A Board of Equalization (BOE) sales tax audit in California is serious business. The BOE is charged with collecting nearly 52 billion dollars in sales tax revenue generated within the state annually. Since sales tax makes up over 40% of the entire state budget, our state government has a keen interest is ensuring that sales taxes are collected by retailers and remitted to the BOE.
To prepare you for your audit, we’re going to look at the purpose of a sales tax audit and suggest some proactive and preventive measures to take. We’ll look at how to work with the auditor to develop a relationship that maximizes the chances of a positive outcome in your favor, how to best deal with records’ requests made by the auditor and will explore the tests and sampling methods commonly used by the BOE to streamline the auditing process.
Purpose of Auditing Sales and Use Tax Records
Because most of the taxes administered by the BOE are self‐assessed by taxpayers, auditing is essential in meeting the following BOE objectives:
- To assure all citizens of the state that the tax is being enforced uniformly;
- To deter tax evasion and carelessness in self‐assessments; and
- To promote accuracy in self‐assessments through aid extended to taxpayers with respect to the interpretation of the law and rules and regulations adopted thereunder.
Relationship of Taxpayer and Auditor from the BOE’s Viewpoint
Currently, the BOE’s Audit Manual states the following:
Consistent with the purpose of tax auditing, there should be no occasion for the auditor to harass taxpayers or to give the impression that the object of the audit is to find errors in the taxpayers’ self‐assessments. Rather, the taxpayer should be assured that the auditor’s function is to determine whether the amount of tax has been reported correctly. The auditor should aid the taxpayer in gaining a correct understanding of the law and demonstrate that we are as willing to recommend a refund of an overpayment as we are to propose a deficiency determination. Care should be taken to inform taxpayers of their rights and privileges in connection with such determinations. The auditor should constantly keep in mind that it is the BOE’s policy to administer the law fairly and uniformly, with minimum annoyance and interference in taxpayers’ business affairs, as well as at the lowest cost consistent with good tax administration.
Oh, if only this were true of each and every auditor and audit!
Cultivating a Good Working Relationship with the Auditor
Despite these laudable goals of the BOE in conducting an audit, no one looks forward to being audited. Any tax audit is extremely stressful and can be very time consuming. However, you (the taxpayer) need to keep your stress in check. If you behave aggressively or negatively towards the auditor from the get-go, you will only hurt yourself. Instead, try to cultivate a cordial relationship with your auditor by responding to all of his or her requests in a timely manner. This courtesy will pay huge dividends in the end and throughout the process (if you need additional time to respond, desire to go on vacation in the middle of the audit, or need to continue the audit at a later date due to a conflict). If you’ve been prompt and polite from the beginning, the auditor is far more likely to be flexible to your needs.
If the audit is on-premises, make sure that you give the auditor sufficient access to the business premises. Consider giving the auditor a tour, explaining the processes you have in place and how workflow operates. If the auditor is going to be there for more than a day, make sure that you provide the auditor with an office or desk and access to the necessary office equipment, e.g., a copier.
You have absolutely nothing to gain by obstructing the auditor. Most auditors will take an obstructionist attitude as a sign of guilt, and that will only make them go through your business records with a fine-toothed comb. In addition, hostility towards the auditor will only antagonize him or her. Do you want your sales tax audit performed by someone who actively dislikes you and already thinks that you’re guilty? Of course not!
At the same time, you don’t want the auditor talking to employees who have nothing to do with sales tax records or business practices. Giving inaccurate, misleading, or incomplete information to the auditor will cause the same result as being hostile or obstructionist – the audit will take longer and be far more extensive and detailed.
Dealing with Records Requests
When you receive notice of your sales tax audit, you will also receive a list of records and documents that the auditor requires. Once again, a soft touch here goes a long way. When you quickly and completely comply with all of the auditor’s requests for documents and records, you greatly benefit yourself. Being open and transparent demonstrates to the auditor that you have nothing to hide and that you are willing to cooperate with the BOE during the audit process.
Commonly required documents and records and include:
- Accounts payable
- Accounts receivable
- General business ledgers
- Quarterly Sales/Use Tax Returns
- Federal business income tax returns
- Federal personal income tax returns
- Additional supporting documentation, including purchase orders, bills, invoices, register tapes, resale certificates, etc.
If you find any document or record request unclear, the best course is to ask the auditor to explain what he or she specifically needs. Some record requests made by the BOE are routine and generic, meaning they may not apply to your particular business. If this is indeed the case, talk to the auditor about alternatives that may satisfy the auditor’s specific need for information.
Remember, sometimes no matter how careful you may be, things happen – chargebacks, lost documents (contracts, invoices, resale certificates, or bills of sale), item returns that aren’t fully documented, etc. If the auditor happens upon one of these and is unable to follow the paper trail, simply cooperate with him or her. Admit the mistake or inaccuracy, and then work with the auditor to clear up the discrepancy. A failure to do so will only result in the auditor making a decision based on too little information. In a worst case scenario, if the information needed by the auditor cannot be located, the auditor may request bank statements directly from your financial institutions and credit card payment processors.
Sampling Methods and Tests
The BOE uses several methods to make the auditing process quicker and more efficient. One of these is the short test. A short test may be defined as the examination of any record, supplemental data, original detail, etc. for any purpose. A short test audit may be a combination of several short tests. A short test might be, for example, the review of an income tax return to see if the mark-up over cost is acceptable for the type of business, a spot check of sales invoices for proper tax accrual, etc. If the foregoing mentioned mark-up test indicates an acceptable margin and total sales per the income tax return agree with total sales reported per the sales tax returns, total reported sales might be accepted. The end result of a short test is a decision as to whether to proceed or to accept as correct that item being tested.
Short tests are done before starting a complete verification of three years’ operations. If the short test indicates the taxpayer has properly reported their tax liability, the auditor will probably not make more extensive tests. The short test avoids wasting valuable time pursuing records that do not require further examination. It also allows the auditor to conduct a control test for the accuracy of a wide sampling of documents. The size of the test period involved depends on how much effort it takes to establish reasonable accuracy when compared to any problem detected.
Many taxpayers are careful to report taxable transactions accurately, especially after having gone through a previous audit. To make an extensive examination of three years’ operations in these situations may not be justified. If your business has been previously audited, the auditor may use the Prior Audit Percentage of Errors. That is, the percentage of errors discovered in a prior audit will be used to establish the size of the sales and accounts payable portion of the current audit.
Finally, an auditor may use various testing or sampling methods to reduce the number of transactions that ultimately need to be reviewed. The auditor’s biggest concern is the existence of errors. Testing and sampling allow the auditor to determine whether errors exist, whether to keep testing or test all transactions, or whether to disregard errors. The most typical sampling methods are block sampling and statistical, stratified random sampling. The former focuses the sample on one or multiple time periods (blocks) of transactions. The effectiveness of block sampling varies widely depending on factors such as seasonality. Tax assessments identified in the block sample are projected over the entire audit period.
Statistical, stratified random sampling is more common. Random numbers are assigned to each record, such as a transaction or an invoice, in the population. The population is then stratified by some predetermined category or dollar size; records assigned with the lowest random number within each stratum are selected; and, after review, errors in taxability or tax are statistically projected back to the population.
In the end, a sales tax audit in California is, at best, a stressful experience. Enlisting the aid of an experienced California tax attorney that specializes in sales and use tax audits can reduce that stress. Such an attorney can guide you through the audit process, using their knowledge of California sales and use tax law to help you achieve the best possible results for your company. Contact us today for a free consultation.