Sales Tax Audits
The State Board of Equalization (BOE) regularly conducts random audits to ensure businesses have paid the correct amount of California sales tax.
The BOE states that nearly one percent of active master accounts are audited each year. However, an audit is almost inevitable for certain cash-based businesses like restaurants, bars, grocers and liquor stores. Other types of business commonly hit with sales tax audits are advertising agencies, vehicle dealers, distributors, manufacturers and construction contractors.
A sales tax audit is rarely started without prior notice, which is either a phone call, a visit to the business or a letter from the auditor.
At the initial contact, the auditor will inform you of the audit period, which is usually three years, and will ask about your business operations and what type of records you keep. For those businesses that do not keep adequate records, auditors are then forced to conduct complex calculations to estimate the amount of sales a business had during the audit period. If an estimate is to be used, it is important to analyze the estimate procedures used to determine whether all relevant factors that may have affected business flow are taken into consideration.
The auditor will then set up a date and location to begin the audit. If you wish to have a representative handle the audit, the auditor will arrange an appointment with this person.
Due to the volume of records requested, BOE sales tax audits are often time consuming and costly.
Field audits on the premises of a business are commonplace to allow the auditor access to the taxpayer’s books and records. Most often examined are:
- Tax Returns
- General Ledger
- Cash and Credit Card Receipts
- Accounts Receivable
- Invoices and Merchant Purchase Orders
- Bank Statements
- Register Tapes
- Balance Sheets
- Resale & Exemption Certificates
The BOE also employs a variety of industry-specific sampling tests to determine if additional tax is owed. For example, bars and restaurants might be subject to an undercover pour test to define the amount of alcohol being poured into every drink. Over pouring can result in additional sales tax being assessed.
Following the preliminary examination, the auditor will either waive the audit or decide a complete sales tax audit is warranted. If the latter is the case, additional information will be requested, and the audit can either be on a sample basis or actual basis.
For a sample basis audit, the auditor randomly selects enough transactions in order to draw a conclusion about all of the transactions under review. For example, an auditor might randomly select invoices for a portion of sales to determine how accurately you have reported tax on all of your sales. It is important to point out any out of the ordinary transactions if they are included in the sampling.
Whether the auditor reviews your records on an actual or sample basis depends on the type, size, complexity, and accounting methods of your business. Sampling is normally used when an actual basis review would take too much time. In many cases, the auditor will use both methods on the same audit. For example, asset purchases might be audited on an actual basis while sales are reviewed on a sample basis.
Estimate of Taxable Sales
There are a variety of methods BOE auditors use to calculate an estimate of taxable sales. Each method, however, gives a rough estimate and relies on certain underlying assumptions for the results to be accurate. A few of the methods used are:
- Markup Analysis-Generally used for cash-based businesses where there is a potential for sales to be understated. The markup analysis compares your cost of goods sold with reported sales to calculate a markup per your records. A markup is then computed based on your current purchase invoices and your selling prices for these same items.
- Credit Card Projection of Sales-The auditor will pick a representative test period to review daily credit card sales. The auditor will then compute a percentage of credit card sales to total sales.
- Observation Test-An alternative method to support recorded total sales or taxable sales is the observation test, which is the physical observation and recording of the activity of the business for a specified period of time.
When the audit is complete, the auditor will present the findings at an exit conference with you and/or your authorized representative and will explain any proposed refunds or additional taxes owed. If it is determined there is no refund or taxes owed, then you will receive a letter stating your returns have been accepted as filed.
At this time you or your representative must agree or disagree with the audit findings. If it is determined you owe taxes, you will receive a report that summarizes the findings of the investigation and indicates your agreement or disagreement with the conclusion.
If you disagree with the audit results, the auditor might defer preparing the final audit report to allow you a reasonable amount of time to provide additional information to support your argument.
Once the auditor has reviewed your additional information, the audit results might be adjusted. The auditor might also request more information and arrange for another discussion or recommend the next step in resolving the dispute by setting up a meeting with the audit supervisor.
The supervisor will schedule a meeting with you and/or your representative in order for you to explain why you disagree with the audit results and present supporting documentation. The supervisor will then decide whether the audit results should be adjusted and discuss any proposed adjustments with you. At this time, you should let the supervisor know if you still disagree with the findings.
Once you receive a Notice of Determination, you will have ten days to decide whether you want to appeal the decision. To appeal the Notice of Determination, the first step is to file a petition for redetermination.
If the appeal is still not resolved following the redetermination, the case is referred to the Appeals Division for an Appeals Conference. At this point, you will be sent a Verification of Appeals Conference form to continue the process.
Following the Appeals Conference, the Appeals Division issues a Decision and Recommendation based on the relevant evidence presented. At this time, one of four recommendations are made. The Appeals Division can:
- Grant your appeal
- Deny your appeal
- Deny your appeal in part
- Issue a re-audit
If you do not agree with the Appeals Division determination, you can request a hearing with the Members of the BOE, which is a board of five people. You will once again be able to present your case. The Board will then issue a determination, and if you still owe taxes, you are required to pay that amount at this time, even if you oppose the determination. If you continue to disagree, you must file a petition for a rehearing within 30 days.
Once you have paid the taxes owed determined by the Board, the next step is to file a claim for a refund where you will specify the amount you believe you have overpaid and the reasons why it was overpaid.
If the refund claim is denied, you can make a request to the Appeals Conference or a hearing before the Board. If the Board denies your claim for a refund, that ends the appeal process with the BOE. The only remaining action to contest the liability is to file an action in court for the refund.
If a BOE audit determines an underpayment of sales taxes, it might cause other state and federal agencies to investigate whether you also underpaid income tax and other taxes. This could create some sizeable liabilities.
A state sales tax audit can be extremely time consuming, costly and complex, and generally requires someone with the knowledge of California tax laws as well as understanding the inner workings of BOE. The experienced tax attorneys of Brown, PC can help you through a sales tax audit. We represent clients in Los Angeles and throughout California. To speak with an experienced California state tax lawyer, please contact the firm online or by calling 424-252-1100.