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Being notified that your business is being audited by the California Department of Tax and Fee Administration (CDTFA) sales tax audit can be daunting. Still, it does not necessarily mean that your business is being audited for any reason. An audit of an account by the CDTFA may lead to an assessment of the possibility that sales and use tax have been properly reported, which could lead to an additional tax, a refund, or no change.

Preparation is the key to passing an audit successfully. Companies that keep their transactions organized, have a clear understanding of their tax holdings, and have clear documentation to answer the auditor will be in a far stronger position.

Notification and record requests are the first steps in a typical audit. Your sales and use tax returns, books, orders, invoices, purchase records, exemption documentation, and electronic accounting records can be examined by the auditor.

The CDTFA’s audit manual specifies that auditors can discuss the business and operations, visit facilities and records, review returns, and discuss applicable publications or regulations.

A streamlined audit trail would be similar to this:

Audit notice – Record request – Initial examination – Transaction testing – Proposed adjustments – Exit discussion – Final determination – Appeal (if needed)

CDTFA states that the accounts can be audited at three-year intervals, when a permit is closed, as part of another permit, or when information is received from outside entities.

The best tool you have is the documentation.

Taxpayers must keep records to establish their proper sales and use tax obligations in California. These may be books of account, invoices, receipts, purchase orders, contracts, schedules, and/or tax-return workpapers. There should be a sufficient level of detail in electronic records to allow the underlying information to be determined.

The CDTFA also assumes that sales records should contain sufficient information to determine the date, sales items, taxable and non-taxable charges, sales price, and tax collected.

One of the best practices is to directly check out your sales before you give a record.

Compare:

• The total amount of sales in your accounting system.
• Point-of-sale totals
• Bank deposits
• Credit-card settlements
• E-commerce reports
• Sales tax returns
• General-ledger accounts

Underreported sales do not necessarily mean differences. Timing differences, refunds, transfers, financing arrangements and non-sales deposits can explain discrepancies.

However, it is important to be aware of all material differences before the auditor queries on the subject.

Incomplete documentation can be a significant audit trip hazard with deductions.

If a business is claiming that sales are non-taxable, it should be able to provide reasons for excluding the sales. Other supporting documents, such as resale certificates, exemption certificates, shipping records, and more, can be essential.

Do not give an auditor the answer, “That sale was not taxable. Provide evidence to support the position.

The most frequent areas for inspection:

• Resale transactions
• Items shipped outside of California.
• Exempt customers/organizations
• Returned merchandise
• Bad debts
• Non-taxable labour
• Discounts
• Separately stated charges
• The cost of purchases/usage tax treatment.

The specific regulations differ depending on transaction and industry, so companies should check the specific California law involved, not a general list of exemptions.

Use tax is often overlooked while businesses are concentrating on sales tax.

When the buyer of a taxable good or equipment buys it without the appropriate California sales tax being collected and uses it in California, use tax may result.

Review purchases from:

• Out-of-state vendors
• Online marketplaces
• Equipment suppliers
• Foreign vendors
• Vendors who made an error with another state’s rate

A pre-audit use-tax analysis can assist in the early detection of issues and in building a defensible position.

Auditors can sample and/or perform analytical procedures on transactions. An error rate which is found in a sample may be representative of the entire audit population.

This is why it is important to choose and document samples.

Make sensible inquiries, e.g.

• What population are you testing on?
• What time frame is the sample from?
• What was the selection criteria for transactions?
• Are out-of-the-normal transactions handled as separate items?
• Are there more documents that could explain the transactions that are sampled?

If transactions in a sample are unusual or not representative, explain with evidence; don’t simply say that the sample is not correct.

Sales-tax issues vary greatly from a restaurant to a construction contractor to a retailer, a manufacturer, a software-related business, and a vehicle dealer. The CDTFA provides business-specific guidance; for example, recordkeeping and tax treatment may differ significantly depending on the type of business. Prior to the audit, you should try to determine the unusual transactions for your type of business and locate documentation to substantiate your treatment.

An audit is not a competition in which the taxpayer is competing to “beat” the auditor. The guidance from CDTFA indicates that auditors should identify underpayments and overpayments, and ensure that the proper tax or fees were reported.

Communication is important.

Have one person with knowledge to coordinate responses. Don’t send lots of unstructured documents without explanations.

If you don’t know the answer, state that you will check. There is no need for inconsistencies in guessing.

Discovering an error during an audit doesn’t mean you should conceal it.

If you discover you have underpaid, make sure to find out how big the underpayment is and talk with the tax professional about how to fix it. On the other hand, if you find an overpayment in your review, be sure to include supporting documentation. CDTFA audit procedures have a debt vs credit approach.

In today’s day and age, an increasing number of audits include electronic records.

There may be information in your point of sale system, accounting software, online-store platform, payment processor, and spreadsheets.

When giving electronic data:

• Keep the source information.
• Create appropriate backups.
• Be familiar with the content of each report.
• Match exports with your accounting records.
• Avoid modifying historical records.
• Maintain documentation of customized reports.

California’s recordkeeping requirement is focused on electronic records and mandates adequate source-document data to identify the underlying transactions.

Then gather evidence addressing each adjustment individually.

An effective response typically provides an explanation of why the adjustment is incorrect, rather than a rebuttal of the auditor’s conclusion, and usually includes documentation.

California offers a Managed Audit Program for qualified taxpayers that lets the taxpayer review its books and records according to procedures established by CDTFA. The law requires the CDTFA to determine the audit period, transactions, procedures, records, schedule, and other factors for the managed audit.

If the cooperative has organised records, this may be a worthwhile topic to discuss with the CDTFA or qualified tax professional.

Professional assistance can be particularly useful when:

• The audit is conducted over several years.
• The possibility of liability is great.
• Records are incomplete.
• Sampling is being utilized.
• The business has complex interstate sales.
• There are large exemption and/or deduction issues.
• The auditor offers serious penalties.
• The taxpayer has objections to significant changes.

A sales-tax attorney, CPA, or experienced sales-tax expert can assist in sorting out legitimate disagreements from documentation issues and develop a response to the transactions.

A determination that is not favourable to the taxpayer is not a final determination.

The audit process and how taxpayers can appeal audit results are explained in CDTFA Publication 76. If you agree with an assessment, be sure to carefully read the deadlines and instructions in the CDTFA’s determination or appeal letter. Keep all necessary back-up documents and develop the argument on the specific factual and legal issues.

Please ensure that you: Prior to and during the audit, ensure that you:

1. Compare sales data from accounting, POS, bank, and tax-return records.
2. Collect all invoices and transaction documents of originality.
3. Check resale/exemption
4. Review use-tax exposure.
5. Maintain electronic record-keeping and audit trail.
6. Recognize tax issues for particular industries.
7. Review unusual transactions prior to the auditor’s review.
8. Keep clean and tidy records throughout the audit period.
9. Follow through on requests in an accurate and consistent manner.
10. Examine suggested revisions, line by line.
11. Keep records of the results if you disagree with the results.
12. Be aware of all appeal deadlines.

Being confrontational is not a way to “win” a CDTFA audit. The key to winning is being well organized, accurate, consistent, and documented.

Inadequate records can lead the CDTFA to use standard accounting practices to determine the tax that may have been due, and the CDTFA can examine records to determine tax liability.

The best audit strategy for California businesses, then, starts before the audit notice is received. Regularly reconcile your books, record exemptions, keep records of use tax, keep electronic records, and understand the meaning of each number on your sales tax return.

If the audit shows up, preparation can help make an investigation manageable and provide your business with the documentation it requires to support valid tax claims.

A CDTFA audit can be initiated for several reasons, including routine audits, closing a permit due to an audit, information received from other agencies or sources, or findings during a CDTFA review. Getting an audit does not always imply that the taxpayer did something wrong or that they owe more taxes.

A company must arrange its sales invoices, receipts, purchase records, exemption and resale certificates, bank statements, accounting records, sales tax returns, POS statements, and electronic transactions. Moreover, it should ensure that these documents certify the reported sales figures, deductions, exemptions, and the use-tax calculations.

Documenting is the best way to defend against any type of dispute. Maintaining valid resale or exemption certificates, shipping documents, invoices, contracts, and other relevant papers explaining how a particular transaction was treated as non-taxable is essential. Furthermore, it is necessary to ensure that each disputed transaction is tied to the documents that demonstrate why it was taxed the way it was.

In case of the business’s review, the changes may be considered, the transactions specified, and/or evidence or explanations provided to the CDTFA concerning the company’s position. In case of disagreement with the final decision, the taxpayer may also have the right to appeal. Businesses must also remember to meet all applicable deadlines in order to take advantage of any filing they have done with the CDTFA.

Professional help may be required to interpret the results of an audit, especially when there is a risk of substantial liability, many years involved, complicated transactions, including sampling, documentation issues, or significant disagreements with the auditor. A qualified CPA, sales-tax specialist, or tax lawyer can assist in this process and provide guidance on how to respond to the results.