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How a California Sales Tax Audit Can Be Your Worst Nightmare

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    The California Board of Equalization is the state government agency responsible for enforcing the obligation to collect and pay over sales tax by businesses. Many businesses believe that they are too low profile to be noticed or audited by the Board of Equalization. However, the reality is that most, if not all, California businesses will face an audit at some point and most will face routine audits of their sales and use tax practices. In fact, for California based businesses such as restaurants, bars, liquor stores, salons, convenience stores, and many other consumer-oriented businesses, audits are simply a fact of life. Unfortunately, businesses that do not adequately prepare and protect themselves can face serious consequences.

    As a starting point, a poorly handled audit or an 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 Board of Equalization are likely to be reported to the IRS. Furthermore, for businesses like bars that require licenses and for licensed professionals, the Board of Equalization 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.

    Overview of a Sales Tax Audit & Its Objectives Conducted by the Board of Equalization

    Audits by the California Board of Equalization 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 Board of Equalization’s website. The typical sales tax audit covers a three year look-back period.

    An agent-auditor from the agency conducts sales tax audits. The auditor is supposed to work impartially to determine the business’s compliance with their tax obligation. The auditor is supposed to determine whether under or overpayments of taxes and fees have been made by the business. Typically, the auditor accomplishes his task by referring to the records a business a business owner must keep and provide per Regulation 1698 Records. In general, the owner of a business must keep and maintain records of the following types:

    • The company’s normal books and accounts. These are the type of records that the “average prudent businessperson engaged in the activity in question” would keep.
    • Any other document “of original entry” that corroborates or supports the records kept in the ordinary course of business including:
      • Receipts
      • Bills
      • Invoices
      • Cash register tapes
    • Schedules the business owner or his or her accountant used in the preparation of tax returns.
    • Any other record that is necessary to determine the correct amount of sales or use tax liability for the business.

    A business owner should, for purposes of Board of Equalization audits, retain business records for a minimum of the preceding 4 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 Board of Equalization will provide the business notification prior to conducting an audit. This allows the business time to prepare for the audit including gathering the records discussed above. However, even the initial contact by 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, 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 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 agent to handle these and other questions.

    What happens if my Records are Insufficient or the Auditor Perceives Errors?

    Some common problems associated with auditors that businesses may experience include:

    • Failure to charge sales tax to customers due to payment of tax to vendors – In some cases business and business owners may assume that since they paid sales tax to the vendor, they are free and clear of further obligations because “the state has already received its money and further sales tax obligations would equal “double taxation.” In reality, the business may have needed to provide exemption documentation. The business may be ineligible for an offset and can face liability for the uncollected amounts.
    • Failure to properly register the business – Most states require registration of a corporate officer for purposes of sales tax. California takes this process a step further and requires the registration of all corporate officers. Furthermore, the Social Security and drivers’ license number for these individuals must be reported.
    • Failure to make required prepayments of sales tax – The Board of Equalization requires certain taxpayers to prepay their sales tax obligations. Individuals with an estimated monthly average tax liability of $17,000 or more must prepay.
    • Failure to adequately discuss audit policies and procedures with the auditor – For audits that go poorly, responsibility is typically shared between the auditor and business for failures at the outset of the process. If you do not handle audits on a day-to-day basis, it can be tempting to “leave it to the auditor” but such an approach rarely results in the favorable outcomes. The basis for the audit and, if necessary, the method of sampling utilized should be agreed upon among other concerns.

    In some cases, records may be incomplete or insufficient for auditing purposes. In other cases the Board of Equalization may find other reporting errors including automatic gratuities, self-consumed issues, and use tax noncompliance. If the auditor finds problems in your records, he or she is likely to conduct an in-depth review. Typically, this means you will face an assessment of sales tax on actual basis, examining every transaction, or on a sample basis, using a certain statistical time timeframe to determine sales tax liability.

    Problems Resulting from Flawed Sample Basis Calculation of Sales Tax Obligations and other Audits That Go Badly

    If events unfold where a sample basis audit is necessary, businesses that have failed to engage with the auditor early in the process may face a difficult situation that can result in significant sales tax liabilities. Most often, this scenario occurs when the sample basis selected by the auditor does not accurately represent the actual sales by the business. A non-representative statistical sampling can result in grossly overstated unpaid sales tax liability for the business. In some cases, this may prove fatal to the company. However, this scenario can often be avoided through a discussion with the auditor early in the process. However, should the auditor choose to audit on a sample basis and then conclude that negligence or willfulness caused the deficiency, per Rev. & Tax. Code Section 6484, you can face an additional 10% penalty on top of the deficiency.

    Other negative consequences that can arise out of a sales tax audit that proceeds badly includes referral to the IRS Criminal investigations Division. If you are referred to IRS CID, you may face felony tax charges. As tax fraud is a crime of moral turpitude, it can be a nightmare for licensed professionals due to the fact that crimes of this type can result in action by the appropriate credentialing or professional responsibility board. Certain businesses, such as bars and restaurants, that are dependent upon an alcoholic beverages license to sell beer, wine, or spirits the California Business & Professions Code section 24205 holds that the license can be suspended when:

    • The business is three or more month behind in payments for sales and use tax.
    • The alcoholic beverage license is directly related to a delinquent seller’s permit.

    However, certain actions can forestall or prevent the imposition of a license suspension. Suspension of a license to sell cigarettes and tobacco products can also be imposed for sale of untaxed tobacco products.

    Preparation is a Key Element in Preventing a Worst Case Sales Tax Audit

    Upon notification of a sales tax audit, the business owner typically has several weeks to prepare. The owner and entity should use this time wisely to engage with an experienced tax attorney. The tax attorney can assist your business in preparing, and reduce the likelihood of a sample audit or a non-representative audit. Furthermore, letting an attorney handle the audit can ensure that the process is met with an experienced and professional handling. An attorney has the perspective and distance to ensure that matters remain professional and do not devolve into personal attacks.

    David W. Klasing is a dual-certified tax attorney and CPA. His sales tax audit approach analyzes problems from multiple perspectives and can address common issues in initial negotiations. By taking a pro-active approach, serious foreseeable issues can be prevented or mitigated. If you have received notice from the California Board of Equalization, call the Tax Law Offices of David W. Klasing today at 800-681-1295 to schedule a reduced-rate consultation.

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