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.