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One of the most common targets in a California sales tax audit is sales for resale. Sales for resale is the most common deduction claimed by California taxpayers and one of the most common targets of the California Department of Tax and Fee Administration (CDTFA).

California Department of Tax and Fee Administration sales tax auditors are especially careful in examining accounting methods used by taxpayers and use various procedures to verify amounts.

Often, California taxpayers will estimate this deduction and will get tripped up in a sales tax audit when the California Department of Tax and Fee Administration auditor uses their verification procedures.

Normally, there are two ways that a CDTFA auditor will verify sales for resale. First, if the claimed deduction consists of relatively few items so that all transactions can be examined in a reasonable amount of time, the California sales tax auditor will audit every item in detail.

Consequently, if sales for resale are numerous and of a reasonably similar unit value, the verification will be made on a test or sample basis.

The auditor will develop perimeters for their test, such as a time period and a method for screening data. This test will then be imputed to the rest of the audit period. California sales tax audits for sales for resale generally are broken down into 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

California Procedures for Detailed Sales Tax Audits Where Resale Data is Available

In the case of a detailed audit, and when a list of claimed resales is available, claimed resales will be summarized by months or by quarters in accordance with the taxpayer’s listings and records. The taxpayer’s detailed schedules will be used as a basis for the verification.

The auditor will examine sales invoices and other documentary evidence of the non-taxability of the sales, such as resale certificates, purchase orders, correspondence, or contracts. The nature of transactions and the type and number of items purchased will be scrutinized to determine whether resale certificates appear to have been taken in good faith.

All sales questioned by the auditor for any reason will be listed on a subsidiary schedule. A copy of this schedule will be given to the taxpayer as an aid in attempting to support the exempt status of the questioned items.

A reasonable period of time must be given to the taxpayer to obtain this information before closing the audit. If a list of claimed resales is not available, then the auditor will request the taxpayer to prepare a detailed listing of all claimed sales for resale and the taxpayer must be allowed a reasonable amount of time to do so.

If questioned resales are not supported by the taxpayer to the auditor’s satisfaction during a California sales tax audit, then those sales will be disallowed.

One special item of note: sales to Mexican merchants for resale are allowable if certain requirements are met. For example, a Mexican Merchant Identification Card must be valid and not expired at the time of the sale and the merchandise purchased for resale must be related to the special business classification codes on the card.

California Sales Tax Audits: Everything You Need to Know

Facing a sales tax audit is an intense time for any business. Even if you are sure that your bookkeeping and records are impeccable, the painstaking process of proving your honesty takes up a lot of time and resources, and hosting an auditor as they comb through your books is always a stressful prospect.

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.

Sales Tax Audits: The Basics

The revenues from sales and use taxes are used for roads, schools, parks and other vital public programs. As state budgets are always in need of more funds, it is in California’s interest to pursue the payment of these taxes aggressively.

The California State California Department of Tax and Fee Administration (CDTFA) is the government body charged with administering, collecting and enforcing the California tax code.

The CDTFA regularly conducts audits to ensure that businesses are correctly collecting, recording, reporting and paying sales and use tax.

There are many reasons that your business could end up under the scrutiny of a CDTFA sales tax audit. Businesses where cash transactions make up a large portion of sales are a natural target for an audit, as are companies which deal with a large number of exempt sales.

If your industry has a reputation for tax irregularities, it is probably only a matter of time.

These are some of the reasons that grocery stores, bars, restaurants and other businesses in the hospitality sector are frequently audited. Sometimes you can get swept up in the fallout of another audit if one of your vendors is found in violation of tax law that may set off a cascade of audits.

If you have had tax trouble in the past or been late or irregular with your filing or payments, you are inviting the closer attention of the CDTFA. Businesses which are undergoing big changes such as the closing or addition of a location can also be flagged for an audit.

What to Expect: First Steps

The objective of a sales and tax audit is to find irregularities, oversights, mistakes or evasions in the way your company deals with sales tax. If your business is selected, initial contact will probably be by letter.

The audit engagement letter is where the auditor will explain the terms of the audit, ask for a call or a meeting, and lay out a preliminary list of records and documents you will need. It is an important piece of paper as it offers your first opportunity to help your business.

Good preparation and the tone of your first interaction with the auditor are very important, so you should take care to comply with all of the requests in the letter. You will have some flexibility in scheduling the audit, and can ask for a reasonable amount of time to collect the required materials. Two or three weeks is standard. If you need more time you may be required to sign waivers.

A Waiver of Limitation is a document which will extend legal requirements if the auditor finds additional tax liabilities owed. The CDTFA usually works with a Statute of Limitations: a three-year limit within which they must investigate and charge delinquent taxes in your tax return. This waiver extends that time limit.

A Waiver of Credit Interest is a document which will absolve the CDTFA of interest owed if the auditor finds a refund or credit owed to you.

It is in your interest to have a tax attorney review your case before you sign a waiver or other document which could affect your rights in the audit.

No Longer in Business?

If you have closed your business recently, you can still be audited, and the CDTFA has been known to attempt to assess liability against as many people as possible. 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. In this case it is particularly important to have good advice from a tax professional before the audit begins.

Preparing for the Audit

After you have agreed on a time and a place for the audit, your next step is to collect and review the documents requested for the time period designated in the letter of engagement. That list is only the starting point, so you can expect further records to be required as the audit progresses.

It is good practice to prepare the most common records reviewed in audits of this type:

• General ledger
• Sales and use tax returns and worksheets
• State and federal income tax returns
• Sales invoices
• Purchase invoices
• Till receipts
• Property tax statements
• Documentation supporting exempt sales, such as resale certificates or freight bills

The auditor may be working on your premises, in which case you are expected to provide them with a space to work, a desk, good lighting and an electrical outlet. If they are working at their field office, you will be responsible for bringing the record to them (you will be given a receipt).

It pays to be professional and accommodating in your relationship with the auditor, but remember that you are not required to volunteer information that has not been requested.

What Are They Looking for?

The auditor will be looking for innocent errors and oversights as well as for evidence of willful misrepresentations and evasions. There are several stages to an audit, beginning with preliminary tests and proceeding to more detailed examinations as indicated by the findings.

Basic comparisons of books with tax returns are a usual first step, followed by more sophisticated statistical samplings and markup tests.

In some industries, undercover investigations may be used: for example, “pour tests” in restaurants and bars are sometimes conducted to ensure that the measures of alcohol reported by the business are truly representative.

After the Audit: What Now?

Once the auditor has finished their investigations, there will be an exit meeting where the findings are reviewed, and the auditor will prepare a Report of Field Audit or a Report of Investigation.

This is the point at which you can raise any disagreements with the assessment. If you want to protest the results of the audit, you will be given some time to collect evidence to support your case, which you will need to present to the auditor. After the official report is filed, you’ll later receive A Notice of Determination (billing), which will outline the taxes and/or fees you owe or A Notice of Refund.

If the CDTFA owes you a refund, they will first check to make sure that you do not have any other outstanding tax liabilities with any state agency. If you do, the refund will be applied to that tax debt. If you do not, they will issue a refund warrant usually within four to eight weeks of the Report of Field Audit.

If you do have a sales tax liability assessed against you and do not plan to appeal, you will need to pay the amount due within 30 days of the assessment.

If you fail to pay within that time period, you will be charged a penalty of 10 percent of the amount owed. Interest is also charged on the amount owed and the interest rates vary. Persistent failure to pay will expose you to aggressive collection actions by the CDTFA such as liens, levies or seizure of property and assets.

If you still disagree with the findings, you will need to file an appeal (“petition for redetermination”) within that 30 day period. The CDTFA has a long appeals process, and at each stage you will be required to make your case.

In an audit situation, the reality is that you are generally assumed guilty until proven innocent.

This is why having a professional tax representative is so important. While there is no need to take an adversarial attitude towards the CDTFA, the reality is that you are up against a huge organization with the full force of the law on its side and a vested interest in proving you wrong.

It is no easy task to navigate through all the rules, regulations and mountains of paperwork to ensure that the audit is conducted properly and fairly.

The advice and oversight of a trained tax attorney can simplify the process. You need someone who understands the intricacies of the California tax code inside and out, and who can analyze and assess the complex statistical methods and general procedures of an audit with a practiced eye

A good tax attorney will work alongside the auditor to oversee each stage of the audit, addressing issues as they arise.

Once the work of the audit is finished, your attorney is there to help you if you need to fight unfair audit results. They will prepare presentations, file documents on your behalf, and deal with every step of the appeals process.

If you can trust that you are in the hands of an experienced professional with your best interest at heart, much of the stress of a sales tax audit can be relieved.

At various stages during the appeals process, you will have opportunities to reach a settlement or an Offer in Compromise where the CDTFA agrees to accept payment of less than the amount you actually owe. Negotiating these deals is best done with your tax attorney by your side.

Whatever the outcome of your audit, you’ll want to do everything you can to avoid going through another audit in the future. Putting extra controls in place, tightening up operations, and reviewing your books at regular intervals are best practices which can keep your business on the good side of the CDTFA.

If you are ever in doubt about your compliance with California tax law, a consultation with a qualified tax attorney can give you renewed confidence and peace of mind.

Sales Tax Audits: An Overview

A sales tax audit has key differences from a regular audit. First, the scope of the audit looks at a business’s gross receipts and various ways of measuring gross receipts.

The businesses that are most frequently subject to sales tax audit include bars, restaurants, retail stores, manufacturers, wholesalers, services businesses that sell goods and a variety of others.

Throughout their years of practice, sales tax auditors have developed ways of determining gross receipts that are innovative and industry-specific. For example, if the business audited were a coin-operated laundromat, the California Department of Tax and Fee Administration may measure water consumption levels for the business against the number of washing machines it has.

Pour tests are common for restaurants and bars (the amount of alcohol used to make each drink) and inventory audits are common for other types of businesses.

The CDTFA sometimes feels that these methods are more telling than a standard gross receipts test. In addition, the CDTFA will normally ask for a substantial amount of documents in testing and verifying gross receipts during a sales tax audit.

These include bank statements, balance sheets, inventory purchase orders, utility bills, and cash register tapes (among other items). In addition, the CDTFA auditor may come out to the target business in order to do a sample test.

A sample test is where the auditor measures gross receipts for a specified period (they will be at your business all day). This sample can later be applied to an entire period in order to properly calculate gross receipts.

The inherent problem with this method is that your sample period may not be representative of a business’s yearly sales. Good examples of this are businesses that have seasonal sales or those being audited for a particular item that had abnormal sales within the sample period.

Obviously, a two-week sample measure might substantially increase or decrease a taxpayer’s sales tax audit liability depending on when that sample was taken.

The Difficulty With Sales Tax Audits

From a practical standpoint, gross receipts are difficult to get a precise measurement on and there is no industry standard method for performing a test for gross receipts. As such, the various methods that the CDTFA uses to measure gross receipts vary in the level of effectiveness in a sales tax audit. Some are quite reliable and others are no more than educated guess work.

In addition, if you have any familiarity with statistics, you know that there is a lot of “wiggle room” associated with how you collect data for a sample and how that data is measured. This leaves a lot of power in the hands of your California Department of Tax and Fee Administration auditor and leads to extraordinary swings in measurements of taxable measure (gross receipts).

As a result, those under audit are often presented with staggering bills at the conclusion. Some of these bills, after attorney review, are found to have no basis in reality.

As you can see, sales tax audits have a lot of built-in complexities that many people fail to consider. Because of the latitude involved in a sales tax audit and the various methods of calculating sales tax liability, I generally recommend that taxpayers engage with a sales tax audit attorney as soon as possible in the process in order to mitigate the damage involved.

Qualified tax counsel can go a long way toward getting the audit under control and mitigating the amount of liability involved.

California Sales Tax Audit Procedures and Techniques

The purpose of a California sales tax audit is to correctly measure the tax. The California Department of Tax and Fee Administration auditor conducts preliminary probing and testing in order to see if there is a potential area of misplaced tax. Sometimes preliminary testing reveals that a California sales tax audit of a business was not warranted.

When deciding whether to waive or perform an audit, the auditors consider the following points:

• Are accurate and complete records kept?
• Does the markup on cost of goods sold appear adequate?
• Are the persons preparing tax returns familiar with the law and the rules and regulations pertaining to their particular business?
• Are the reported amounts reasonable considering the type of business, nature of the premises, the location in the community, etc.?
• Do the reported amounts vary materially from period to period?
• Is there a good system of internal control?
• Is the taxpayer’s past record good?

In the course of a California sales tax audit, the auditor prepares an Audit Memorandum of Possible Tax Liability. Government Code sections 15618 authorizes an auditor to examine records of the taxpayer and of persons doing business with the taxpayer. Revenue and Taxation Code (RTC) section 7054 provides additional authority for the examination of records pertaining to the sales and use tax.

Similar provisions are found in other tax and fee programs administered by the CDTFA. Government Code section 15613 authorizes the Department  to issue a subpoena for the attendance of witnesses or to produce books, records, accounts and papers.

An Auditor or supervisor can request records and documents from the taxpayer but must explain to the taxpayer why records and documents are being requested. If the taxpayer refuses to provide records, CDTFA can subpoena them.

The auditor can not review records if access denied by the taxpayer, unless the auditor has a subpoena. If the taxpayer insists on video or audio taping the auditor as a condition of making the records available, the CDTFA may issue a subpoena for the records.

Most of the time a taxpayer’s request for video and audio taping is not approved anyway. The CDTFA may allow a taxpayer to audiotape audit discussions with the auditor provided the CDTFA makes its own audio recording.

In cooperation with the Department of Justice (DOJ), the CDTFA can provide assistance in the enforcement of money laundering violations by reporting suspected violations to DOJ. To accomplish this, CDTFA will pay attention to suspicious transfers of over $5,000.

Once the taxpayer has filed a claim for a refund and has requested or suggested determining the amount of refund by means of sampling, the claim will be assigned to an auditor who will contact the taxpayer to determine if sampling is feasible and, if so, develop a mutually agreeable sampling plan.

If a refund situation arises in the course of the audit, the auditor normally secures a claim for refund from the taxpayer utilizing the form CDTFA–101, “Claim for Refund or Credit.” The taxpayer should always be allowed a reasonable time in which to support a claim for refund during a California sales tax audit.

Under most circumstances, 90 days is considered reasonable. For extension of the 90 day period, CDTFA will usually require a waiver of credit interest, as a condition to deferring action on a claim for refund (Revenue and Taxation Code section 6908(b)).

The taxpayer will have to sign the form CDTFA–146, Waiver of Credit Interest  which can also be signed by a partner, corporate officer, or holder of proper power of attorney). On occasion, CDTFA can give 90 more days without waiver if the size of claim and amount of supporting detail required is large.

The maximum extension time a taxpayer can obtain to compile all necessary data is usually 12 months.

If the taxpayer does not provide the supporting data within the 12-month period, the claim for refund will be denied on failure to support the grounds upon which the claim was based. Extensions over 12 months are very rare and must be approved by high-ranking CDTFA officials.

Examination of Records

In a California sales tax audit, the CDTFA will examine a taxpayer’s record to determine whether sales or use tax was not paid. The verification procedure will include an examination of debits in certain general ledger accounts. The auditor will examine various asset and expense accounts and will trace the originating documents.

The auditor will examine invoices representing purchases of significant taxable additions to fixed asset accounts. Unsupported debits to the fixed asset accounts will be questioned by the auditor and listed on a subsidiary schedule.

The taxpayer must be provided with a copy of this schedule and given a reasonable period of time to obtain support for the items in question before closing the audit.

If no support is provided, use tax will be asserted against the taxpayer. As an example, if the proper amount of use tax has not been paid to the Department of Motor Vehicles on the purchase price of a vehicle, the use tax is to be asserted against the purchaser. To establish purchases subject to use tax, the auditor will look at other records as well.

For example, they will look at that Business Property Statement that taxpayers are required to file with their county assessor’s office on an annual basis. The statement lists all equipment the taxpayer uses in their business along with the purchase price and acquisition date. The auditor will also examine journal entries and requisitions.

California Sales Tax Audit – Form CDTFA–503 – ABC Letter Procedure

During a California sales tax audit, the taxpayer may be able to prove that the questioned items were not subject to tax, or were reported in another reporting period, or the tax was paid by the vendor on their tax return or audit determination.

To assist the taxpayer in satisfying their use tax obligation, the CDTFA has developed the Form CDTFA–503 – ABC Letter Procedure (called “ABC Letter”). When it is appropriate to use the “ABC” Letter process, the auditor will provide the taxpayer with a copy of the CDTFA–503–A, B and C.

The auditor must discuss the “ABC” Letter process with the taxpayer and explain that a satisfactory response to an “ABC” Letter inquiry alone is not necessarily enough to relieve the taxpayer from payment of the use tax, and that other evidence may be considered in reaching a conclusion.

The auditor should also explain that since the “ABC” Letter is not a substitute for a receipt for payment of use tax, additional documentation or information may be required.

A period of four weeks will be allowed for the taxpayer to prepare and send the “ABC” statements and for taxpayer’s vendors to reply. The CDTFA recommends that ABC statements are sent directly to them. If this is the case, the auditor will provide the taxpayer with return envelopes with the address of their district or branch office.

If the taxpayer elects to have the “ABC” statements returned to the taxpayer, then they should keep in mind that the likelihood of having CDTFA staff contact the vendor or sending an additional mailing is greater.

During a California sales tax audit, the taxpayer may customize the “ABC” cover letter (CDTFA–503–B) by using the text approved by CDTFA on their own letterhead. The text in the sample letter, which can be found at https://www.cdtfa.ca.gov/ should be used without additions, deletions or changes.

Any modification to the cover letter must be approved by the auditor’s supervisor. However, the CDTFA advises that the use of a standardized “ABC” statement will reduce any possible controversy over whether the substantiation provided is satisfactory. The taxpayer’s vendor is requested to return the completed “ABC” statement within 10 days.

The auditor, at their own  discretion, can require a second ABC Letter, if necessary. Upon receipt of the letter, the auditor will check the response for any inconsistencies. If inconsistencies are found, then the auditor will contact the taxpayer for explanation.

The original “ABC” statement should be sent or faxed to the CDTFA by the taxpayer’s vendor. If the completed “ABC” statements are to be sent directly to the taxpayer, the signed original will be examined.

CDTFA Sales Tax Audits — Part One: What is an Audit and How are Companies Selected?

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