A sales tax audit is different from an income tax audit in one way that changes everything. The CDTFA is not looking only at what you reported. It is estimating what you should have collected, and when the records cannot prove otherwise, its estimate becomes the tax.
That makes a sales tax audit a contest over method as much as over documents: which weeks are tested, what markup is assumed, how cash sales are reconstructed, and which exempt sales are allowed. Restaurants, bars, auto repair shops, liquor stores, and other businesses with cash sales are audited most often, and a business that closes its seller’s permit is frequently audited on the way out.
This article follows a CDTFA audit in the order it progresses.
Engagement
Understanding the audit period and taking over contact before the questionnaire is answered.
The letter
The audit begins with an engagement letter naming an auditor, an audit period, and an opening conference. The standard audit period is three years of returns. If returns were not filed, or the CDTFA believes there was fraud, it can reach back eight years.
The questionnaire
Before fieldwork, the auditor sends a questionnaire about how the business operates: its point-of-sale system, cash handling, pricing, suppliers, and record keeping. The answers shape the audit method. We complete it with the owner, because an offhand answer about how cash is handled can set the assumptions for the entire audit.
Representation
With a power of attorney on file, the auditor’s requests and meetings go through us. The owner is not interviewed alone, and the auditor’s visits to the business are scheduled, not surprise observations.
Records
Assembling what the auditor will test, and finding the gaps before the auditor does.
What the auditor asks for
- Sales records: point-of-sale reports, daily summaries, and sales journals
- Bank statements and merchant processor statements for the whole period
- Purchase invoices, especially for goods bought for resale
- Resale certificates and exemption documents for every sale claimed as exempt
- Federal and state income tax returns for the same years, which the auditor compares with reported sales
The gap analysis
We compare the records against the returns before the auditor does. If reported sales are lower than deposits, or exempt sales lack certificates, we know the exposure and can decide how to address it. Missing resale certificates can sometimes be obtained from customers after the fact, and we start that process immediately.
Fieldwork
Managing the test periods and the auditor’s method, which decide the result for the whole period.
Test periods
An auditor does not examine three years of transactions. The auditor tests a sample, often a few months or a few weeks, and projects the result across the whole audit period. Which periods are tested, and whether they represent the business’s normal operations, is the single most important negotiation in the audit.
Indirect methods
When records are incomplete, the auditor estimates sales by indirect methods: a markup analysis that applies an assumed profit margin to purchases, a credit card ratio that assumes cash sales bear a fixed relation to card sales, or an observation test in which the auditor watches sales for a day. Each method rests on assumptions, and each assumption can be challenged with evidence about how this business actually operates. Spoilage, employee meals, discounts, and theft all reduce a markup, and we document them.
Exempt sales
Sales for resale, sales to out-of-state buyers, and other exempt sales are allowed only with the right documentation. We organize the certificates by customer and tie them to the sales claimed.
Findings
Reviewing the auditor’s working papers and correcting them before the Notice of Determination issues.
Working papers and the exit conference
The auditor’s conclusions are set out in working papers that show every schedule, test, and projection. We review them line by line before the exit conference and present corrections there. Errors fixed at this stage never become an assessment.
The Notice of Determination
The CDTFA then issues a Notice of Determination stating the tax, interest, and any penalty. A negligence penalty adds 10 percent. A penalty for collecting tax from customers and not remitting it adds 40 percent, and fraud adds 25 percent.
A petition for redetermination must be filed within 30 days of the Notice. If the deadline passes, the determination becomes final and the only remaining questions are about payment.
Appeal and Payment
Contesting the determination, settling, and protecting the owner personally.
The petition and what follows
A timely petition leads to a review by the audit staff, then an appeals conference with an independent CDTFA attorney or auditor, and if still unresolved, an appeal to the Office of Tax Appeals. The CDTFA also runs a settlement program for cases in dispute, and many audits end there.
Payment
A final liability can be paid in installments, and the CDTFA grants payment plans on terms similar to the other agencies. Interest continues during a plan. The CDTFA also has an offer in compromise program for a liability the taxpayer cannot pay in full, most often where the business has closed and the owner is being pursued for its tax. The CDTFA evaluates an offer the same way the IRS and the FTB do, on what it could collect, and our offer in compromise guide explains that calculation.
The owner personally
Sales tax is collected from customers and held for the state. When a corporation or LLC closes or cannot pay, the CDTFA can assess the unpaid tax personally against the people who controlled the business’s finances. A buyer of the business can also be held liable for the seller’s unpaid tax if a clearance was not obtained. Both issues are addressed before a business is sold or closed, and our guide to closing a business covers the sequence.
Before an Audit Ever Starts
The businesses that come through a CDTFA audit well share three habits: a point-of-sale system whose reports are kept, not overwritten; a resale certificate on file before an exempt sale is rung up; and reported sales that reconcile to bank deposits every quarter. We help clients put those in place, and for a business that knows its records are weak, the CDTFA’s managed audit program can reduce the interest on what is found.
What It Costs
CDTFA audit representation is billed by the hour, because the work depends on the state of the records and how far the audit goes. We give an estimate at the first meeting after reviewing the engagement letter, the questionnaire, and a sample of the records.
- The engagement letter and questionnaire
- Sales and use tax returns for the audit period
- Point-of-sale reports or sales journals for the same period
- Bank and merchant processor statements
- Purchase invoices and any resale certificates on file
- Federal and state income tax returns for the audit years
Gregory Grigoryants is a California attorney (State Bar No. 286804) who has represented individuals, families, and business owners in bankruptcy, debt collection defense, and tax resolution matters for more than 13 years. He practices from offices in Sherman Oaks and Beverly Hills and speaks English and Russian.