Sam Brotman, JD, LLM, MBA February 16, 2022 21 min read

The Car Dealer's Guide To CA Sales & Use Tax Audits - Part 3

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Sam Brotman, JD, LLM, MBA

Owner and Director of Legal
Brotman Law

In The Car Dealer's Guide to CA Sales & Use Tax Audits - Part 2, you learned what to expect if you were the recipient of an audit engagement letter, some common techniques the auditor uses as well as how the interview and records examination will be conducted.

In Part 3 of our guide, we will discuss what happens after a Notice of Determination is issued, a little on California's special tax districts, DMV registration fees, not-so-secret warranty strategies and the importance of keeping your bills of lading.

THE APPEALS PROCESS & SETTLEMENT OPTION

After a Notice of Determination is issued, you will have 30 days to file a “Petition for Redetermination.” You can use the CDTFA's form, or file your own petition, which must:

  1. Be in writing.
  2. Identify the amount(s) you wish to contest
  3. State the specific grounds or reasons that the tax is not owed.
  4. Be signed by the taxpayer or an authorized representative.

In this petition you may also request an Oral Hearing in front of the California Department of Tax and Fee Administration and an Appeals Conference. At every stage you will be asked to present your evidence and make your case. At this point you have the option of making a Settlement Proposal.

Judicial Proceedings

If you cannot reach an agreement through the appeals process or through a Settlement Proposal, the next stage is going to court. There is a Full Payment Rule which requires you to pay the proposed tax in full (though you are not required to pay the interest at this time), and then apply to the court for review. If the court finds in your favor, you are eligible for a refund.

While this is the typical process that auditor’s follow in a used car sales and uses tax audit, there is no specific structure to a California Sales Tax audit.

The auditors are authorized to use a wide range of tactics to find the information they need. The auditor will be searching for two basic things.

These things are:

  1. taxable sales that were not taxed, and
  2. taxable sales that were not properly taxed.

Taxable Purchases That Were Not Properly Taxed

This is the use tax part of the audit. If you purchased something for personal consumption instead of resale, use tax is due.

A dealer should be familiar with the use issue presented by questions regarding whether the dealer or their family members own their own cars or whether they drive cars off the lot.

Although a dealer may already be both aware and compliant that family members are not to use dealer license plates for personal use, the dealer may not be aware of certain circumstances in which they may be liable for use tax for personal use of a vehicle they drive.

These penalties also apply to cars that a dealer might lend to an employee or even loaner cars given to customers while their vehicles are being serviced. It is important to go into the initial interview well prepared and ready.

At some point, the auditor may come to the dealership and take a tour of the lot. The auditor will be looking for anything out of the ordinary. They will be making an evaluation on whether the sales tax collected is reasonable based on the size and activity of the dealership.

The auditor may also peek into windows and examine car interiors. The auditor may examine the interiors of the vehicles to determine whether any of the cars in inventory are being driven for personal use.

If a car should come under suspicion, the auditor may request to take an odometer reading and compare the mileage to that at the time of purchase. The auditor will also be looking to find any other sources of revenue that the dealer may have; such as a body or repair shop, or other items held at the dealer for sale.

Taxable Purchases That Were Not Properly Taxed

This is the sales tax part of the audit. The auditor is looking for instances where you did not charge tax, or where you charged the wrong tax rate.

Special Tax Districts: Applying The Correct Rate

Most people are familiar with the fact that the sales tax charged in one California city can differ from the rate charged for the same item in another California city.

The reason behind the varying rates is because California has what are called “special tax jurisdictions,” also referred to as special tax districts. Special Tax Districts cause a great deal of confusion among many used car dealers, and even some tax professionals.

The State of California allows each city or “jurisdiction” to set their own sales tax rate to a limited extent. Each jurisdiction may choose to implement their own tax which they may charge on top of the State’s base rate of 7.25%.

Because each district may choose a different amount to add to the State’s minimum, special tax districts are created which charge varying amounts of sales tax.

Outside of the car dealer industry, the seller usually charges their customer the rate according to the district they do business in.

However, there is a dealer-specific exception which requires the dealer to charge the rate applicable to the district where the vehicle will be registered.

This means that the dealer is required to charge a different rate from one customer to the next. While most sellers would not be required to charge a different sales tax rate unless physically moving their business to a new district, the dealer may need to calibrate the sales tax rate repeatedly for each transaction.

For many car buyers, their purchase will often be the largest financial transaction they will make in years. Therefore, a dealer can expect that their buyers may have come to them from a district with a different sales tax rate which must be applied.

More often than not, car dealer newcomers are susceptible to this mistake out of unfamiliarity with dealer-specific rules. However, it is no surprise that even veteran dealers get tripped up by this tricky exception.

Failure to apply the appropriate special district rate can result in collecting the wrong amount of sales tax. Auditors routinely look here first for sales tax mistakes.

The auditor will first take a look at the dealer’s previous transactions; apply the proper sales tax rate (based on the registration address) to the sales price; and then compare the appropriate sales tax amount to the actual amount collected by the dealer.

If the auditor finds that a dealer has undercharged, the dealer may likely be held responsible for the difference in sales tax which should have been collected.

Of course, charging the wrong district rate may also mean that the dealer has overcharged in some instances. In the case that a dealer has overcharged, they must return the excess tax collected to the customer or turn over the excess amount to the CDTFA.

In either case, the bad news is the dealer may find himself with an unexpected tax bill. The resulting liability from this avoidable error often ends in financial burden, particularly for dealers in need of a steady cash flow to cover their floor plan curtailments.

You can plug-in the customer’s address here to find the appropriate tax rate to charge by address. Be sure to have a conversation with your F&I to ensure that your dealer is in compliance with this regulation.

If you think there is a chance your dealer may have miscalculated sales tax in the past, please reach out to a tax professional and discuss how you can take the appropriate steps to resolve the issue.

Registration Fees

The amount a dealer charges the customer for registration of the vehicle is non-taxable so long as it does not exceed the actual amount paid to the DMV.

Hopefully you are already in the practice of refunding the difference between fees actually paid to the DMV and the amount you estimated and charged the customer at the time of purchase.

There is a risk that the DMV will also take issue with any over assessment of registration fees which have not been refunded. Again, anything collected in excess of what is paid to the DMV no longer qualifies as a tax-exempt fee. Which means that the dealer will be liable for sales tax on these amounts.

Countless dealers give their customers a refund without getting a signed cash receipt or photocopy of the refund check to file away in the deal jacket. Failing to document the refund may signal the need to dig deeper into your records, under the belief that there will be more violations for the auditor to uncover.

By contrast, a well-documented record of refunded DMV fees indicates to the auditor that the business owner is responsible and familiar with the rules and regulations of the industry.

Establishing credibility with the auditor is important. In some cases the auditor might call off the audit entirely if a preliminary finding indicates that the dealer is in compliance.

Warranties: Optional vs. Mandatory

Warranties provide a great opportunity for both the dealer and the customer. The dealer can make a little extra profit, and the customer can drive off with peace of mind.

As an additional benefit, these customer’s purchase of a warranty is a non-taxable sale. This means you will not have to worry about collecting more tax when selling this product. Please note however, warranties only qualify as tax exempt if they are optional to the buyer. 

By contrast, a mandatory warranty occurs when the seller requires a buyer to purchase a warranty as a condition to the general transaction. This disqualifies the sale of warranty from the sales tax exemption allowed when left optional.

Persuading purchase is ok, but beware of the sales tax liability created when the customer’s choice is hindered. If the customer does not want to buy the warranty, the dealer should not be called off the sale.

This might pose an issue for dealers who tack most of their gross onto the back end. Due to an over-saturation of dealerships in the market, dealers undercut competitor prices as they often find themselves vying for the same customer.

Before the last wave of lease returns came due, a shortage of inventory caused auction prices to spike; this severely limited the ability of most dealers to engage in these price wars. These dealers use mandatory warranties to gain a competitive edge.

This is done by marking the vehicle at or near cost to bring the customer in. The dealer then makes up the profit on the back end by mandating the purchase of warranty.

The customer may leave or reluctantly oblige; figuring that if they are going to pay the same overall price elsewhere anyway, they may as well get the added benefit of a warranty.

What once was a crafty strategy to gain competitive edge is now the worst kept secret in the industry. The CDTFA is also aware of this strategy.

Pricing below the fair market price by shifting dollar amounts from the sale of the vehicle to the sale of the warranty has sales tax implications. This is because the vehicle sale is taxable, whereas the warranty is sales tax exempt.

When dealers also undercut the vehicle price, they short the amount of sales tax otherwise owed to the state. Auditors are specifically instructed to examine deal jackets for transactions that have a low sales prices and an added warranty charge.

Because auditors usually come from accounting backgrounds, they are keen to notice these transactions.

If almost every deal has an extended warranty, you might raise an auditor’s suspicion without realizing you have done anything wrong. Although dealer intentions are often benign, a pattern of moving dollar amounts from a taxable column to a non-taxable one can be interpreted as sales tax avoidance.

Trade-in Valuation

Another area the auditor will be on the look-out for sales tax avoidance is deals with trades.  Depending on how a deal is structured, a trade-in value assigned in a deal may grab the attention of an auditor. This is particularly an area of concern if the auditor suspects that the trade price and the sale price were both lowered to minimize the amount of tax paid. The Auditor will base their assessment on the fair market values of the vehicles.

Of course, there are times where a dealer will have the opportunity to steal the trade; and there are times where a dealer will give an over allowance on the trade to make the deal work. An over allowance is treated like a discount, these generally do not present an area of concern for the auditor.

In contrast, an under allowance­––assignment of a trade value that is below its fair market value––can lead to sales tax liability. This is the case even for isolated instances if the auditor determines the under allowance was made for the purpose of sales tax evasion.

Here is what the auditor is looking for:

  1. Recorded trade-in allowances that are consistently below market value and that are not attributed to less than fair condition of the trade-in.
  2. Gross profit margins that are consistently lower on transactions involving trade-ins than on those without trade-ins and which are not attributed to business practices followed by the industry, such as trades on loss-leader automobiles, or trades during promotional sales.
  3. A widespread pattern of under allowances occurring consistently throughout the audit period.

Although the auditor will primarily look for a pattern of behavior, if the auditor determines that a dealer deliberately under allowed the trade-in value in an isolated incident in order to avoid sales tax, the under allowance will be taxed as an additional gross receipt. Additionally, an intent to evade penalty may also be assessed.

Tax-Exempt Sales

Out-of-state buyers may qualify for a tax-exempt transaction. However, you may not allow the out of state customer to drive the vehicle off the lot. It does not matter that the dealer is fully confident that the buyer actually intends to drive the vehicle right out of state.

If the vehicle touches the road, it is considered to have been used in California and the seller can now find themselves with a tax liability.

To qualify for the exemption, the vehicle must be transported across state line. The dealer is responsible for documenting this by keeping a bill of lading. Should you find yourself in an audit, you will be glad to have kept it.

"Sam is a wonderful, results-oriented and extremely knowledgeable and talented attorney, who really has 'heart' in working on behalf of his clients, and explains options in a straightforward, respectful manner. He has assisted us with great outcomes which have added to our quality of life. I would not hesitate to recommend Sam for his services as he is an ethical, personable and expert attorney in his field. You will likely not be disappointed with Sam's work ethic, approach and his efforts."

-Aileen Dwight, Licensed Clinical Social Worker & Psychotherapist

Last updated: September 24, 2022

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Sam Brotman, JD, LLM, MBA

Owner and Director of Legal
Brotman Law

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