tax audit.
These include bank statements, balance sheets, inventory purchase orders, utility bills, and cash register tapes (among other items). In addition, the CDTFA auditor may come out to the target business in order to do a sample test.
A sample test is where the auditor measures gross receipts for a specified period (they will be at your business all day). This sample can later be applied to an entire period in order to properly calculate gross receipts.
The inherent problem with this method is that your sample period may not be representative of a business’s yearly sales. Good examples of this are businesses that have seasonal sales or those being audited for a particular item that had abnormal sales within the sample period.
Obviously, a two-week sample measure might substantially increase or decrease a taxpayer’s sales tax audit liability depending on when that sample was taken.
The Difficulty With Sales Tax Audits
From a practical standpoint, gross receipts are difficult to get a precise measurement on and there is no industry standard method for performing a test for gross receipts. As such, the various methods that the CDTFA uses to measure gross receipts vary in the level of effectiveness in a sales tax audit. Some are quite reliable and others are no more than educated guess work.
In addition, if you have any familiarity with statistics, you know that there is a lot of “wiggle room” associated with how you collect data for a sample and how that data is measured. This leaves a lot of power in the hands of your California Department of Tax and Fee Administration auditor and leads to extraordinary swings in measurements of taxable measure (gross receipts).
As a result, those under audit are often presented with staggering bills at the conclusion. Some of these bills, after attorney review, are found to have no basis in reality.
As you can see, sales tax audits have a lot of built-in complexities that many people fail to consider. Because of the latitude involved in a sales tax audit and the various methods of calculating sales tax liability, I generally recommend that taxpayers engage with a sales tax audit attorney as soon as possible in the process in order to mitigate the damage involved.
Qualified tax counsel can go a long way toward getting the audit under control and mitigating the amount of liability involved.
California Sales Tax Audit Procedures and Techniques
The purpose of a California sales tax audit is to correctly measure the tax. The California Department of Tax and Fee Administration auditor conducts preliminary probing and testing in order to see if there is a potential area of misplaced tax. Sometimes preliminary testing reveals that a California sales tax audit of a business was not warranted.
When deciding whether to waive or perform an audit, the auditors consider the following points:
- Are accurate and complete records kept?
- Does the markup on cost of goods sold appear adequate?
- Are the persons preparing tax returns familiar with the law and the rules and regulations pertaining to their particular business?
- Are the reported amounts reasonable considering the type of business, nature of the premises, the location in the community, etc.?
- Do the reported amounts vary materially from period to period?
- Is there a good system of internal control?
- Is the taxpayer’s past record good?
In the course of a California sales tax audit, the auditor prepares an Audit Memorandum of Possible Tax Liability. Government Code sections 15618 authorizes an auditor to examine records of the taxpayer and of persons doing business with the taxpayer. Revenue and Taxation Code (RTC) section 7054 provides additional authority for the examination of records pertaining to the sales and use tax.
Similar provisions are found in other tax and fee programs administered by the CDTFA. Government Code section 15613 authorizes the Department to issue a subpoena for the attendance of witnesses or to produce books, records, accounts and papers.
An Auditor or supervisor can request records and documents from the taxpayer but must explain to the taxpayer why records and documents are being requested. If the taxpayer refuses to provide records, CDTFA can subpoena them.
The auditor can not review records if access denied by the taxpayer, unless the auditor has a subpoena. If the taxpayer insists on video or audio taping the auditor as a condition of making the records available, the CDTFA may issue a subpoena for the records.
Most of the time a taxpayer's request for video and audio taping is not approved anyway. The CDTFA may allow a taxpayer to audiotape audit discussions with the auditor provided the CDTFA makes its own audio recording.
In cooperation with the Department of Justice (DOJ), the CDTFA can provide assistance in the enforcement of money laundering violations by reporting suspected violations to DOJ. To accomplish this, CDTFA will pay attention to suspicious transfers of over $5,000.
Once the taxpayer has filed a claim for a refund and has requested or suggested determining the amount of refund by means of sampling, the claim will be assigned to an auditor who will contact the taxpayer to determine if sampling is feasible and, if so, develop a mutually agreeable sampling plan.
If a refund situation arises in the course of the audit, the auditor normally secures a claim for refund from the taxpayer utilizing the form CDTFA–101, “Claim for Refund or Credit.” The taxpayer should always be allowed a reasonable time in which to support a claim for refund during a California sales tax audit.
Under most circumstances, 90 days is considered reasonable. For extension of the 90 day period, CDTFA will usually require a waiver of credit interest, as a condition to deferring action on a claim for refund (Revenue and Taxation Code section 6908(b)).
The taxpayer will have to sign the form CDTFA–146, Waiver of Credit Interest which can also be signed by a partner, corporate officer, or holder of proper power of attorney). On occasion, CDTFA can give 90 more days without waiver if the size of claim and amount of supporting detail required is large.
The maximum extension time a taxpayer can obtain to compile all necessary data is usually 12 months.
If the taxpayer does not provide the supporting data within the 12-month period, the claim for refund will be denied on failure to support the grounds upon which the claim was based. Extensions over 12 months are very rare and must be approved by high-ranking CDTFA officials.
Examination of Records
In a California sales tax audit, the CDTFA will examine a taxpayer's record to determine whether sales or use tax was not paid. The verification procedure will include an examination of debits in certain general ledger accounts. The auditor will examine various asset and expense accounts and will trace the originating documents.
The auditor will examine invoices representing purchases of significant taxable additions to fixed asset accounts. Unsupported debits to the fixed asset accounts will be questioned by the auditor and listed on a subsidiary schedule.
The taxpayer must be provided with a copy of this schedule and given a reasonable period of time to obtain support for the items in question before closing the audit.
If no support is provided, use tax will be asserted against the taxpayer. As an example, if the proper amount of use tax has not been paid to the Department of Motor Vehicles on the purchase price of a vehicle, the use tax is to be asserted against the purchaser. To establish purchases subject to use tax, the auditor will look at other records as well.
For example, they will look at that Business Property Statement that taxpayers are required to file with their county assessor’s office on an annual basis. The statement lists all equipment the taxpayer uses in their business along with the purchase price and acquisition date. The auditor will also examine journal entries and requisitions.
California Sales Tax Audit – Form CDTFA–503 – ABC Letter Procedure
During a California sales tax audit, the taxpayer may be able to prove that the questioned items were not subject to tax, or were reported in another reporting period, or the tax was paid by the vendor on their tax return or audit determination.
To assist the taxpayer in satisfying their use tax obligation, the CDTFA has developed the Form CDTFA–503 – ABC Letter Procedure (called “ABC Letter”). When it is appropriate to use the “ABC” Letter process, the auditor will provide the taxpayer with a copy of the CDTFA–503–A, B and C.
The auditor must discuss the “ABC” Letter process with the taxpayer and explain that a satisfactory response to an “ABC” Letter inquiry alone is not necessarily enough to relieve the taxpayer from payment of the use tax, and that other evidence may be considered in reaching a conclusion.
The auditor should also explain that since the “ABC” Letter is not a substitute for a receipt for payment of use tax, additional documentation or information may be required.
A period of four weeks will be allowed for the taxpayer to prepare and send the “ABC” statements and for taxpayer’s vendors to reply. The CDTFA recommends that ABC statements are sent directly to them. If this is the case, the auditor will provide the taxpayer with return envelopes with the address of their district or branch office.
If the taxpayer elects to have the “ABC” statements returned to the taxpayer, then they should keep in mind that the likelihood of having CDTFA staff contact the vendor or sending an additional mailing is greater.
During a California sales tax audit, the taxpayer may customize the “ABC” cover letter (CDTFA–503–B) by using the text approved by CDTFA on their own letterhead. The text in the sample letter, which can be found at https://www.cdtfa.ca.gov/ should be used without additions, deletions or changes.
Any modification to the cover letter must be approved by the auditor’s supervisor. However, the CDTFA advises that the use of a standardized “ABC” statement will reduce any possible controversy over whether the substantiation provided is satisfactory. The taxpayer’s vendor is requested to return the completed “ABC” statement within 10 days.
The auditor, at their own discretion, can require a second ABC Letter, if necessary. Upon receipt of the letter, the auditor will check the response for any inconsistencies. If inconsistencies are found, then the auditor will contact the taxpayer for explanation.
The original “ABC” statement should be sent or faxed to the CDTFA by the taxpayer’s vendor. If the completed “ABC” statements are to be sent directly to the taxpayer, the signed original will be examined.
CDTFA Sales Tax Audits — Part One: What is an Audit and How are Companies Selected?
This post is one in a four-part series explaining how the California 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 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 markup audit. A markup 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 markup 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 (POS) 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 whether 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 one percent 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 is 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.
CDTFA Sales Tax Audits — Part Two: Audit Procedures and Techniques
This post is the second in a four-part series explaining how the California 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 California Department of Tax and Fee Administration 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 California Department of Tax and Fee Administration 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.
CDTFA Sales Tax Audits — Part Three: How to Prepare for an Audit
Welcome to Part Three in the CDTFA sales tax audit series. In Parts One and Two, we provided an overview of how an audit is conducted and how companies are selected for audit as well as audit procedures and techniques.
Now, you will learn how to prepare for an audit, including how to work with an auditor and which records and documents to have ready. You will also read about audit testing and sampling as well as the PAPE program and cut-off techniques.
One note before you begin your preparations: be ready to comply with auditor’s requests but do not volunteer additional information.
Do not sign anything without careful examination because the auditor is unlikely to explain the consequences or agreements. It is up to you to research and clarify what you do not understand.
Working with the Auditor
Like your parents told you, first impressions are important. Display your best manners and a helpful attitude. Respond promptly to meeting requests even if it is to negotiate a time better suited to your business. If you have been courteous, the auditor will be more likely to be flexible.
Provide the auditor easy access to your facility. Include a tour to review the workflow, the types of controls you have in place, and to explain the use of any new machinery. If the auditor is on the premises for a while, offer a comfortable desk or office.
Being obstructive or offering an uncomfortable environment will only work against you. It can indicate guilt and antagonizes the auditor.
Help the auditor understand your specific business so records can be examined in the correct context. This is especially important if you have unusual business or accounting methods.
Provide access to a staff member or employee who has a good understanding of the business and is capable of answering questions or locating documents in your absence. This saves time for both you and the auditor.
That being said, the auditor should not be conducting informal conversations with staff members who have incomplete knowledge of the business. The audit may become more extensive, or issues may occur due to the sharing of inaccurate or incomplete information.
You will have received a list of records and documents in the audit engagement letter telling you what you must have ready and available. Providing these documents neatly prepared and organized conveys transparency and a willingness to work with the auditor, whicn can make the process more comfortable.
If a request is unclear, ask the auditor to explain. Some requests are generic and may not apply to your particular business. Talk about any alternatives the auditor may want instead.
If you are asked to prepare documents for a time period that is not representative of how your business normally operates, you may be able to negotiate with the auditor, which will go more smoothly if you have been reasonable and open throughout the process.
Some examples of common records requested include:
- Accounts Payable (A/P)
- Accounts Receivable (A/R)
- General Ledger (G/L)
- Federal Income Tax Returns (FITR)
- Supporting documentation such as purchase orders, paid bills, invoices, contracts and customer exemption certificates
The process is not meant to be inconvenient, but transactions can get lost, chargebacks occur, returns aren’t accounted for ... clearly things happen. If the auditor is unable to follow a trail or find all the documentation, be willing to cooperate.
If you do not assist, the auditor may make an assessment based on a lack of information. Everyone will work harder, and the outcome may not be positive.
It is much better to keep a transaction out of an audit finding at the start than fight to have it removed from the findings later. If the information cannot be found, and if the CDTFA district administrator approves, CDTFA staff can request information directly from your financial institutions, either with your approval or by subpoena.
Tests and Sampling Methods
The CDTFA tries to streamline the audit process whenever possible. One way audits can be performed more quickly is by using a short test at various points in the process.
The auditor will examine any record, supporting data, or other information to determine whether or not to proceed with the audit on that document or if it can be accepted as correct without further examination or investigation.
A short test can be expanded into a full examination any time but saves time when a full examination is clearly not required to establish accuracy. In some instances, a short test is designed as a control test of documents over a short period to determine the most representative sample size for audit.
Testing is split into two categories: statistical and block sampling. Block sampling is used when statistical sampling is not possible. The auditor also looks into the conditions for employing the tests, especially when looking at the consistency of units sold or in business characteristics during the test period.
The size of the test period depends on what it takes to provide reasonable accuracy without excessive effort in comparison to the problem. Test periods are usually complete months or quarters. If daily or weekly controls are established, periods shorter than one month may be selected.
If your business has excellent controls, the test period will probably be a very small sample of the audit period.
PAPE Program and Cut-Off Techniques
The PAPE (Prior Audit Percentages of Error) program is another method of streamlining the audit process, but its use is limited to a particular set of circumstances. The program uses the percentage of error developed in a prior audit for the sales and accounts payable portion of the current audit.
To be eligible for PAPE, you must have been audited at least once before, and your business operations must meet certain standards of consistency during both the prior and current audit. PAPE cannot be used in two subsequent audits, only in the most current audit.
Cut-off techniques are methods of determining when to stop testing or examining data. Cut-offs can be used for the entire examination or a specific test or piece of data. The auditor has the discretion to accept test results, alter the audit approach, or to discontinue the audit on the strength of tests already completed.
The auditor’s biggest consideration when determining acceptance is the existence of errors. The auditor decides whether errors do exist, whether or not to keep testing, and whether to disregard the errors. If the test results are accepted, then the auditor has reached a cut-off.
One other time-saving technique is whole dollar auditing in which all transaction amounts are rounded to the nearest dollar to make calculations easier. It will not be used if you object or when markup from shelf orders are being calculated. It also will not be used if precise data is required.
The auditor generally tries to work with you and keep the inconvenience to a minimum as long as you do not create problems. Have records ready and remain cooperative for an efficient audit.
In Part Four, the final part of the series, we will discuss what happens after the audit is complete.
CDTFA Sales Tax Audits — Part Four: After the Audit
Here is the final installment of our four-post series about California Sales Tax and Use Audits. In Part One, we covered how audits are triggered and companies are selected for audit.
Part Two is about how the audit is conducted and the types of documents you may be required to provide.
Part Three gave you some tips for working with an auditor and the type of investigation an auditor may perform.
In Part Four, we take up what happens after an audit is complete, and how an experienced tax attorney can help you through the process of an audit by the California Department of Tax and Fee Administration.
The Exit Conference
When the auditor has completed the field work, an Exit Conference is called to present the findings and copies of the auditor’s working papers. A CDTFA supervisor may be in attendance as well.
One the findings are presented, you have the chance to disagree with the findings and explain why. You will be given time to gather documentation and present any information you think supports your case.
After you have made your argument, the auditor may do one of three things:
- Adjust the findings
- Request more evidence
- Arrange another meeting to discuss your case
Meeting with the CDTFA Supervisor
If the supervisor was not present at your exit conference, you may now request a meeting with that person if you and the auditor are unable to reach an agreement about the audit findings.
You will again have the opportunity to present your information and reasoning while the auditor prepares a Report of Field Audit or a Report of Investigation. The CDTFA supervisor will analyze both sets of data.
If you are still unable to reach an agreement on the outcome of the audit, you may meet with a CDTFA representative within 10 days of your meeting with the CDTFA supervisor. Otherwise, you may consider meeting with the District Principal Auditor (DPA) to discuss your disagreement with the audit.
The DPA is actually relatively helpful in resolving issues or clarifying the CDTFA’s position on them.
Afterward, you will have a follow-up meeting with the California Department of Tax and Fee Administration representative and make your presentation once again. At this point in the process, if you and the CDTFA continue to disagree about the audit and the case remains unresolved, the CDTFA will issue a Notice of Determination, and you may enter the Appeals process.
Appeals Process and Settlement
Once the Notice of Determination has been issued, you have 30 days to file a Petition for Redetermination using Form CDTFA-416. You may, instead, file your own petition but it must contain the following elements:
- It must be in writing.
- Identification of the amount or amounts you are contesting.
- Statement of the specific grounds or reasons you believe the tax is not owed.
- Your signature as the taxpayer or the signature of your authorized representative.
If you prefer, you can also request an Oral Hearing in front of the California Department of Tax and Fee Administration. You may also request an Appeals Conference where you can present your case.
At this point, you have the option to make a Settlement Proposal instead using Form CDTFA-393.
If you are not proposing a settlement and the case remains unresolved, there is a final step you can take.
You must go to court and attempt to prove your case. However, at this point, you are required to pay the proposed tax in full, although you will not be asked to pay any interest now.
The request for a judicial proceeding is a request for the court to review your information and the results of the audit. If the court finds in your favor, you will be refunded the tax you paid. If not, you will now be asked to pay the interest and any penalties as well.
How a Tax Attorney Can Help You
California has over 800 laws and regulations included in the Sales and Use Tax legislation, all with supporting documentation. There are also two guide books with 24 chapters between them and a list of around 110 sales and use tax-related statutes.
Just the thought of receiving a notice for a sales and tax audit can make you feel like David getting ready to meet Goliath.
Your best bet is to hire a qualified tax attorney as soon as possible, preferably when you receive the audit engagement letter. If you decide to wait, you can bring an attorney in at any phase of the process from audit through the judicial proceedings.
Tax attorneys can legally represent you, the taxpayer, and manage almost all the activities related to an audit including how it is performed. They can then analyze the statistical methods the CDTFA auditor uses to make sure you are getting a fair shake.
They can prepare and perform any presentation required in front of the District Principal Auditor and file any necessary documents to request an appeal. Your rights are protected at all times.
You receive legal guidance throughout the appeal, checking that every path of appeal has been considered, so your liability is reduced as much as possible.
If you need representation in front of the California Department of Tax and Fee Administration’s Appeals Review Conference and Oral Hearing, your tax attorney can represent you. Your attorney takes care of filing all requests for oral hearings, petitions for rehearing and requests for relief from penalties.
If you need a settlement, Request for Reconsideration, or Claim for Refund drafted, your tax attorney can handle that as well.
The Benefits of Hiring a Tax Attorney
Hiring a tax specialist brings a host of advantages. Tax attorneys have broad and deep knowledge of the tax code and all the ins and outs. They know where the pitfalls are in both the audit and appeals segment. They know how the laws and policies are commonly interpreted so they can position your case to best advantage.
A tax attorney is your intermediary between you and the California Department of Tax and Fee Administration. Your rights are advocated at every turn, and your interests are front and center.
This concludes our series on California Sales and Use Tax Audits. We hope it was informative for you. Please do not hesitate to contact Brotman Law with any questions.
What Happens in a Sales Tax Audit and Appeals?
Sales tax audits and the appeals process that follows them are extremely complicated due to the technical nature of how the California Department of Tax and Fee Administration assesses sales tax. The arsenal of audit techniques used by the CDTFA to investigate sales tax compliance is powerful and includes everything from a general overview of accounts and markup calculations in retail shops to undercover operations, such as pour tests in restaurants and bars.
The CDTFA can even conduct surprise inspections of your business during business hours.
Even the general preparation of your books and records for inspection is a huge task because of the sheer volume of transactions. A basic list of materials requested by the CDTFA during an audit can be overwhelming, including (but not limited to) any or all of the following:
- Accounts receivable
- Balance sheets
- Bank statements
- Cash receipts
- Disbursement records
- Exemption certificates
- General ledgers
- Inventory records
- Physical inventory
- Purchase journals
- Purchase orders
- Register tapes
- Resale certificates
Once the CDTFA completes their audit review and sends the taxpayer a copy of the California Department of Tax and Fee Administration audit work papers, there is a complex and lengthy series of appeals to get through.
A basic sketch of a sales tax appeals process includes:
- Exit conference. At the end of the audit, there is a meeting where the auditors will present their case. If you disagree with their findings, you will be expected to produce a detailed answer with evidence and documentation to support your disagreement. Additional evidence may be presented or the audit results can be disputed at the audit level.
- Meeting with the CDTFA Audit Supervisor. Once you have registered your dispute of the audit findings, your case will be escalated to the supervisor. At this point in the discussion, you will have another chance to discuss the audit. A Report of Field Audit or Report of Investigation will be filed by the auditor after this meeting to summarize the final findings of the audit, and will include a note about your disagreement.
- Meeting with a California California Department of Tax and Fee Administration Representative. You will receive a letter giving you 10 days to meet with a member of the CDTFA, where again, you will need to discuss your issues with the audience and present a compelling case with documentation and evidence.
- Notice of Determination. After the Notice of Determination is issued, you’ll have just 30 days to prepare and file your first petition.
- California Department of Tax and Fee Administration Settlement. Prior to an appeals conference, you will be given an opportunity to attempt to settle the matter with the California Department of Tax and Fee Administration Settlement Division.
- Appeals conferences. This is an “informal” series of meetings where you will be asked to present all of your evidence and documentation to an Appeals Division attorney or auditor, also known as the conference holder.
- Decision and Recommendation. After the conference, the conference holder will prepare a document with analysis of the case and recommendations
- Hearing before the Members of the California State California Department of Tax and Fee Administration. If you still do not agree with the recommendations, you may request a hearing before the CDTFA, where you will once again be required to resend your case and evidence.
- Settlement or Judicial Proceedings. At this point, you will need to come to some agreement on the payment of the determined sales tax owed or proceed to court
The Consequences of an Audit Gone Wrong
If you attempt to represent yourself in an audit and make a single misstep at any stage, things can go south very fast. Once you lose control of the audit process and are left with the deficiency, serious consequences can start stacking up:
- Additional taxes. The determination made by the auditor may be much higher than you anticipated.
- Seller’s permit revocation. The CDTFA has the power to take away your seller’s permit if they determine that you are delinquent. It is a crime to continue to sell without a permit, so this can effectively shut down your business overnight.
- Other license revocation. Thanks to a recent bill, the broad powers of the CDTFA allow them to revoke or suspend the professional permits and licenses of severely delinquent taxpayers, including their contractor, medical or driving licenses.
- Information sharing with other governmental bodies. The CDTFA will send an audit report to the state income tax body, the California Franchise Tax Board (FTB), which then reports to the IRS. This can lead to cascading tax audits from several agencies at once.
The Benefits of Hiring a Tax Attorney
While dealing with the fallout of a CDTFA sales tax audit is rarely pleasant, it is possible to mitigate the effect on your business, if you have the right help.
When you confront an audit on your own, you are dealing with the complexities of the system for the first time and navigating your way through this process without a map.
Hiring a qualified tax attorney is like choosing an experienced guide to lead you through a hazardous landscape. They know the territory like the back of their hand and can steer you away from pitfalls and back onto solid ground. Here’s what you can expect from your tax attorney:
- True qualifications. A law degree, admission to the state bar and subsequent education in the specifics of tax law have uniquely equipped your attorney for all the complexities of a CDTFA audit.
- Confidentiality. Unlike conversations with your bookkeeper or accountant, everything you discuss with your attorney is protected under attorney/client privilege. You can be completely frank and open in your meetings, which will allow your attorney to advise you with greater clarity.
- Thorough knowledge of California Tax law and understanding of CDTFA procedures. They understand the many intricacies of the law and are able to analyze complicated tax information with a clear and practiced eye. Unlike the auditor, who only knows the audit procedure, your attorney can look ahead to the appeals process, which gives you a strategic edge in negotiations. Please note that California sales and use tax law is a particularly complex area and it is best to hire a specialist or someone with a broad understanding of CDTFA audit procedure.
- Complete understanding of state court rules and procedures. If your case ends up in court, your attorney knows the rules of evidence and all the other requirements and processes of court cases.
- A barrier between you and stressful encounters with tax authority agents. Once you’ve hired an attorney, the tax agents are required to deal with the attorney and not with you. For most clients, this is an incredible relief ﹘ no more stressful phone calls or meetings to cope with. You can relax, knowing your case is in good hands.
- A tireless advocate. Tax issues can be extremely isolating, and it is terrible to feel alone when you are confronting a huge government agency. Your attorney is unconditionally on your side, every step of the way. They can negotiate for you in meetings and CDTFA appearances, help you towards a settlement, or stand up for you in court. They will walk you through the audit and appeals to get you out of trouble and allow you to get on with your life.
If you have been selected for a sales tax audit, you can probably remember in excruciating detail the exact moment you opened that envelope. Chances are you are still reeling.
While receiving a sales tax audit proposal from the California State California Department of Tax and Fee Administration is a serious matter for any business, it is not reason to panic. The best thing that you can do is stay calm and contact a qualified tax attorney. With the right representation by your side you can find a clear path through this process and come out the other side with your business and your sanity intact.
Why Hire an Attorney for Sales Tax Representation?
For small business owners with everything on the line, facing down a sales tax audit is a hugely intimidating prospect. In spite of all the possible complications during the audit process, we still see many people attempting to represent themselves before the California Department of Tax and Fee Administration.
When you are facing a frighteningly large sales tax determination and desperately trying to cut the costs associated with handling the matter, the temptation to tackle the audit yourself rather than investing in a qualified tax attorney can be strong. It is an understandable instinct, but it may not be in your best interest.
The truth is that it is easy for small business owners to fall into trouble with th eCalifornia StateCalifornia Department of Tax and Fee Administration (CDTFA) — even through no fault of their own — and it is exceptionally difficult to correct the problems that they create for themselves without a knowledgeable expert to navigate them through the process.
Sales Tax Audit Statute of Limitations: Is Time on Your Side?
A sales tax audit is a sobering ordeal, but it is one that many (if not most) California businesses will face eventually. If you are selected for an audit by the California California Department of Tax and Fee Administration (CDTFA), you will have to prepare a massive quantity of documents and records for your auditor to review, but how far back will the CDTFA want to look, and what are your rights? We will take a look at the California sales tax audit process, the statute of limitations and what they might mean for your business.
Introduction: What is a Statute of Limitations?
In general, statutes of limitations are laws which determine how much time can pass between an event and any legal filings related to that event. After that time period has passed, legal actions like claims and collection actions either can no longer be filed, or are likely to be dismissed if they are filed.
In criminal matters, after the statute of limitations has passed the courts no longer have jurisdiction. Different legislative bodies set different statutes of limitation which will vary by event, crime or location.
In terms of California sales tax audits, the statute of limitations refers to how many years the CDTFA has to assess any unpaid taxes, fines, and penalties you may owe.
The Sales Tax Audit Statute of Limitations
There is a time period within which the CDTFA must audit your business: this is the statute of limitations. Once that time period has passed, they cannot assess or collect taxes or penalties for those years.
In California, the general statute of limitations is three years for taxpayers who have filed tax returns. That means the CDTFA has three years within which they can audit those returns. However, if you fail to file tax returns, the statute of limitations is eight years.
There are some exceptions which could extend these statutes of limitations:
- If you have an amount due and payable for tax reporting periods before January 1, 2003
- You did not participate in the 2005 tax amnesty program
- Fraud or intent to evade tax is discovered
- From January 1, 2009, if the CDTFA has audited a company that has gone out of business, they can issue a deficiency determination (that is, a bill for unpaid tax and penalties) to a responsible person within the earlier of the following two periods:
- “Three years after the last day of the calendar month following the quarterly period in which we (the CDTFA) obtain actual knowledge of the entity’s termination, dissolution or abandonment. (Knowledge through its audit activities, compliance activities or written communication by the business.)”
- “Eight years after the last day of the calendar month following the quarterly period in which the entity was terminated, dissolved or abandoned. If the business files a notice of termination, dissolution or abandonment of the entity with a state or local agency other than the CDTFA, that filing will not constitute actual knowledge by the CDTFA of the filing.”
California Sales Tax Audits
California sales tax is charged statewide at a standard rate of 7.5 percent but local jurisdictions have added additional district taxes in many areas, which can range from 0.10-2 percent. The money raised by sales taxes is the main source of funding for state parks, roads, law enforcement and other public services.
California’s California Department of Tax and Fee Administration (CDTFA) is the body responsible for administering and collecting many of the state’s taxes, including sales and use tax. The CDTFA regularly conducts audits of California businesses to ensure that they are complying with state tax law.
The goal of an auditor is to find misreported or unpaid taxes which have been neglected either in error or through tax evasion.
Exactly how an audit is conducted varies depending on the type of business being audited, but at a minimum, they include an examination of records such as sales and use tax returns and worksheets, state and federal income tax returns, ledgers, invoices, statements, till receipts and more.
In some cases, auditors may use other types of tests such as markup analysis, statistical sampling, credit card percentage tests, and even undercover operations such as “pour tests” in bars and restaurants.
A sales tax audit can happen for any reason; sometimes it is just your turn to be audited. However, there are many circumstances which may make it more likely that you will be selected. If your business is largely cash-based, if you work in an industry known for high rates of non-compliance, if one of your vendors has been audited or if you have had tax problems in the past, you may be at greater risk of a sales tax audit.
If you have recently gone out of business, you can still be audited, and the CDTFA will attempt to hold you and anyone else directly involved personally responsible for found liabilities.
Appealing the Findings of a Sales Tax Audit
Appealing to the CDTFA
The process for appealing a CDTFA sales tax audit begins at the exit conference after the auditor has finished their investigation. If you disagree with the auditor’s report, you will generally be given a time period within which to collect evidence and make your case.
The CDTFA appeals process is lengthy, so you will have several opportunities to prove that you do not owe the assessed liability. If your appeal is denied at every level, you can eventually appeal to the courts, although California law requires that you must pay the assessed tax (minus interest) before you can file.
If the court finds in your favor, then you can request a refund.
Preventing Future Audits – How a Tax Professional Can Help
While nothing can guarantee that you will never undergo an audit, preparing now will make any future audits as painless as possible. Reviewing your sales tax recordkeeping on a regular basis and making sure that you have good systems and internal checks and balances in place is your best defense.
Having a tax professional perform a “reverse audit” or your records from time-to-time is a great way to ensure that your bookkeeping is impeccable and ready for review by the CDTFA or the IRS at any time.
If you are selected for an audit, you should consider speaking with a qualified tax attorney early on. Your attorney will be able to determine whether the CDTFA is operating within the statute of limitations. They will help you prepare and review your records for the auditor, they will work with the CDTFA to ensure that the audit is conducted properly and fairly, and they will negotiate on your behalf to ensure that you get the best possible outcome in any appeals process or settlement.
A sales tax audit is a stressful process for any business, but having an experienced tax lawyer on your side can smooth the way and give you true peace of mind.