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?

At the Tax Law Office of David W. Klasing, our innovative, forward-thinking team of tax attorneys and accountants provides sales and use tax audit and appeals representation, criminal tax defense representation, and business bookkeeping and tax planning and compliance services for all kinds of businesses statewide. Whether you are facing a sales or use tax audit, are concerned about criminal tax exposure, or simply have questions about best practices for bookkeeping and accounting, tax planning, or tax compliance, rely on our dual licensed California Tax Lawyers and CPAs for clear and trustworthy guidance.

Nature and Scope of Sales and Use Taxes

The various sales and use taxes that are levied in California together form a comprehensive tax system applicable to the sale, use, storage, and consumption of personal property. Sales and use taxes are mutually exclusive but complementary and are designed to be exact, from all consumers of tangible personal property within the state, an equal tax based on a percentage of the purchase price of the property in question. Under the California Sales and Use Tax Law, in essence, a sales tax is a tax on the freedom of purchase, and a use tax is a tax on the enjoyment of that which was purchased.

While the sales tax and the use tax are complementary to each other, they are not interdependent. Each is a separate tax. The sales tax is imposed on the retailer for the privilege of selling tangible personal property. The use tax is imposed on the purchaser who stores, uses, or consumes property in this state.

Purpose of the California Sales Tax Audit

The 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.

We can help you maintain and make available for examination on request by the California Department of Tax and Fee Administration (CDTFA) or its authorized representative all records necessary to determine the correct sales tax liability under the Sales and Use Tax Law and all records necessary for the proper completion of the sales and use tax return. Such records can include but are not limited to:

(i) Normal books of account ordinarily maintained by the average prudent businessperson engaged in the activity in question;

(ii) Bills, receipts, invoices, cash register tapes, or other documents of original entry supporting the entries in the books of account; and

(iii) Schedules or working papers used in connection with the preparation of tax returns.

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.

Please be aware that you should never attempt to bluff or explain an item or transaction. Anything you say can and will be used against you. There are no informal conversations with CDTFA agents. If the explanation is false, it is evidence of fraud.

When the California Department of Tax and Fee Administration is not satisfied with the amount of sales tax reported by you, it may determine the amount required to be paid on the basis of any information within its possession or that may come into its possession.

Our team specializes in helping forward-thinking, entrepreneurial organizations and individuals by providing a full range of services designed specifically with their needs in mind. We are trained in dealing with complex sales and use tax issues for privately held business entities and are experts in identifying tax-planning opportunities that may apply to their businesses.

Who can be Audited for Sales and Use Tax?

Service Enterprises Generally

Persons engaged in the business of rendering service are consumers, not retailers, of the tangible personal property which they use incidentally in rendering the service. Tax, accordingly, applies to the sale of the property to them that is involved with providing the service they sell. If, in addition to rendering service, they regularly sell tangible personal property to consumers, they are retailers with respect to such sales, and they must obtain permits, file returns, and remit tax measured by such sales. If their purchases of tangible personal property are predominantly for consumption rather than for resale, they should not give resale certificates covering such purchases but should follow the procedure prescribed in the regulation governing “Tax-Paid Purchases Resold.”

The basic distinction in determining whether a particular transaction involves a sale of tangible personal property or the transfer of tangible personal property incidental to the performance of a service is one of the true objects of the contract; that is, is the real object sought by the buyer the service per se or the property produced by the service. If the true object of the contract is the service per se, the transaction is not subject to sales tax even though some tangible personal property is transferred. For example, a firm that performs business advisory, record keeping, payroll, and tax services for small businesses and furnishes forms, binders, and other property to its clients as an incident to the rendition of its services is the consumer and not the retailer of such tangible personal property and thus is not required to collect and remit sales tax from their client’s. However, they must pay sales tax on any tangible personal property utilized in providing the service.

Contractors and Subcontractors

In general, construction contractors are consumers of materials that they furnish and install in the performance of construction contracts. Either sales tax or use tax applies with respect to the sale of the materials to or the use of the materials by the construction contractor.

Manufacturers, Producers, Processors

The sales tax applies to the sale of tangible personal property to persons who purchase it for the purpose of use in manufacturing, producing, or processing tangible personal property and not for the purpose of physically incorporating it into the manufactured article to be sold. Examples of such property are machinery, tools, furniture, office equipment, and chemicals used as catalysts or otherwise to produce a chemical or physical reaction such as the production of heat or the removal of impurities.

Overview of a Sales Tax Audit

Audits by the California Department of Tax and Feed Administration are governed by the policies and procedures set forth in a yearly audit publication. Furthermore, the audit guidelines alone, with recent changes to sales and use tax audits, can be accessed on the CDTFA’s website. The typical sales tax audit covers a three-year look-back period.

A CDTFA auditor conducts sales tax audits. The auditor is supposed to work impartially to determine the business’s compliance with its sales tax obligations. The auditor is supposed to determine whether under or overpayments of sales taxes have been made by the business. Typically, the auditor accomplishes his task by referring to the records a business owner must keep and provide per Regulation 1698 Records.

A business owner should, for purposes of CDTFA audits, retain business records for a minimum of the preceding four years. The auditor may also request third-party records held by government agencies or other businesses such as wholesalers.

Typically, though with some rare exceptions, the CDTFA will provide the business notification prior to conducting an audit. This allows the business time to prepare for the sales tax audit, including gathering the records discussed above. However, even the initial contact with the auditor can have a substantive effect on your business. During this initial telephone call or in-person notification, the auditor is likely to ask about the type of business, the extent of operations, and the type of records you keep. The auditor will then inform you of the type of records you should have available for the sales tax audit. If you wish to have an attorney, accountant, or other authorized representation handle the audit on your behalf, you should inform the auditor of this fact, provide contact information, and allow your representative to handle these and other questions.

Need help or have a Business Tax Audit? Contact us!

Hire a Sales Tax Audit Attorney

Hiring a tax lawyer 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.

During an eggshell sales tax audit, the CDTFA is looking for the possibility that you, as a subject of a seemingly civil sales tax audit, will make criminal admissions and or sufficient badges of fraud are discovered to provide the criminal investigation division of the CDTFA with sufficient information to lead to the initiation of a potential criminal sales tax investigation followed by a criminal sales tax prosecution. The worst part of this type of audit is the CDTFA is known to share very incriminating information it uncovers with the criminal tax functions of other appropriate California and Federal agencies like those associated with the FTB or the IRS.

These types of audits are extremely common amongst cash intensive businesses, businesses that use “zappers” or participants in California Underground Economy. Therefore, as a starting point, a poorly handled audit or an eggshell sales tax audit that uncovers discrepancies can result in a significant assessment of additional tax owed, fines, and penalties. Furthermore, the Board of Equalization is known to share information with other appropriate government agencies. Therefore, problems found in an audit by the CDTFA are likely to be reported to the IRS & FTB. Furthermore, for businesses like bars that require licenses and for licensed professionals, the CDTFA may also report to the licensing board or the credentialing authority. For business owners and professionals who depend on and can only carry out their business activities with their license, a sales tax audit can signify the beginning of a chain of events that can be described only as a nightmare.

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.

Use of ”Zappers”

A zapper is a certain type of software program that can surreptitiously alter records of transactions and sales. The zapper program is loaded onto a retail point of sale (POS) system, typically via a USB drive. Once it is installed and configured, the zapper program allows business owners to reduce the amount of revenue that they attribute to sales. By reducing income, the business can fraudulently reduce its sales and income tax burdens. The owner then pockets or disburses the ill-gotten cash basis gains to others participating in the scheme.

California’s anti-zapper law, which became effective Jan. 1, 2014, criminalizes even the mere possession of a zapper device or the software contained on it. In California, any business that is detected using a zapper can face serious penalties that include a potential three years in California state prison. Furthermore, owners of businesses who are caught using zapper software are held financially liable for the unpaid sales and income taxes and all fines and penalties that may be associated often by way of a restitution order associated with a California or Federal criminal sales and or income tax prosecution.

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.

You should be aware that the CTFA has a strong grasp over all possible sales and use tax issues. It has trained its agents, so they are equipped with the knowledge of all the issues and terminology pertinent to the collection of sales and use tax. The goal is simple—the CDTFA wants to ensure that their examiners are fully equipped to catch any irregularity, big or small, while they examine your sales tax returns.

Therefore, it is crucial that you are thoroughly prepared for a sales tax audit. While representing you, we strive not to be surprised by anything raised by the agent conducting the sales tax audit or by information that may be inadvertently disclosed by you during the audit. That is where our years of experience comes in. Once we determine that you might be facing potential criminal liabilities, our primary goal becomes the prevention of initiation of a criminal sale or income tax investigation, and we do whatever we legally can to achieve that. Consequently, attempting to prevent the taxing authority from interacting directly with you goes a long way towards that goal.

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.

Why do You Need Us?

It is important to recognize the signs when a sales or use tax audit is likely heading towards a criminal tax investigation, which a reputable and experienced Criminal Tax Defense Attorney is trained to spot. Commonly recognized indicators that a criminal investigation is potentially looming include:

The audit is mysteriously suspended and clandestinely handed off to a federal or California criminal tax investigator without notice to the taxpayer;
The auditor suddenly becomes unreachable;
The auditing agent collects voluminous and excessive documentation and makes copious amounts of copy requests;
The taxpayer is summoned to provide records and make an appearance;
More than one auditor, their manager, or the taxing authority’s legal counsel and court reporter attend a taxpayer interview;
The auditing agent makes undisclosed contact with third parties.

If you think that your sales tax auditor is likely to reach a conclusion that you cheated on your sales tax returns, the biggest mistake you can make is to consult the original preparer. The reason is that they are likely to become the primary witness against you if the CDTFA decides to initiate criminal tax proceedings. They would have absolutely no incentive to protect you and are likely to reveal everything, including the information that you thought was confidential. A CPA, EA, or CTEC certified preparer generates most of his income from tax accounting and preparation; thus, they are strongly motivated to protect their reputation with the taxing authorities at the expense of your reputation. As uniquely qualified and extensively experienced Criminal Tax Defence Tax Attorneys & Kovel CPAs, our firm provides a unique platform to efficiently achieve the optimal and predictable results that simultaneously protect your liberty and your net worth.

You would think that a forensic accountant may be able to spot issues or identify explanations for your failures. However, you should know that the privilege provided by the Internal Revenue Code for certain communications between an accountant and a taxpayer does not exist in the context of a criminal case. Thus, communications between you and the third-party accountant would be subject to IRS discovery and potentially admissible evidence in the event of a criminal trial. That is why you need us and the unique solutions we provide because David Klasing is a former public auditor and dual-licensed Tax Attorney and CPA with over a decade of specialized training in criminal tax defense and has a full staff of Kovel Accountants that he trained personally to assist him.

Why Our Approach Works?

While representing you, our objectives in dealing with the examining agent are:

(i) to attempt to limit the scope of the inquiry;

(ii) to limit the information provided to avoid both waiver of the Fifth Amendment and incrimination;

(iii) to avoid tying you to an explanation you cannot support;

(iv) to prevent the presentation of false or misleading information that could lead to the allegation that you are engaged in a scheme to cover up the fraud; and

(v) to avoid claiming the Fifth Amendment or otherwise alerting the revenue agent to the fraudulent aspects of the returns.

There is a world of difference between an ordinary audit and a sales or income tax fraud investigation. The objective in most civil audits is to present as much evidence as possible to convince the agent or conferee that an adjustment is not appropriate. The goal in a fraud investigation is to prevent a referral for criminal tax prosecution.

The Tax Law Offices of David W. Klasing has decades of experience providing high-risk sales and use tax audit representation, including representation concerning eggshell audits and reverse eggshell audits to all kinds of businesses within the state of California and across the U.S. as to federal audits or criminal tax investigations. With decades worth of experience, our award-winning dual licensed Tax Attorneys & CPAs are uniquely equipped to protect your net worth and your liberty. Mr. Klasing is a dually licensed Tax Attorney and CPA who has decades of experience as a former auditor himself from working for various public accounting firms. As such, he can often anticipate the approach auditors will take and can craft a strategy to meet these challenges. To schedule a confidential, reduced-rate initial consultation, call our Irvine or Los Angeles law firm at 800-681-1295 or schedule online today HERE.

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