California Sales & Use Tax Audit Process

Defending against a California sales tax audit conducted by the California Department of Tax and Fee Administration (CDTFA) involves several strategic steps. The California Department of Tax and Fee Administration (CDTFA) is responsible for conducting sales and use tax audits for businesses operating within California.

Sales Tax Audit Notification: The sales & use tax audit process begins when a business receives an audit engagement letter from the CDTFA. This letter outlines what the sales tax audit will cover, specifies the tax periods under review, and lists the documents required for the audit. Businesses are typically asked to provide records like sales invoices, purchase invoices, exemption certificates, financial statements, and tax returns. These documents help auditors verify the accuracy of reported sales and use taxes. Businesses usually have a few weeks to gather these documents. If more time is needed, one might negotiate with the sales tax auditor or sign a waiver to extend the statute of limitations. The most common types of sales tax audit information requested during a sales tax audit involve: 1)Verify you have valid resale certificates for all claimed exempt sales; 2) Check for compliance with use tax on out-of-state purchases or purchases where sales tax wasn’t charged. Ensure your exempt sales documentation is in order as these are frequent targets for review due to complexity.

Types of California Sales Tax Audits:

• Field Sales Tax Audit: This process involves face-to-face contact with a CDTFA tax auditor at your place of business or at a CDTFA office. This is the most common form of sales tax audit in California. Sales tax auditors usually prefer to visit and conduct tax audits where sales tax records are physically stored. Online stores, restaurants, retail stores and construction business are prime targets of sales tax audits.
• Remote Sales Tax Audit: Sales tax and related business documents are sent to the tax auditor via mail, fax, or electronic means for review. These types of audits are not as common but is usually conducted for businesses that sell few high priced items such as airplanes, yachts, or equipment generally worth several million dollars and up.
• Managed Audit: The business performs a self-audit under the guidance of CDTFA, which can sometimes result in fewer penalties if discrepancies are found and corrected. These types of audits are usually reserved for large scale companies in California like Boeing, Tesla, Raytheon, Chevron, Google and Facebook. The purpose for these types of tax audits are to ensure compliance and inspect procedural system for reporting both sales and use tax for these large organizations.

Sales Tax Audit Process: The auditor examines your financial records against the sales and use tax returns filed. They look for discrepancies in reported taxable sales, exempt sales, and use tax liabilities. Auditors pay special attention to sales claimed as for resale, ensuring proper documentation exists. CDTFA often will use Mark Up Test which involve Comparing purchases (cost of goods sold) with reported sales to estimate potential underreported sales. In addition, Ratio Analysis will be conducted on the company’s cash flow to audit ratios like cash vs. credit card sales to detect underreported cash transactions. Credit card ratio test is one of the most popular methods used by CDTFA for its Sales Tax Audit as it provides and independent third party verified income source. As part of the tax audit process, sales tax auditor will be assigned with or without notice to spend significant amount of time to observe “spy” on your business to record sales tax related transactions. This information will be disclosed to the taxpayer as the sales tax audit progresses.

Behavior During the Sales Tax Audit: Professional Conduct should be observed at all times when engaging the CDTFA sales tax auditor. Many taxpayers or their untrained CPA take antagonistic approach to the sales tax auditor from our experience. Although some auditors may seem aggressive, their job is to ensure compliance and not necessarily to penalize a business owner. Building a rapport with the sales tax auditor can sometimes lead to a more lenient sales tax audit outcome. However, taxpayer is not required to volunteer information beyond what is requested especially if there are sensitive information which may expose the taxpayer to tax fraud or criminal sales tax charges.

Post Sales Tax Audit Issues: If you disagree with the audit outcome, you have 30 days to file a Petition for Redetermination. This can be extended if agreed upon with the CDTFA. If sales tax penalties are assessed, your representative can often negotiate these down, especially if no willful intent was involved.

Criminal Sales Tax Considerations: Potential for Criminal Referral exist in any sales tax audit by CDTFA. Experienced tax attorney will be able to anticipate and potentially mitigate criminal tax exposure. In cases where the sales tax auditor suspects fraud or uncovers transactions that support unreported sales transactions, there could be a referral to criminal authorities for prosecution. Having a tax attorney at the onset of the sales tax audit can greatly mitigate this risk.