Brotman Law Presents

The Ultimate Guide to California Sales Tax Audits

Our Secrets for California Sales Tax Audit Defense

If you are a small or mid-size business owner in California selling tangible personal property, you should be collecting and reporting sales tax. You also have to file sales tax returns with the state of California.

In our experience, most businesses try to do things correctly when it comes to their sales and use tax compliance.

The last thing that pretty much every company wants is to run afoul with the California Department of Tax and Fee Administration.

However, sales tax in an area of the law that is confusing to many people, including tax attorneys that do not focus on state taxation. Even for people that try and stay compliant with the sales tax laws, your business can still be a target for the CDTFA and be hit with a California sales tax audit.

That is why our law firm has dedicated the time and the resources to creating our complete guide to California sales tax audits.

We wanted to put together the best resource on the internet for taxpayers faced with the prospect of a CDTFA audit. The state government publishes little guidance to help those facing audits and there is a lot of misinformation out there.

We have also noticed that when speaking to businesses and business owners that many people do not really understand the audit process. So, we decided to tackle this issue head on and to reveal many of the tips, tactics, and strategies that we use in our law firm for dealing with sales tax problems.

Although our ultimate guide is fairly daunting and some of the material is rather technical, it is not our intention that you sit down and read this cover to cover. Rather, we have broken everything down into a smaller, easy to digest chapters that cover different aspects of the sales tax audit process and to give you a better understanding of what the law is and how to deal with your tax auditor.

As always, our tax law firm is about trying to help people and we are always here if you have questions or need further assistance. One of the reasons that we publish these resources is to help not only our clients, but anyone who stumbles upon our website and is in need of a helping hand.

Regardless of whether or not you have the means to retain a California sales tax audit lawyer to help you with your CDTFA audit, we want you to not be on an unequal playing field with the auditor, so have written down and shared some of our best sales tax audit defense tactics and sales tax audit strategies to help you.

Thank you in advance for reading “A Tax Attorney’s Complete California Sales Tax Audit Guide.” It was a labor of love and our law firm welcomes all questions, comments, concerns, and feedback that you may have about this free resource.

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Sales Tax Audits – What You Need to Know

A sales tax audit is exactly what it sounds like; the California Department of Tax and Fee Administration (CDTFA) comes in and checks to make sure that sales tax was paid properly.

The goal of an audit 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, it includes 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. 

What does the sales tax audit process look like? Sales tax audits are pretty rough. They involve large amounts of data, complicated statistical methods and in certain cases, they involve sampling. 

This means that the state can go through a business's records over three years and audit every single transaction, but the problem with a lot of businesses, particularly a lot of retail businesses, is cash transactions.

The auditor and the representative are working through this very large amount of data and trying to make conclusions on it to make sure the appropriate amount of tax was paid in statement.

For some businesses, you can have tens of thousands, if not, hundreds of thousands, even millions of transactions over a three-year period. We see businesses all the time, particularly those with low margins and high frequency, that just have an absolutely insane amount of transactions.

In some cases, tax 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 that 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.

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.

Chapters in This Guide

01

What is California Sales Tax?

In this chapter, we define both sales and use taxes and we discuss the mechanics for how sales taxes work in California.

We discuss how the sales tax permitting process works and the responsibilities for businesses that are issued a California seller’s permit by the California Department of Tax and Fee Administration, which is the body responsible for the administration and enforcement of sales and use tax laws in California.

Then, we look at the concept of “tangible personal property” and what type of sales are subject to California sales tax.

Finally, we discuss the government functions, roles, and responsibilities of the California Department of Tax and Fee Administration known as CDTFA.

02

What Triggers a Sales Tax Audit in California?

This chapter examines the process for how businesses are selected for a CDTFA audit and the general goals of the CDTFA in promoting tax compliance among sellers of tangible personal property in California.

We look at how businesses are targeted for sales tax audits and the common things that we have discovered in our tax law practice that trigger a California sales tax audit.

Then, we turn to how far back a sales tax audit can go and examine a few different things related to California’s statute of limitations for sales tax audits.

Finally, we take a deep dive into the role of the sales tax auditor, what they are looking for in a sales tax audit, and how they find sales tax mistakes during the course of their examination.

03

Risks For Your Small Business in a California Department of Tax and Fee Administration Audit

This next section is all about making sure that you understand and are prepared for the risks that a California sales tax audit poses to both your business and the owner personally.

As we cover, the main problem with sales tax audits as opposed to a federal income tax audit (for example) is the amount of data you and the tax auditor have to deal with.

We talk briefly about statistical sampling (covered in detail in later chapters) and about civil and criminal penalties for sales tax fraud and serious errors on your business’s sales tax returns.

Finally, we spend a little time discussing what a dual determination is in the context of an audit and how the tax auditor’s decision to extend liability to business ownership can have pretty severe consequences.

04

The California Sales Tax Audit Process

Over the next several chapters, we will walk you through a California sales tax audit from start to finish and reveal insider information about how our firm handles audits.

As we explain, audits are won or lost well before the initial meeting with the auditor. Sales tax audits are almost an exercise in planning over anything else.

We will discuss what to you when you receive the initial audit notice and the document request attached.

Afterward, we talk about the initial contact with the auditor and the importance of having input into and pushing back on the tax auditor’s plan for the audit. We provide you with our tax attorney’s recommended strategies for dealing with the CDTFA auditor and responding to the records request.

05

How to Prepare for Your California Sales Tax Audit

This chapter is about one thing: preparation, preparation, preparation. We will share some of the biggest mistakes that we have seen small businesses make during the audit process and how to prepare for the challenges that lie ahead in your first meeting with the sales tax auditor.

We look at common problems in the sales tax audit preparation process, how to deal with challenges associated with poor record keeping, gathering the documentation for your audit, and the importance of the integrity of data in the course of a sales tax audit.

Finally, we discuss the importance of eliminating confusion around what the sales and use tax law is and how to take advantage of the auditor’s knowledge gaps.

06

How To File a California Sales Tax Audit Appeal

This chapter is all about the California sales tax appeals process for audits and CDTFA administrative tax resolutions.

We walk through both the receipt of the “Notice of Determination” and the response, which is called a “Petition for Redetermination.”

The appeals process in California is a fairly informal proceeding, but it is marked by tight deadlines and you need to make sure that you are properly prepared going into the CDTFA appeals conference.

If not, there could be several adverse consequences of what happens when the audit goes wrong.

07

Should I Hire a California Sales Tax Lawyer to Help Me With My Sales Tax Audit?

Usually our firm are big proponents of clients educating and trying to resolve tax issues on their own accord, but we do not recommend going it alone (or with a CPA).

Hiring a California sales tax attorney and having the support of someone who is specifically knowledgeable about sales and use tax law in California often make the difference in a tax audit.

You will see some of the strategies that we recommend and utilize in our California sales tax audit defense practice.

By providing this overview, we hope that you can get a sense of how you can take a process that seems like you are at a disadvantage and give you an advantage over the auditor.

08

How the California Sales Tax Audit Defense Practice Works with Brotman Law

This chapter contains a quick overview of what it is like to work with our firm.

We are one of the very few California tax law firms that focuses on our California sales tax audit defense practice and leverage our knowledge and working relationships with the local CDTFA district offices to our advantage in a sales tax audit and for the benefit of our clients.

Finally, we discuss the legal costs associated with retaining counsel in a sales tax audit. Usually, the cost/benefit associated with retaining counsel in a sales tax audit often makes this an easy choice.

Clients are often frustrated and stressed out by the audit process, but a sales tax attorney can help come in and get your California sales tax audit organized from start to finish.

09

What is Use Tax in California?

This is all about California use tax and California use tax audits. Use tax is often considered a companion tax to sales tax because use tax will often apply to situation where sales tax does not apply or where an exemption exists.

We cover a few more of the more technical issues associated with use tax in California and look at the impact of certain situations, such as resale certificates, on your sales tax audit. Sales tax issues and use tax issues often go together hand in hand.

10

Your Rights as a California Taxpayer

When you deal with the tax agencies of California, you may feel like you do not have any rights.

These agencies can be aggressive and overwhelming to most individuals not used to dealing with them.

However, you do have rights, an important detail to remember any time the CDFA contacts you.

In this chapter I give an overview of your rights as a taxpayer engaging with the California Department of Tax and Fee Administration.

11

What is Sampling and Testing in a Sales Tax Audit?

This chapter contains the most difficult, technical concepts that we have discussed in this guide, but they are at the core of some of the most important information.

Because sales tax often relies on statistical sampling, disputes in sales tax often come down to statistical matters even over the interpretation of the law.

In this chapter, we detail some of the methods that California tax auditors use when compiling data and how to challenge each method. You’ll learn what to look out for when being audited and minimize your exposure.

12

Types of Testing Used in Sales Tax Audits

When it comes to sales tax audits, the CDTFA has established in its capacity that time is money, which is why its auditors will use short tests and sampling to abbreviate the process.

There are a variety of testing methods, which I will describe in this chapter. In a nutshell, the auditor is going to take a “snapshot” of your business’ transactions, then extrapolate that to ultimately determine if you are copacetic with your sales tax reporting.

With careful planning, you can devise a strategy to control the audit and reduce the number of transactions that the auditor can look back at.

13

California Sales for Resale and Resale Audits

In this chapter  you can read about the two ways that a CDFA auditor will verify sales for resale and how an auditor will develop perimeters for their test, such as a time period and a method for screening data.

We also run through California sales tax audits for sales for resale 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
14

Sales Tax Requirements for Retailers Outside of California

An out-of-state retailer “engaged in business in California is required to register, collect use tax on taxable sales made to consumers in California, and remit this tax to the California Department of Tax and Fee Administration.

This encompasses a wide scope of descriptions, including maintaining office space. If you do any sort of retail business or have an agent doing business for you, this chapter will provide you with some important information.

15

What Types of Penalties Can I Face in a California Sales Tax Audit?

The next chapters deal with penalties that are commonly associated with sales tax audits and how to mitigate and deal with those penalties in the context of the audit.

Often, we tell our clients to be equally mindful of the penalty portion of their potential liabilities in an audit and we do whatever we can during the audit in order to mitigate those sales tax penalties.

16

Negligence Penalties in California Sales Tax Audits

The CDTFA recognizes two major classes of negligence: negligence in keeping records and negligence in preparing returns. These two types of negligence allow for the imposition of the negligence penalty.

In this chapter I will discuss Negligence Penalites, which are defined in general as a failure to exercise due (proper) care that a reasonable and prudent person would exercise under similar circumstances.

In addition, with respect to business tax matters, negligence may be further defined as a substantial breach by the taxpayer of some duty imposed by the law.

17

What Are the Penalties for Tax Evasion and Tax Fraud in California Sales Tax Audits?

Evasion is one step above negligence and occurs when taxpayer acts beyond just failing to exercise proper care and diligence, and if such failure was intentional and for the purpose of tax evasion.

In this chapter, we will discuss how the CDTFA must prove such deliberate intent by so called “clear and convincing evidence”.

We will explore how this can be proven leaving no substantial doubt as to the truth.

The taxpayer’s intent is the key to impose tax evasion penalties. For example, intent can be shown through consistent multiple tax return under-reporting by taxpayer.

18

What is a California Sales Tax Exemption? [Definition andExamples]

Our ultimate guide concludes with a chapter that discusses sales tax exemptions in California. Although last, this chapter certainly is not the least important by any stretch of the imagination.

Understanding sales tax exemptions is one of the key technical issues that you need to know in a California sales tax audit.

Businesses lose out on millions of dollars in potential exemptions every year and the audit is the perfect time to seek a course correction of any overpayments of sales and use tax that you may have paid.

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Chapters