rs-california-sales-tax

What is the direct method of testing in a sales tax audit? So the direct method of testing is looking at source documents in the course of an audit and making sure that everything matches. That’s the preferential way of dealing with sales tax audits because it’s the most reliable because it’s based on actual data and not a guess.

So the direct method of testing, we can use restaurants for example, is looking at the bank statements for a given year, looking at the sales tax returns that were filed in that given year, looking at the 1099Ks, the merchant account processing statements for credit cards, looking at the internal accounting that was done during that year, and then looking at the POS system reports. You take those five or six pieces of data and you compare them across each other to make sure everything lines up.

So for example, one of the easiest things that we see in sales tax audits with people who are underreporting their sales tax, is their federal income tax returns and their sales tax returns don’t match. So to the extent possible, and particularly the client hasn’t done anything wrong, you want to keep everything to a direct method of testing. If the direct method of testing holds up and the auditors are unable to challenge it, then there’s no real reason to go towards any sort of statistical analysis. And the quickest and easiest way to wrap up an audit is to say, look, here’s six pieces of paper that prove I don’t have any sales tax liability and going from there.

The problems announce when you find discrepancies in those audits and then you have to move to an indirect method of testing, which we can cover in a later point.

In a prior video we talked about the direct method of testing. The direct method of testing involves testing actual source documents, lining up and comparing them when you have a breakdown in the direct method. Then sales tax auditors will resort to what they call indirect methods. Indirect methods of testing is a fancy way of saying we’re going to play guessing games with statistics. So one of the indirect methods of testing is audit path sales. They look at current sales and they’ll do statistical comparisons between past sales and current sales. So one of the easiest ones they do is they do an observation test. They’ll send an auditor in a business for a couple of days to look at the sales that are being performed, whether the employees are ringing everything up correctly, whether they’re charging tax and then the auditor will sit there and literally record every single transaction and they’ll compare that against the POS system reports to see if there are any discrepancies. That’s called an observation test so if there is an error within that test, then they’ll do certain things based on

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When you have a sales tax audit and you can’t agree on the audit, the very first step in the process is that you have an exit conference with the auditor and the manager, and if that doesn’t bear fruit, the auditor is going to submit the sales tax audit report. It’s going to go up through technical review. They have a review department review the audit report to make sure it’s technically correct and then it goes to a final billing. Once it goes to a final billing and I notice the determination is issued, that is your ticket to file your petition of redetermination to go into Appeals. So you file your petition and redetermination, the case moves from Sacramento, it goes back down to the district level and then the district level will try one more time to get it resolved before going through Appeals. What this usually means is as follows. Number one you get a chance to do a 10-day conference with the district principal auditor so CDTFA will schedule you to talk with the head of the audit unit for the particular district that you’re working in and the manager and the auditor will both be there and then you can kind of negotiate. If there’s an opportunity to get the case settled with the person who is making the final decision on the issue (for the district number two, this is just your principal auditor) and you don’t agree for whatever reason and the case can’t be resolved in the district, then you go through the formal CDTFA appeals process. The way it usually works out is you’ll get a hearing officer at CDTFA, you’ll go in for an appeals conference which is much like a mediation, so you’ll sit there, the auditor sits there, the manager sits there and the Appeals officer sits there. Usually the appeals officer is either an attorney or their former auditor, and then there’s a discussion between the parties on what the issues are and how to resolve. So what usually happens is there’s a conference and then there’s a follow-up document submission for the petitioner, usually the taxpayer, to prove their point and so on and so forth. What ends up happening after that is an exchange of information back and forth between you and the auditor and the manager of “here’s our documents that prove our point,” “here’s our counter response” and you kind of go back and forth. Eventually you read through to the point where you can’t submit any more documents, you can’t make any more arguments and the parties just kind of wear themselves out and at that point

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What Is the CDFTA Settlement Process Like? So CDTFA settlement process when dealing with the sales tax audit it used to be a very good Avenue to resolve cases unfortunately nowadays it’s been late a little bit more difficult and here’s why so the problem is is if you go through settlement you can’t resolve things and then you go through Appeals cases will naturally progress to something called the office of tax appeals which is California’s version of a Tax Court and recently cbt fa has been so good at disposing of taxpayer cases and Tax Court but the issued guidance to their own settlement division which basically states don’t settle cases let them go forward to Appeals now it will still give some measure of reduction through the settlement division usually about 10% sometimes as much as fifteen but settlement is no longer as reliable as an option as it once was so unless you have new documents or new evidence and we’ve actually had some pretty good victories in settlement in light of the changes but it’s very difficult to get things pushed through and get your tax payer in a position where they’re gonna be happy so the important thing.

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Is It a Good Idea to Meet With Your Sales Tax Auditor? yYES! a hundred percent go meet with your sales tax auditors spend as much time as possible with your sales tax auditor driving your sales tax auditor completely crazy in all seriousness way that we have had the most success in the firm is by face-to-face contact the more time you spend with these auditors as individuals. The more you get to know them the more they like you the more latitude that gives you people naturally do business with people once you get to know like and trust somebody then you start to develop a relationship with it you know one of the big reasons were successful in problem in law is because we deal with these cases over and over and over and over and over again we deal with the same people over and over and over and over and over again I might not know every auditor in the San Diego office of CDTFA but I know a ton of them and it’s really important and we’ve developed that relationship because of face-to-face contact because an auditor or manager who I’m having a disagreement with is not gonna take it on a reasonable position if they know they have to see me again and again and again and again and again so it’s not like you know we’re gonna take a hard line on this case and you know hope this never shows up again because there’s a level of contact there’s a level of familiarity if you decide to represent yourself in the CDTFA on it which I don’t recommend but if you do you want to have as much contact as much touch point with you auditor as possible you’re not gonna be able to like influence them or buy them dinner bribe them under the table but just having that familiarity developing trust and developing rapport is a very important so I would absolutely recommend you go and meet with your sales tax auditor I would recommend that you bring them into your business I recommend you actually go to see the cafe the meetings will be a lot shorter you’ll get the time to interact with in the conference room you can walk them through your documents and you just give them much better presentation by doing.

So we’ve done a lot of sales tax audits on our firm and I can speak very generally about some of the problems that we see most often that our clients encounter or that we’ve encountered through the course of dealings. So problem number one is the majority of people who are under reporting on sales tax for whatever reason or another don’t do enough to cover their bases. While that seems fairly silly, it’s really true. The biggest way that people get nailed for sales tax audits is by data that doesn’t match. So what happens is when you file a sales tax return that gets reported to CDTFA and then in the evaluation process to determine whether they’re going to audit you, CDTFA is looking not only at your taxable sales and your total sales due looking at your federal income tax returns, but they’re looking at the information that was reported on your 1099 Ks and any other publicly available information that they could find. So the biggest problem that people have right off the bat is sales tax returns and federal income tax returns not matching. You’re reporting a lower or higher amount of sales than you are on your federal

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So in the context of a sales audit, an observation test is kind of what it sounds like. You’re observing something or more specifically the auditor’s observing something. So an observation test is when an auditor visits a client’s business to verify the total sales and the taxable sales that the client is conducting during a period of time. The most common example is with a restaurant. So let’s say they send an auditor into a restaurant between ten o’clock in the morning and four o’clock in the afternoon. The order is sitting over there in a corner recording every sale that comes through the place and then at the end of the day the auditor is taking their notes and they’re taking the POS system reports and they’re making sure that all sales are being recorded properly. They’re doing this on an aggregate basis. So they’re looking at what total sales are, what taxable sales are but they can also do observation tests for the purposes of doing a cash to credit card ratio or establishing a frequency count or a variety of different things. So an observation test is just a method for the sales tax auditor to use and verifying the information that they’re being presented in the POS system report is accurate and that it’s telling a consistent story. If the observation test doesn’t go well, then it really creates problems with the audit because the auditor is left to rely on the data that they’ve gathered with their own two eyes versus records that they’re not able to verify.

What is a markup test? So in the context of a sales audit, a markup test is kind of what it sounds like. A markup test is a test to determine the markup in the aggregate of taxable products that are being sold.

So what the auditor does is, let’s take a restaurant, for example, they’ll look at all the menu items and they’ll have somebody break out food cost and say, okay, if you’re selling burritos, tell me all the ingredients that go into the burrito and give me a cost of how much it costs you to make that. And then let’s see what your markup is.

So markup tests are really dangerous because markup tests generally vary across different products. So a restaurant selling beer can have a certain markup. A restaurant that’s serving shots coming out of a bottle is going to have a higher markup on liquor than with beer. So when trying to take an average of those two things, it’s really difficult to get an appropriate average markup.

So we try and avoid markup tests whenever possible. If we have to go through them, we will try and limit the scope of the market test to make it as easy as possible on the client and to make sure that the results that we’re getting are really consistent.

Market tests are very common, particularly in retail settings, with restaurants, in a variety of other businesses, and they really should be avoided at all costs.

So statistics, just to give you a brief lesson, are about the integrity of the data that you have. So what you’re doing with statistics is you’re taking a representative population or an entire data set, let’s call it a business’s sales over a three-year period, and then you’re taking a representative sample, you’re trying to create a fair and accurate sample of that population. So if we were to look at the business of sales over a three-year period, the goal would be how do we take a smaller subset of that that we feel is going to be fair and accurate? So here’s where CDTFA audits often get into it as we have what we call a data file. So CDTFA and your sales tax auditors have very limited resources. When they do an observation test, when they do a mark of test and when they’re using the indirect methods of testing, they’re only going to do it for a certain period of time usually two to three days max. And so obviously the challenge is if you’re going to take a three day sample or a two day sample, how can that possibly be representative of over a thousand days over the course of a three-year period. Three days, a thousand days, it’s not very representative because you can have a variety of things that would go into those three days that could heavily tip the scales in one way or the other. Hopefully in the favor of your taxpayer anyway.

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So aside from discrepancies between the client’s reported taxable sales and the taxes due, with CDTFA’s calculation the the biggest problems that we see are in little technical areas. So the first one is sales for resale in California. When you sell a product for resale and obtain a valid resale certificate, that product is not taxable to you so the important thing here is number one, the product is being sold for resale. So it’s moving down the supply chain because from the state’s perspective, the state doesn’t want to tax it in the middle of the supply chain, it wants to tax it at the end of the supply chain. So if you’re manufacturing baseball bats and somebody is buying them to resell them to consumers, the state wants to tax it when it’s sold to the consumer at a higher market price versus when it’s sold to the retailer. So with sales for resale, the actual resale itself is an exempt sale but it’s only made exempt by the attainment of a resale certificate. For that particular transaction, the problem that we see with clients and one of the biggest discrepancies

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