Investigation Leads to Arrests of 15 Individuals who Evaded $34 Million in Tobacco Taxes
The state Department of Justice, working closely with the U.S. Attorney’s office, the Bureau of Alcohol, Tobacco, Firearms and Explosives, and the state Board of Equalization charged 15 retailers with tobacco smuggling and tax evasion schemes that diverted some $34 million from state and county health care programs and the state’s general fund.
The three-year investigation uncovered “rampant fraud” among tobacco retailers, with estimated tax losses totalling more than $80 million. More than $20 million in tobacco, property, and cash were seized.
We are here to tell you how you can save yourself from becoming the subject of a similar press release.
The Taxman’s Focus on Retailers
The IRS and California taxing authorities have a keen interest in the retail industry. As per a recent report from the California Department of Tax and Fee Administration, the sales and use tax audit program uncovered net deficiencies of nearly $553.1 million during the fiscal year 2018-2019.
Retail is one of the largest industries in the United States and accounts for approximately 10 percent of the gross national product. Retail business covers many different areas, including auto dealerships, convenience stores, gift shops, clothing stores, grocery stores, etc. Retail differs from other forms of business in many respects. Retail typically involves a large number of sales transactions involving a relatively low dollar amount. There are numerous lines of merchandise carried with a constant change of product lines to meet customer needs. There is a broad assortment of items in many of the lines/departments of merchandise carried. All of these factors can lead to a multitude of tax issues that need to be handled with care and attention.
Failing to comply with state and federal tax regulations can expose your business to a vast array of risks, as mentioned above. The only way to avoid exposing your business and company to these risks is through careful tax planning and thorough recordkeeping. If you need assistance preparing for an IRS audit, fighting a federal of California tax evasion charge, filling California or federal tax returns, making a voluntary disclosure, appealing the results of a tax audit, or settling another type of tax dispute, we advise you to seek legal guidance from a dually California licensed Tax Attorney and CPA immediately.
It’s safe to say that most executives and business leaders understand that businesses get audited for sales and use tax, but only a small percentage are aware of the potential material impact on their company should a state auditor come knocking on their door. Unless you’ve been audited in the past, you might not know why certain businesses are targeted, what the most common types of errors auditors look for, and most importantly, how much it will cost the business should the audit outcome not weigh in your favour.
At the Tax Law Office of David W. Klasing, we are California tax attorneys and CPAs with over multiple decades of combined experience providing award-winning service to retailers that are based or do business in California. The tax services that we offer include IRS audit defence, California state audit defence, criminal tax defence, and audit appeals representation. We can also assist you or your business with tax compliance, tax planning, personal or business tax preparation, and bookkeeping and accounting services tailored to the retailing industry.
Retail Entities and the Risk of Getting Audited
Small retailers, such as independent convenience stores or strip mall boutiques, are sometimes called “mom and pop” stores because they are family-owned and operated. This type of business may be a sole proprietorship. However, it is not unusual for “mom and pop” stores to enter into a partnership or for family members to form a partnership to give each member a share in profits or to grow the business.
Large retailers, such as well-known “big box” chain stores, typically include many store locations and hundreds of employees. Both small and large retailers might include activities reported as sole proprietors on Form 1040, Schedule C, as partnerships on Form 1065, or as corporations on Form 1120 or Form 1120S.
Please be aware that retailers who file a Schedule C are much more likely to be audited than the general public. The Internal Revenue Service has found that self-employed individuals are much less likely to comply with tax laws than those employed by others. Therefore, it has chosen to aggressively pursue Schedule C taxpayers. In 2017, the Internal Revenue Service audited 1.3% of all Schedule Cs showing less than $100,000 in revenue (not profit, but revenue). It audited 2.1% of returns showing gross revenue between $100,000 to $200,000 and 1.9% of returns showing gross revenue over $200,000 on Schedule C in 2016.
The IRS audits retailer partnerships at varying rates based upon income and gross assets as it does other tax returns. Because partnership returns generally result in pass-throughs to the respective partners, there is some overlap between the numbers indicated for individuals in the previous paragraphs and the number of audits conducted of partnerships. For example, someone who invests in a partnership would probably substantially increase his/her chances of becoming the subject of an IRS audit. Notably, the IRS has indicated it intends to increase audits of partnerships in 2021 and going forward.
In determining whether to audit a retailer corporation, the IRS considers the value of the corporation’s assets. The greater the assets shown on the corporate balance sheet, the more likely it was that the return would be audited. For example, in 2017, the Internal Revenue Service audited 1.1% of returns with balance sheets between $250,000 and $1,000,000, 1.3% of returns with balance sheets showing between $5,000,000 and $10,000,000 in assets, and 26.8% of all corporations showing between $5,000,000,000 and $20,000,000,000 in assets. In most instances, the greater the company’s assets, the greater the chance of securing substantial deficiencies. The average deficiency for the largest corporations audited by the Internal Revenue Service in 2017 was $26,428,278.
Selection of Tax Returns for Audit
The IRS relies heavily upon its computer system to select tax returns for audit. Each return received by an IRS Service Center is statistically scored to determine its audit potential. The system is known as the Discriminant Function System (DIF). The score which results from this scoring system is called the DIF score.
The IRS computer analyses two primary measures in determining the scores: Total Positive Income (TPI) and Total Gross Receipts (TGR). TPI is the sum of all positive income items shown on the return. Negative items are treated as zero. Non-business TPI is the sum of all positive income on returns except income from Schedules C and F. For non-business tax returns, TPI is used to separate respective income classes for scoring by the IRS. For business returns, total gross receipts are used to separate the respective classes for scoring. Total gross receipts are the sum of all gross receipts on Schedule C and Schedule F. The IRS believes that gross business receipts are better indicators of business activity for classification than the net income reported for the return.
Many factors can lead to or trigger an audit in the retail industry. The following are some examples of factors that can lead to an audit.
Suppose you are involved in the purchase or sale of a large number of exempt items or services. In that case, this can trigger an audit because there can be a misinterpretation of the law regarding an exemption on an item in error and sometimes just outright noncompliance.
An audit may also be triggered because of late return filings, i.e., consistently filing sales and use tax returns after the due date and remitting the tax payment non-timely.
Mathematical errors may also draw inquiry and often lead to a full-blown examination, particularly if the mistakes are persistent. A significant increase in sales can increase the potential for errors and omissions. There is always the threat of a current vendor audit or a current customer audit in all retail businesses. If your vendor gets audited and that vendor did not charge you sales or use tax or charged you incorrect tax, this may trigger an audit. Furthermore, if one of your customers is being audited and you have not charged the proper sales or use tax, this can also trigger an audit.
How are Different Retailers Audited for Sales/Use Tax?
At the Tax Law Office of David W. Klasing, we are dual licensed California Tax Attorneys & CPAs with a long record of successfully representing retailers in California and Federal civil audits and criminal tax investigations, Appeals & Litigation before the IRS, FTB, and Office of Tax Appeals (OTA). Equipped with nearly 30 years of business bookkeeping and accounting experience, including more than two decades of public accounting auditing experience, David Klasing and his staff of California Tax Lawyers & CPAs can protect and advise your small or large business on all of the issues impacting your profits.
Accurate reporting of income and expenses by businesses in the retailing industry is among those areas that have gotten extremely keen attention from the IRS and the California taxing authorities, such as the Franchise Tax Board (FTB), the California Department of Tax and Fee Administration (CDTFA), and the Employment Development Department (EDD). Consequently, the IRS has developed an Audit Techniques Guide (ATG) to provide guidance to its agents on how to examine businesses in the retailing industry.
We truly understand how the IRS and California Tax authorities function and run their civil audits and criminal tax investigations. In other words, we know the other side’s game plan and use it to guide our clients while they navigate the troubled waters of audits and criminal tax investigations! We are well conversant with the background information that IRS, CDTFA, FTB, and EDD have on the retail industry and how it familiarizes and trains its examiners with the issues they need to understand when civilly auditing or criminally investigating/prosecuting you.
From our decades of experience, we know that the examining agents are instructed to tailor their techniques to provide the most accurate analysis of a specific taxpayer’s possible income stream. There are several techniques employed by state and Federal taxing authorities that are used when auditing businesses in the retailing industry.
Given the volume and multiplicity of products sold by high-volume retailers, such as grocers and electronics stores, etc., an audit of such a business may involve a much smaller sample. A period of as little as two days or two weeks may be selected. The distinctions between taxable and exempt purchases for high-volume retailers are frequently unclear and can lead to many disputes.
The auditor’s approach to tracking transactions may be as follows:
- the seller’s categorization of each item in inventory as taxable or exempt, which may be reflected in a bar code on the product itself;
- the program for the cash registers that reflects taxable or exempt status;
- the taxable or exempt product lists given to each clerk in less-sophisticated systems;
- the items rung up on the miscellaneous key;
- the system used to allocate the sales to the proper departments once their tax status has been determined;
- the handling of store and manufacturers’ coupons and other unusual transactions; and
- actual observation of the way checkout counters are run.
In our experience, the most common problems are:
- improper collection of taxon sales involving coupons,
- inaccurate ring-ups in systems where the clerks must remember what is taxable or exempt or in systems that have been programmed incorrectly, and
- simple bookkeeping errors.
Sales by Manufacturers or Processors
Some of the sales tax collection issues involved in sales by manufacturers are
- lack of, or incomplete, certificates for resale and exempt use;
- the failure by the company in error to collect sales taxand to deduct the sale on the next return when an item is returned;
- vendors not including accounts receivable in gross sales for sales taxreporting; and
- when to recognize the sale, such as when high-tech companies use layered billing where a specified percentage of the contract price is due at each stage of the order, delivery, testing, and final approval, with recognition generally occurring after the customer tests the product (for a video producer, the sale occurs when the video is delivered and accepted by the customer, not when progress payments are received).
Businesses Serving Contractors
Businesses that serve contractors are another audited group presenting sales tax issues. Contractors as purchasers frequently present resale or exempt use certificates when in fact, they should be paying sales tax because they are the consumers of the materials and other supplies. An issue that can affect businesses that serve contractors is the allowance of an early payment discount and collection of sales tax on the gross sales price.
Common Issues to Avoid
It’s not surprising that auditors target the retail industry. From a revenue perspective, retailers are a primary source of recovery, as state deficits have dramatically increased due to the explosion of e-commerce.
While there are many reasons why a business might make errors, California’s audit program pinpoints three noncompliance issues that account for more than half of collected revenues:
- Unsupported sales for resale: sales claimed as exempt without supporting documentation. Generally, a seller should obtain and retain a resale certificate at the time of the transaction.
- Unreported sales: sales not reported on the sales and use tax return.
- Out-of-state vendor purchases: assessments made for purchases of tangible personal property from out-of-state vendors that did not collect use tax.
Understanding product taxability is particularly challenging for many retailers as most tangible products are subject to sales tax in the U.S. However, product taxability rules and rates vary widely and change frequently. If that wasn’t bad enough, certain goods and services fall into a nebulous category called “sometimes taxable” where use can make a difference in how an item is taxed.
As retailers grow, they are more likely to operate across state lines, which can trigger nexus, a “connection” in a state that creates an obligation to collect and remit sales tax. As such, they need to pay closer attention to where customers and partners are located and ensure point of sale, e-commerce systems, and shopping carts are set up to calculate the correct tax in each state and jurisdiction in which they now have nexus.
Why Do You Need the Help of our Dual Licensed Criminal Tax Attorneys and CPAs?
If you took a position on a tax return that could not be supported upon an IRS or state tax authority audit, eggshell audit, reverse eggshell audit, or criminal tax investigation, you would be well served to hire a dual licensed Tax Defence Attorney and CPA to guide you through the process. During eggshell audits, the agents are looking for the possibility that you, as the subject of a civil audit, will, under pressure, crack under pressure and inadvertently provide incriminating information, or worse yet, apologize and admit to the wrongdoing that eventually leads to a referral for criminal tax investigation. As your dual licensed Tax Defense Attorneys & CPAs, our goal when advising you through an eggshell audit is the resolution of the audit without a referral by the civil examiner to the California or IRS’s criminal investigation divisions (CID).
If you are a retailer and find yourself in the unfortunate situation of receiving a federal or California audit or criminal tax investigation notice, and know for a fact that you cheated on the returns under audit, do not contact the original preparer under any circumstances. You are going to be bitterly disappointed if you think they are going to stand up in your defense and help you in any way. If the government even hints at seeking criminal tax charges, they are likely to become a key government witness against you, fearing that they could be viewed as having aided and abetted your tax evasion.
If you are a retailer and are facing an IRS, FTB, CDFTA, or EDD audit, contact the experienced tax lawyers of the Tax Law Offices of David W. Klasing today. To speak to our Tax Lawyers who are experienced and thoroughly versed in IRS, California FTB, and California audit and criminal tax investigation techniques and the litigations and appeals processes, call 800-681-1295 or contact us online today to schedule a reduced-rate initial consultation.
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More Commonly Asked Tax Audit Questions
- How should Tax Audits be Handled by Criminal Tax Counsel?
- How to survive audit when I cheated on return being audited
- What is an eggshell audit?
- What is a reverse egg shell audit?
- Why is a reverse egg shell audit dangerous for a taxpayer?
- Warning signs of a criminal referral from an IRS audit
- Effective tax defense counsels goals in an egg shell audit?
- How are the 4 goals and outcomes 1 and 2 best obtained?
- What are the possible outcomes of an egg shell audit?
- Is it my right to know why I was selected for examination?
- What can I do to prepare for an audit?
- What is an IRS civil examination?
- How IRS decides which tax returns are audited
- What are my appeal options if I disagree with IRS?
- What are my basic taxpayer rights if the IRS audits me?
- Options if I am unable to pay at the conclusion of audit
- What a 30 or 90-Day Letter from the IRS means
- What is involved with appealing disagreements?
- Rights to disagree with IRStaxauditor’sss findings
- Can I stop the IRS from repeatedly auditing me?
- Can I have the examination transferred to another area?
- Can I record my IRS interview and is it a good idea?
- How many years of returns are at risk during an audit?
- Common reasons for the IRS to conduct a tax audit
- How to avoid negative consequences from an IRS interview
- Have to agree to interview by taxing authority directly?
- Are all audits the same?
- What should I do if the IRS is investigating me?
- What ifIdon’ttt respond to a taxing authority audit notice
- Your rights during an IRS tax audit
- Risks of attending an IRS audit without a tax lawyer
- Most common audit technique used by taxing authorities
- Don't go into an IRS audit without representation
- Why hire an attorney to represent me in an audit?
- Why hire David W. Klasing to represent me in an audit
California Sales Tax Questions and Answers
- Common issues encountered during sales tax audit
- What is a sales tax audit?
- Disagreeing with business audit conclusions
- Timeline to file Petition for Redetermination?
- What should Petition for Redetermination contain?
- Is the appeals conference formal or informal?
- Appeals Division’s Decision and Recommendation
- Are a mark-up percentage and a profit margin the same?
- Problems with the mark up audit
- Can State Board of Equalization ignore my business records
- What is a sales tax deficiency determination?
- Business being audited for sales tax. Should I be worried?
- Audit determined fraud to avoid sales and use tax
- Definition of “sale” for California Sales Tax
- What do California sellers need to know about sales tax?
- How do I apply for a sellers permit?
- What are my obligations as a permit holder?
- What is sales tax?
- What is tangible personal property?
- What is a sale?
- What are total gross receipts?
- What is use tax?
- Who is responsible for paying the use tax?
- Who is a retailer engaged in business in California?
- Who is a qualified purchaser?
- Do I need a Certificate of Registration Use tax?
- Do I need a Use Tax Direct Payment Permit?
- What types of sales are exempt from sales tax?
- How are Internet Transactions Taxed?
- How is California sales or use tax determined?
- What is the statewide sales and use tax rate?
- Are there other local and district sales and use taxes?
- Total sales and use tax rate calculation
- How to protect against successor liability in California
- Recourse when issued California sales tax liability notice
- CA Sales Tax liability extend to purchasers/successors?
- Waiting Until Audited to Take Action on Tax Matters
- Sales tax records needed in California
- What are California’s sales and use taxes?
- Why does the State of California audit businesses to ensure compliance with sales and use taxes? How does the State determine whether to audit my business?
- The BOE reviews the purchase invoices of my business
Questions and Answers for Criminal Tax Representation
- When tax defense counsel parallels tax crime investigation
- Guilty of tax obstruction by backdating documents?
- To be found guilty of tax obstruction must a person actually be successful in impeding the IRS’s functions?
- Help! The Document I Gave the IRS Had False Information
- Tax crime aiding or assisting false return IRC §7206(2)
- What is the crime known as tax obstruction § 7212?
- What is the difference between tax perjury and tax evasion?
- What is the tax crime commonly known as tax perjury?
- What is a Klein Conspiracy?
- Increased possibility of civil action in IRS investigation
- Am I Guilty of Tax Evasion if the Law is Vague?
- What happens if the IRS thinks I committed tax crimes?
- What are ways to defend against a tax evasion charge?
- Difference between criminal tax evasion and civil tax fraud
- What accounting method does the IRS use for tax fraud
- Can I Change Accounting Method to the Accrual Method
- What is the willfulness requirement for tax evasion?
- I didn’t know I committed tax fraud. Can I get off?
- Concealed assets from IRS. Can I avoid tax evasion charges
- How government proves I willfully engaged in tax evasion
- What is the venue or court where a tax crime case is heard?
- Must the IRS prove tax crimes beyond a reasonable doubt?
- Is it a crime to make false statements to the IRS?
- Will the IRS overlook my tax evasion if it’s minor?
- Failed to tell IRS about my nominee account
- Audit risk with cash based business transactions
- How to defend a client charged with tax evasion
- Is it tax evasion if I didn’t file income tax return?
- Government says I attempted to evade my taxes. Now what?
- I forgot to pay my taxes or estimated tax. Is this a crime?
- Government proof I “willfully” failed to pay taxes
- 5 Ways to Respond to Tax Evasion Charges
- Being audited after using a tax professional
- Rules for what an IRS agent can do while investigating me
- How tax preparers, attorneys and accountants are punished
- How the IRS selects tax crime lead for investigation
- How does the IRS prosecute suspected tax crimes?
- Does IRS reward informant leads for suspected tax crimes?
- How the government proves deficiency in a tax evasion case
- Do prior tax crimes factor into new IRS tax convictions?
- Requesting conference before investigative report is done
- Requesting conference after IRS Special Agent Report
- What are my rights during an IRS criminal investigation?
- Avoid prosecution for tax crime with voluntary disclosure?
- Defense tactics that make it hard for to prove willfulness
- How a tax attorney can stop your criminal tax case?
- What can you generally tell me about tax crimes?
- Continuing filing requirement with investigation pending
- Federal criminal code crimes that apply to tax issues
- Penalty for making, subscribing, and filing a false return
- CID special agent’s report for criminal prosecution
- What is the discovery process in a criminal tax case?
- What the IRS includes in indictment for tax case
- What is the hardest element of a tax crime to prove?
- IRS methods of gathering evidence to prove tax crime
- What does a grand jury do in IRS tax crime prosecution?
- Failure to keep records or supply information
- Failure to make a return, supply information, or pay tax
- What is attempting to evade payment of taxes?
- What is income tax evasion and how is it punished?
- What is attempted income tax evasion?
- What is the crime of failure to pay tax? What is punishment
- Crime of making or subscribing false return or document
- Criminal Investigation Division investigation tactics
- Tax crimes related to employment tax forms and trust funds
- Tactics to defend or mitigate IRS criminal tax charges
- How the IRS generates leads about suspected tax crimes
- What is the crime ”evasion of assessment” of tax?
- Specific examples of “attempting” to evade tax assessment
- What is the so-called Spies evasion doctrine?
- Does overstating deductions constitute tax evasion?
- Is it tax evasion if my W-4 contains false statements?
- IRC §7201 attempt to evade vs. common-law crime of attempt
- What are the penalties for Spies tax evasion?
- How government proves a taxpayer attempted tax fraud
- What is a tax that was “due and owing.”
- What is evasion of assessment for tax liability?
- Is evasion of assessment different from evasion of payment
- Does the IRS have a dollar threshold for tax fraud?
- What is the IRS burden of proof for tax fraud convictions?
- Are Tax Laws Constitutional?
- What is the source of law that defines tax evasion?
- Does section 7201 create two distinct criminal offenses?
- Does tax evasion definition include partnership LLC
- What if I helped someone else evade taxes?
- Is it illegal to overstate deductions on my tax return?
- Is it illegal to conceal bank accounts from the IRS?
- Do later losses justify prior deductions?
- Common reasons the IRS and DOJ start investigations
- What is the Mens Rea component of tax crimes?
- What is a proffer agreement and what are the risks?
- Why to have an attorney to review a proffer agreement
- Why enter into a proffer agreement?
- Limited use immunity from proffer agreements
- Difference between civil and criminal fraud allegation
Questions about delinquent payroll taxes and trust fund recovery penalty
- What happens if an employer continues to incur new payroll tax liabilities?
- California Employment Taxes Basics
- How Does the IRS Develop an Employment Tax Fraud Case from the First Indication of Fraud to a Criminal Indictment?
- Can more than one person be considered responsible by IRS
- How unpaid employment tax payments are allocated
- When a corporate officer is considered a responsible party
- Examples of trust fund recovery penalty determinations
- Failing to pay employment taxes after notice is given
- How to determine responsible person for trust fund recovery
- Assessing trust fund recovery penalty and option to appeal
- What is the trust fund recovery penalty?
- What are the penalties for failure to pay employment taxes
- When am I considered liable for company’s employment taxes