California Sales Tax Audit

In a down economy where the government has significant shortfalls, it is to be expected that its tax collection and enforcement agency will continue to become more aggressive. This includes California’s apparent redoubling its efforts in conducting sales and use tax audits. You do not ask for a sales tax audit; rather, one happens to you. If you have found your way into one, the question you should be asking is, What must I do to ensure this runs as smooth as possible? What can I do to prepare for an audit?

Purpose of the California Sales Tax Audit

california sales tax audit helpThe purpose of a sales tax audit is to determine whether a taxpayer has paid the correct amount of sales tax to the State. In California, it is the California State Board of Equalization (BOE) that attempts to discover revenue that has not been properly taxed or revenue where sales tax was collected and not remitted. Audits seek to promote compliance with the tax laws, and serve as a means for increasing state revenue. Most California companies are audited from time to time.
If your business is presently, or shortly will be, subject to a California sales tax audit, there are some things you should consider to prepare:

Books and Records

The first thing you should do is assure yourself that you have maintained accurate books and records. It is good practice to assume that you could come under audit soon after filing your sales tax returns. Many sales tax problems arise because there is a lack of adequate record keeping. A sales tax Attorney / CPA can help to determine whether your records are adequate, and also advise you whether to reconstruct records prior to submitting to a sales tax audit.
You are better situated if you begin preparing for an audit now, as opposed to waiting for the notice to arrive. Yet, if the audit notification has already arrived, you must begin gathering the necessary documentation and conduct a “private” audit before the auditor arrives.

Read the Audit Notice

Many people skip over this part, but it is an important step. Read the notice and respond within the appropriate timeframe. After reading the Notice, you will discover which items the auditor seeks to review. I routinely recommend that a representative be hired before making contact with the sales tax auditor.

Treat the Audit Seriously

Recall that the auditor has an inherent adverse interest to you: he is not your friend. Thus, be respectful with the auditor, but do not assume he is your friend. It is instructive to know that a California sales tax auditor often thinks that businesses routinely intentionally avoid charging and collecting sales taxes. Their attitude is, in practice, often one of a presumption against your business-and their goal is not to determine whether your business has cheated under sales tax law, but simplyby how much it has.
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Hire a Sales Tax Audit Attorney

Hiring a tax attorney is a good idea since he knows how to navigate the complex tax laws and the government’s audit procedures and will zealously advocating for you. The job of your tax attorney is to ensure that your business is treated fairly during its sales tax audit. This means, among other things, he seeks to ensure that the government does not overstep its bounds by interpreting complex sales tax law to your disadvantage. The government is often wrong in its conclusions, and it often takes a sales tax attorney to threaten litigation for the government to admit to its error. Your sales tax attorney will also advocate for you by preventing the government from making unfair assumptions about your business revenue. It is wrong for the SBE to overtax businesses simply because the California government needs the revenue.
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Commonly Asked Questions

"Why was my company selected for audit?”

At this point you may be wondering why your business was selected for audit in the first place. The reason why your business was selected could have been arbitrary, but it is also possible it was because of certain triggering events that arose from your business’s history of sales and use taxes. In particular, there are a number of factors that may lead to a sales tax audit:
  • (i) Failing to report sales and use tax;
  • (ii) Consistently reporting/filing your sales and use taxes late;
  • (iii) Reporting substantial exempt sales;
  • (iv) Past sales tax audits lead to suspected present sales tax problems;
  • (v) One of your vendors was recently audited;
  • (vi) You’re in an industry where substantial non-compliance has been found
By way of example, suppose your business tends to report substantial amount of exempt sales. This may trigger an auditor to inquire about the nature of those sales. When this happens, you want to be in the best defensive position possible which, among other things, will include gathering all documentation supporting the view that those sales are, indeed, tax exempt. There may be your company was selected for audit.

What sorts of questions does an auditor ask?

It may be helpful to know in advance of an audit what sorts of questions the auditor will ask of your business, and what types of documentation will be examined. The auditor will seek to find unreported taxable income by examining evidence related to:
  • (i) Book sales compared with sales reported on the sales tax returns;
  • (ii) Bank deposits compared with sales reported for sales tax returns;
  • (iii) Sales tax returns compared to sales reported for sales tax returns;
  • (iv) Engaging in a significant amount of internet based purchases or sales;
The auditor will likely have a questionnaire for you, asking for general information about the business: its owner, structure, and its intended market share. In addition, the auditor will likely request the following: income tax returns, general ledges, sales ledgers, invoices, receipts, purchase and sale journals, bank statements, and depreciation schedules, among others.

Do the California Auditors Work with the IRS?

Often conducting a sales tax audit leads to a double slam-dunk for the government. This is because, in addition to finding discrepancies with your business’s sales taxes, the auditor may discover  income tax fraud or evasion. If discovered, the auditor will discretely refer your case to the Franchise Tax Board or IRS’s Criminal Investigations Division, with a possible recommendation for prosecution. Sales tax fraud can also be prosecuted directly.
Even if no factors lending themselves to criminal prosecution are apparent in a client’s fact pattern, the State Board of Equalization (“SBE”) often shares information gleaned under audit with the IRS and the California Franchise Tax Board (FTB). For this reason, it is crucial to dispute all false sales tax audit adjustments-even if, at first, it does not seems worthwhile or cost effective. Where a sales tax liability is proposed to exist for unreported revenue by the SBE, additional corresponding income tax penalties and interest due from the IRS or FTB could quite logically follow upon the SBE making a referral to either agency because the FTB and IRS routinely share information.

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