What Causes a Sales Tax Audit and Sales Tax Audit Triggers
A sales tax audit occurs when the CDTFA suspects a business’s reported sales have been understated. Most commonly, this occurs in situations where there is a “mismatch” or an incongruency between the sales tax returns filed with CDTFA and what was reported to other agencies (like the IRS). For example, a business that has different total sales amounts on their sales tax returns and their federal income tax returns is likely to get audited.
In situations where CDTFA believes that there is understated taxable measure, CDTFA headquarters in Sacramento will send those files to the local district office who will then select the businesses that they are going to audit. In addition to this, random audits can be scheduled as well. The CDTFA has stated that it will audit nearly one percent of active accounts each year.
However, more often there is a definite trigger leads to a CDTFA audit. CDTFA audits are time consuming and California has limited resources and auditors to effectuate them. So, although we have come across audits that we believe are random, it is far more common to see audits with some underlying motivation. Keep in mind the following:
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
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.
Common Sales Tax Audit Triggers in California
Here is a list that we have developed internally of the most common audit triggers:
Failing to Report Sales and Use Tax to CDTFA
This one is pretty obvious, and it is not that hard for the CDTFA to figure it out. If you have a website or phone number for your business but are not in the CDTFA’s system, or if you are paying payroll tax or other tax in California but have not registered for sales and use tax, you have a big red target on your back.
CDTFA has also been known to look for business registrations and to cross reference federal tax filings in an attempt to look for businesses that may be evading sales tax.
Vendor and customer audits, as well, are prime sources of information. If you or your vendors are audited by the CDTFA, it can trigger follow-up investigations by other agencies. Even if you are located outside the state, if you sell anything in California, or it makes a stop in California while being shipped elsewhere, you may be assessed a tax and could be targeted for a CDTFA audit as well.
Consistently Reporting or Filing Your Sales Taxes Late
If you have a history of failing to report, file or pay sales tax, the CDTFA can become suspicious of your bookkeeping practices. After all, continually procrastinating with the filing and payment of your sales taxes does not inspire a lot of confidence. CDTFA also understands that if you are struggling to pay the tax, there is an incentive to under-report sales as well or to take other reporting shortcuts to try and minimize your sales tax burden.
High Exempt Sales or Deductions Taken on the California Sales Tax Return
Reporting of tax-exempt sales is not uncommon especially among certain industries, but going back to the presumption that all sales are taxable unless proven otherwise, a high amount of exempt sales or deductions taken against total sales may trigger an audit.
Overstating deductions in order to reduce the amount of tax due and owing to CDTFA is equally prevalent as understating sales. Additionally, the rules and regulations governing exempt sales are complicated, and there is a high tendency towards misunderstandings and mistakes. Tax due to California as a result of a CDTFA audit can also be caused by innocent oversights and negligence as well as willful fraud.
To reiterate, if you have a high amount of exempt sales or deductions taken against total sales, the CDTFA may likely audit you in order to find out why.
You Have Been Audited by CDTFA in the Past
This is especially true if you have been audited in the past for a specific issue that you have not yet cleared up. If you have been audited once, you are likely to be audited again if the CDTFA feels that another audit will yield additional tax due and owing to the government. If you have not fixed the problem, you will be charged again until the CDTFA is satisfied you are doing things right.
One of Your Vendors Was Audited by CDTFA
This is called audit by association. A few paragraphs ago we said an audit at one of your vendors could trigger an audit of your business. If you learn that one of your vendors or suppliers is being audited, do not be surprised to find an audit letter addressed to you in the near future.
Large companies get audited regularly, and these can trigger “whipsaw audits” on all of their clients and vendors. This is one of the ways that smaller businesses that previously flew under the radar attract notice.
Your Business Had a Major Change
If you acquired a business, opened a new location, or closed one, the CDTFA may become interested in your sales tax records. It also pays attention to when there is a sudden increase or decrease in sales. This is why businesses that go through some sort of a transition may be at risk for an audit.
If you have closed your business recently or try to sell it, you can still be audited, and the CDTFA has been known to attempt to assess liability against as many people as possible in order to make sure that any tax collected is ultimately paid. 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.
Your Industry Is Known for Substantial Non-Compliance
Some industries just have a reputation for sales tax non-compliance, especially businesses dealing in cash:
- Grocery stores
- Car Dealerships
- Gas stations
- Liquor stores
Cash is easily “lost” or hidden, but the CDTFA wants every bit of it recorded and reported. Scaring other cash businesses and industries that are big on cash into compliance is one reason that these businesses are audited frequently. It is easy to cheat when things are in cash.
Cash businesses and others that are notrorious for non-compliance are also frequent targets for CDTFA audits because they tend not to adhere to sales and use tax law as a matter of course. There may be a lack of internal controls, or the requirements are not understood.
If your industry has a reputation for tax irregularities, it is probably only a matter of time even if you have not done anything wrong.
A CDTFA audit is nobody’s idea of fun, but it happens. Sometimes, the reason for the audit is out of your control, but these common factors identify those who have potentially a greater risk.
How Far Back Can a Sales Tax Audit Go? 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 CDFA) 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.”
However, the problem with California sales tax audits is that once the audit is open, California can essentially force an extension of the statute by just assessing the taxpayer if they refuse to extend the statute.
With essentially the ability to control the pace of the audit, interest can continue to build on any adjustment in tax that comes at the end of the audit. It is, therefore, important to control the pace of the audit and there is some strategy built around how to leverage the statue of limitations in an audit to your advantage.
What the CDTFA Auditor is Looking For
CDTFA’s auditors are looking for mistakes, errors, and omissions. They are looking at your data, they are examining the relationship that different data has to other data. they are looking at the returns that were filed, and they are looking for any errors that exist.
Within your data, the auditor is then going to look at different things. They are going to look at purchases to make sure that the appropriate amounts of tax were charged and paid, they are going to look for exemption certificates with any resales that were made, they are going to look to make sure that shipping charges were appropriately taxed, and they are going to go through and look at various different issues that are specific to your industry.
The CDTFA is not auditing you by accident. You got selected for audit because they are looking for something (whether or not you are subject to a random audit). They believe that the effort that they put into the audit is going to yield some error in the amount of tax that you paid, so it is the auditor's job to go through your data and try and find mistakes.
If they do not think they are going to find any mistakes, they cut bait. However, keep in mind that the law is very complicated and auditors are very good at finding mistakes.
The way you mitigate the auditor going on a fishing expedition is to present something that is very tight, very concise, and to control the scope of information that you give to them. The more tightly controlled the data you are providing to the auditor is, the more that you are going to be able to limit mistakes in your presentation, and the less likely that the auditor is going to make adjustments during the course of your sales tax audit.
How CDTFA Auditors Find Mistakes
The most common errors are discrepancies between primary source data and the sales tax returns that were filed. For example, if the sales on your federal income tax returns do not match the sales that were filed in the sales tax returns, the auditor will find that error and figure out a way to calculate what the true percentage of sales were, from the auditor's perspective.
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.
We will cover this more in later chapters, but CDTFA auditors have different methods for analyzing data and different methods for finding mistakes or assessing you for different things on your return. The important thing to remember is that when you are in a CDTFA audit, you can consider yourself under the microscope.