Sam Brotman, JD, LLM, MBA February 11, 2022 12 min read

The Car Dealer's Guide To CA Sales & Use Tax Audits - Part 2

In “The Car Dealer's Guide To CA Sales & Use Tax Audits - Part 1,“ we discussed the CDTFA's history of targeting car dealerships for sales tax audits due to the high abuse and error in the industry, as well as the complexity of these kinds of audits. We also outlined how auto dealers are selected for an audit.

In Part 2, you will learn what to expect if you are the recipient of an audit engagement letter, some common techniques the auditor will use as well as how the interview and records examination will be conducted.

HOW THE AUDIT IS CONDUCTED AND WHAT TO EXPECT

If the CDTFA suspects your business may be in non-compliance, you may receive an audit engagement letter. The first step of any sales tax audit is the “audit engagement letter.”

In the letter, the auditor will briefly set out the terms of the audit and a preliminary list of documents to prepare for the first meeting.

A thorough review of records is universal, but questionnaires, interviews, and even covert observation are all common techniques. There will be a request to contact the auditor, who will likely request an interview.

The interview typically consist of a wide array of questions from the auditor while he or she types away a report of their observations and identifies potential areas of liability. After the interview, a dealer can expect more burdensome document requests.

The requested documents typically span several years of financial statements, inventory records, and deal jackets. The auditor will also make document requests to third parties in order to cross reference information given by the dealer.

Many times these third party records are unreliable and often result in an over assessment of liability.

Auditors will often use a sample to make their assessment. This means that one improper tax assessment can cost you many times over.

This is because the auditor will treat the sample if as representative of the total taxable sales. A tax professional can take a closer look at the auditor’s findings and help identify any discrepancies.

Lastly, the auditor will make their determination. If there is a liability found, the CDTFA can add penalties, levies, and even prosecution in instances of felony tax evasion.

However, before the determination is finalized you will have an opportunity to rebut the auditor’s results. If the auditor is convinced by your argument and evidence, he or she may adjust the amount owed.

If the auditor disagrees, you can still engage in the appeals process. If a settlement cannot be reached after the appeal, the last available option is to sue.

The Interview

The first step the auditor may take is to reach out and set up an interview. This is a critical stage in the audit, and the auditor will ask specific questions that may pertain to both sales and use.

The auditor will likely ask about sources of inventory, resale to wholesalers, consignment sales, cash expenses, and whether the dealer is engaged in any in-house financing.

The auditor may also ask whether the dealer or any family members own their vehicles or are allowed to drive vehicles off the lot.

The auditor is looking for leads here. CDTFA auditors are trained to already look for certain flaws based on the type of actions the dealer is engaged in.

For example, when an auditor learns that a dealer is engaged in buy-here pay-here financing, the auditor will already be on the lookout for underreported sales when examining those accounts.

An Examination of Records

Once the auditor makes their way to the office, the first item they will likely look to secure for examination are the ROS books assigned to the dealer from the DMV.

The auditor will have already called the DMV and got the ROS book numbers that correspond with the audit period.

The auditor will also request to look at the dealer jackets and inventory books. Although many dealers may not maintain double entry accounting systems, you should expect for the auditor to request your general ledger if one is available.

Auditors will usually examine a sample period out of the tax years under audit. The size of the period will depend on the experience and judgement of the Auditor. The following principles should be considered in selecting a test period:

  • The size should be large enough to ensure reasonable accuracy
  • The auditing time required should not be excessive in relation to the problem

In general, when auditing a business with good internal control, and a good accounting system, the test period may be a relatively small portion of the total audit period. However, in an audit of a business with little or no internal control, the test period most likely will cover a larger proportion of the audit period.

The Auditor will compare the dealers reported sales from their sales tax returns to the dealers Reports of Sale to verify that there was not any underreporting of sales.

The auditor will also look at voided reports of sale to ensure that there are no taxable sales that the dealer has treated as unwinds.

Beware, for added measure the auditor will next compare these reports to information gathered from a DMV Sales Database that provides the auditor with a list of all transactions that the dealer completed registration for.

After crosschecking the reports, the auditor may come up with a list of vehicles that they will claim the dealer owes sales tax on. Because the results are from a sample, any liability found may be multiplied across the remainder of the periods.

The results will be compared and analyzed for reasonableness in consideration of the dealer’s business as a whole. If the results seem unreasonable, the auditor will discuss the situation with the dealer.

The auditor and the taxpayer will need to come to some kind of agreement as to whether the results are representative of the business for the time period in question.

The auditor will, whenever possible, discuss the use of test periods with the taxpayer, include the taxpayer in the development or selection of a sampling plan, and try to reach an agreement.

In fact, very often the auditor will discuss and consult with business taxpayer its procedures and techniques, to obtain necessary information for the audit.

If, during the course of a sample, a document cannot be located, normal auditing procedure requires the auditor to obtain the reason for the missing or incomplete documents.

When the investigation fails to reveal any specific reason, the auditor may first determine whether there is any acceptable alternative evidence. Auditor and dealer will work together to obtain missing documents or auditor can ask for additional documents that may indirectly provide information sought by auditor.

The auditor will develop a sampling plan to outline methods of testing, time frame and so on. Prior to determining the type of testing to be used in a given audit situation, the auditor must make a thorough examination of the business operation for the period under audit.

This examination includes a review of source documents, changes in business activity, and changes in accounting procedures and key personnel. The plan is usually completed with assistance and input from the taxpayer.

The information and methods documented in this plan are not binding on either the taxpayer or the CDTFA staff.

The sampling plan can and will be continually evaluated (and changed, if necessary) based upon information obtained during the audit process. However, if any deviation from this sampling plan is required, the deviations are fully explained and discussed with the taxpayer.

CDTFA staff must first try to obtain from the taxpayer any data or documents which should have been retained in accordance with Revenue and Taxation Code section 7053.

However, if all other available avenues of information have been exhausted and approval of the district administrator has been obtained, CDTFA staff may request the information directly from the taxpayer’s financial institution either by obtaining the taxpayer’s authorization or by issuing a subpoena duces tecum.

Procedures for requesting records directly from a financial institution must comply with the California Right to Financial Privacy Act.

Follow Up Meeting with a CDTFA Representative

Once again you will be expected to make a presentation of the evidence in your favor. At this point, is your case remains unresolved, a "Notice of Determination" will be issued.

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Sam Brotman, JD, LLM, MBA

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