The State Board of Equalization of California often uses a “mark-up audit” when it suspects that the reported sales were understated, especially where a cash intensive business is concerned. It is often employed when the taxpayer’s records “cannot be verified by a direct audit approach,” according to California’s Board of Equalization Handbook on the matter. See http://www.boe.ca.gov/sutax/manuals/am-04.pdf Consequently, the auditor will seek to obtain that information from other sources, including by conducting a mark-up audit. The “mark-up” is the amount that is added to the cost to obtain the sales price. The mark-up as a percentage is: (Gross Profit)/(Cost of Goods Sold)*(100).
The “mark up” figure may be used to determine a business’s sales or even to verify a deduction. Here are some bullet point observations from our experience with mark up audits to date:
1. BOE sales tax auditors routinely use the mark up method while attempting to prove a business’s accounting is materially misstated or fraudulent especially where cash intensive businesses are concerned.
2. BOE sales tax auditors are trained to be aware of illegal programs that periodically make a corresponding amount of sales and cost of goods sold disappear from the company’s point of sale system along with informing the owner of how much cash to illegally skim from their point of sales systems. If this program is found to have been used and sales tax is underreported criminal tax evasion sanctions are possible. Most of these programs leave electronic bread crumbs that can be detected should the BOE be so inclined as to look for them.
3. Auditors will approach vendors directly to see if the dollar amount of goods sold to an audited business matches what is in the business’s cost of goods sold account for the same period. The reason for this is that BOE auditors are aware of sales tax cheats that hide sales by under recording cost of goods sold or by purchasing cost of goods sold with skimmed cash in order to hide it. BOE auditors are aware that they are prevented from utilizing the mark up method to detect unreported sales if they can’t identify the correct dollar amount of goods purchased by the audited business. This is why they often request third party vendors to provide the amount of goods sold to the audited business for the time period under audit.
4. Certain types of businesses are especially susceptible to mark up audits. May types of cash intensive businesses have been found to cheat by the BOE based on their audit history with the BOE. Therefore for example, bars, restaurants, gas stations, convenience stores and liquor stores are at high risk for sales tax audits utilizing the mark up method.
5. Criminal liability / exposure for tax crimes commonly stems from mark up audits because unreported sales are routinely reported to the FTB and possibly to the IRS criminal investigation division. The BOE routinely reports unreported sales of $100,000 or more found in any one quarter audited by the BOE to the FTB. The FTB may either automatically adjust the business’s income tax return for the amount of unreported sales determined by the BOE or open a criminal investigation. Lastly, unreported sales can result in prosecution by the BOE directly for felony sales tax evasion.
6. If the BOE hits pay dirt in an audit, re-audit on the same issues at a later date is virtually guaranteed because BOE auditors are encouraged to select business’s that owed large amounts of sales tax in the past for re-audit to see if the business’s reporting problems have been corrected.
7. There is virtually no way to argue that the BOE should not be relying on the mark up method rather than on a business’s books. The BOE is jaded and believes that all cash basis businesses routinely underreport cash sales and thus simultaneously commit income tax evasion and sales tax evasion. The available appeal functions within the BOE will fully support the use of the mark up method by BOE auditors. If the case is brought before the Board of Equalization itself, they too will support the use of the mark up method.
8. If a bar tender or cocktail waitress / server is running their own business while embezzling from the bar’s owner, the BOE’s position is that since the customer paid sales tax, the business owes the sales tax on the corresponding embezzled sales which in my opinion adds insult to injury.