A sales tax “markup test” is an indirect sales tax audit technique that estimates a business’s actual gross receipts by comparing its cost of goods sold (COGS) to the selling prices it charges, i.e., the markup. When records are incomplete, inconsistent, or deemed to not be credible, California sales tax auditors extrapolate sales by applying an industry standard markup factor to the cost of goods sold that it verifies with you vendors. Both the IRS and California’s CDTFA (sales and use tax) use formal versions of this method. The IRS recognizes the Markup Method as a “formal indirect method” to reconstruct income when there’s a reasonable indication of unreported income; examiners analyze sales and/or cost of sales and apply, what they deem appropriate, markup percentage to arrive at estimated gross receipts. On the state side, the CDTFA’s Audit Manual defines markup as the amount added to the cost to obtain the sales price, sets out formulas (e.g., Gross Profit ÷ COGS = % Markup; COGS × Markup Factor = Sales), and instructs auditors on using shelf tests, weighted averages, and purchase segregation to compute defensible markups. Practically, a markup test is standard in cash-intensive trades (restaurants, bars, liquor and convenience stores, groceries, gas stations, jewelry)—anywhere inventory is a principal income-producing factor and day-to-day records are deemed by the CDTFA unreliable often because they suspect cash sales are not being accounted for or reported.
How Auditors Actually Perform a Markup Test (IRS vs. CDTFA)
Federal Income Tax (IRS)
Under the IRS’s Indirect Methods framework, the Markup Method is deployed when books are missing or irregular, cash is not banked, or other methods (bank deposits, net worth) would be ineffective. Examiners first establish that the use of an indirect method is justified, then document why markup is the most appropriate tool given the business model. The IRS Manual emphasizes that the process need not be mathematically perfect—only reasonable in light of facts, supported by credible evidence and typical industry ratios—and cites cases upholding aggregate estimation.
California Sales & Use Tax (CDTFA)
CDTFA auditors typically (1) verify purchases/COGS, (2) determine the taxpayer’s actual markup using one or more procedures, and (3) extend that markup over the audit period. The Manual explains:
- Markup definitions & formulas: Markup = Gross Profit ÷ COGS; Markup Factor = Sales ÷ COGS; therefore, Sales = COGS × Markup Factor (where the factor equals 100% + % markup).
- How they build the factor: Preferred approaches include a weighted average across a complete purchasing cycle, purchase segregation by commodity groups where markups differ, or (less preferred) an average of selected items via a shelf test.
- Short tests and reasonableness checks: For grocers, CDTFA states that all audit assessments using the markup method should include a short test in the working papers to support reasonableness; more broadly, short tests are a standard reasonableness tool.
When Markup Tests Are Used and the Most Common Traps
Audit programs pivot to markup when reported markups look implausibly low for the industry, when scanning system controls are weak, or when key records (invoices, Z-tapes, POS detail) are missing. The IRS expressly recommends markup for businesses where inventories drive income and pricing is reasonably consistent (e.g., liquor stores, taverns, gas stations, restaurants, jewelry). CDTFA’s sector chapters (e.g., bars and restaurants; grocers) instruct auditors to compare “achieved” markups from the taxpayer’s records against short-test markups and to pursue further analysis where differences persist.
Where taxpayers get hurt is in the assumptions. A few examples we routinely see:
- Single-period snapshot → full-period projection: Auditors may assume today’s markup equals the entire audit period’s markup, ignoring historical pricing, seasonal promotions, loss leaders, or shocks (supply chain spikes).
- Sales-mix distortion: A shelf test dominated by high-margin items will overstate overall markup; weighted averages by volume are usually required where classes of merchandise have materially different markups. CDTFA prefers weighted methods for just this reason.
- Inventory & shrinkage: If inventory roll-forwards are not done, purchases may be treated as COGS—potentially taxing goods not yet sold. The manuals require adjustments and allow documented shrinkage (spoilage, breakage, pilferage). Grocers using the markup method may claim up to 1% of the cost of taxable merchandise when using the retail inventory or markup method; up to 3% for nongrocery taxable items only when using the purchase-ratio method, otherwise capped overall at 1%.
- Tax-included vs. ex-tax prices, deposits, and multi-packs. Mis-handling bottle deposits, “tax-included” shelf labels, or multi-pack conversions can inflate the factor; CDTFA specifically instructs auditors to normalize these details.
- Projecting from non-representative periods. Manuals allow using periods outside the audit window only when current records are too incomplete, but the burden is on the auditor to show representativeness and give effect to markdowns.
- Over-reliance on generic statistics. The IRS can reference external data (BLS, surveys), and case law has upheld statistical estimation in appropriate circumstances, but examiners are told to start with your records and accept plausible explanations for deviations from averages.
Bottom line: markup tests are legally sanctioned tools, but the math must track your actual business realities and credible evidence. If assumptions are off, results are off. Unfortunately, in practice we have seen some wildly taxpayer unfriendly results when the mark up method is misapplied by an incompetent auditor.
Contact the Tax Law Offices of David W. Klasing to Build and Defend Your Position When a Markup Test Appears
The best defense begins before an audit: preserve invoices, POS exports, price books, promotion logs, vendor deals, and inventory counts. If you’re already facing a markup test, our dual-licensed Tax Attorneys and CPAs at the Tax Law Offices of David W. Klasing work to (1) verify the base (purchases/COGS), (2) rebuild a representative markup using weighted methods across complete purchasing cycles, and (3) document adjustments the manuals require (self-consumption, shrinkage, markdowns, deposits, tax-included labels, single vs. multi-pack equivalencies). CDTFA’s own guidance says assessments using markup must be supported by short tests; we hold them to that, and we present our short tests (e.g., bank deposits tie-outs, net income analyses) to show reasonableness.
On the federal side, when the IRS invokes the Markup Method, we insist on the procedural safeguards embedded in the IRM: demonstrate the reasonable indication of unreported income; document why markup—not net worth, not bank deposits—is the right tool; and incorporate credible taxpayer-specific pricing evidence rather than defaulting to generic ratios. We also remind examiners (and, if needed, Appeals) that the method must be reasonable in context and that plausible, well-supported differences from “typical” margins are acceptable.
Do not return to your original preparer to ‘explain’ the numbers. Your conversations with a non-lawyer preparer are generally not privileged; in a high-risk civil audit or a criminal tax context, that person can be subpoenaed and, in practice, often becomes government witness number one. By contrast, the attorney-client privilege and attorney work-product doctrine protect candid strategy discussions with a lawyer. Where specialized forensic accounting is needed, we bring our dual-licensed Tax Attorneys and CPAs under a Kovel engagement so their work is conducted within the privilege umbrella.
Practical steps we routinely take in markup matters (state or federal):
COGS Verification
Reconcile vendor statements to recorded purchases; correct misclassifications (e.g., supplies vs. resale), back out non-inventory items.
Representative Pricing
Develop weighted markups over full purchasing cycles; segment by commodity groups where margins diverge; normalize for markdowns and promotions.
Required Adjustments
Quantify self-consumption and shrinkage per manual allowances; translate allowances from percentages to dollars with supporting schedules.
Short Tests
Corroborate with bank deposit tie-outs and POS/scanner analytics; where scanning systems are used, ensure required control records are produced and consistent.
Narrative of Business Reality
Document seasonality, product mix shifts, supply shocks, and vendor rebates—exactly the factors a one-size-fits-all shelf test can miss.
If the government still presses an inflated result, we challenge the assumptions, the representativeness of test periods, and any failure to perform or document required short tests; we also consider Appeals or litigation, leveraging IRM and CDTFA manual language to show why their approach is unreasonable for your facts.
If the IRS has raised the Markup Method in an income tax examination or if CDTFA is proposing a cost-plus-markup assessment in a sales and use tax audit, you are in eggshell territory where civil issues can morph into criminal tax exposure if not handled correctly. Our dual licensed Civil and Criminal Tax Defense Attorneys & CPAs know exactly how the IRS and CDTFA construct and attack markup factors, how to rebuild a defensible number grounded in your records, and how to insulate you with the attorney-client privilege (and, where appropriate, a Kovel CPA engagement). Start with a confidential, reduced-rate initial consultation with the Tax Law Offices of David W. Klasing: call (800) 681-1295 or reach us through our online contact form HERE today.
