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Sales Tax Audits: What to Know and How to Prepare

California does not hesitate to pursue unpaid taxes, and in 2025, with budget pressures mounting and an economy still recovering from inflationary strain, enforcement is only intensifying. Whether your business is thriving, struggling, or even closed, it could still face an audit from the California Department of Tax and Fee Administration (CDTFA).

If you’re a California business owner, especially in a high-risk industry like hospitality, retail, or fuel sales, now is the time to prepare.

Why Sales Tax Audits Are on the Rise

California’s economy is slowly stabilizing after several turbulent years marked by supply chain disruptions, worker shortages, and inflation. However, these disruptions led to underreported revenues, incomplete filings, and an increase in noncompliance, some accidental, some deliberate.

In response, CDTFA (which replaced the Board of Equalization in 2017 for most tax functions) is ramping up audits to recover state revenue. Key reasons for increased audits include:

  • State budget shortfalls
  • Rise in online and hybrid business models
  • High error rates in cash-heavy industries
  • Cross-agency enforcement with FTB and IRS

How Do California Sales Tax Audits Begin?

Audits typically begin when the CDTFA contacts a business by phone or through a formal audit engagement letter. This notice includes:

  • The audit period (generally 3 years)
  • A list of required documentation
  • The auditor’s contact information and audit scope

Audits may be conducted remotely or on-site. Businesses are usually given 2–3 weeks to prepare, but extensions may be requested. If the audit period goes beyond the standard statute of limitations, the auditor may request a Waiver of Limitation.

Who Is Most Likely to Be Audited?

While any business collecting sales tax can be audited, CDTFA tends to focus on:

  • High-volume or high-revenue businesses
  • Industries with high cash transactions (e.g., restaurants, bars)
  • Retailers with a high ratio of exempt sales
  • Fuel, alcohol, tobacco, and cannabis distributors
  • Businesses in regions with known compliance gaps

Even closed businesses are subject to audit if the state suspects outstanding liabilities. CDTFA also receives data from credit card processors, online marketplaces, and other agencies, giving it unprecedented insight into underreporting.

What Does CDTFA Look for During an Audit?

The audit aims to determine whether you correctly collected, reported, and remitted sales and use tax. Auditors review:

  • Sales tax returns (state)
  • Federal tax returns
  • Invoices and receipts
  • Purchase records
  • Resale certificates
  • Bank statements
  • General ledger entries

Common issues that raise red flags:

  • Misapplied tax rates
  • Unreported out-of-state sales
  • Invalid or missing resale certificates
  • Underreported gross receipts
  • Improperly claimed exemptions

What Happens After an Audit?

Audits conclude with an exit conference to review findings. There are three possible outcomes:

  1. No further action: CDTFA accepts your records as filed.
  2. Determination of taxes owed: You’ll receive a Notice of Determination detailing the amount due.
  3. Refund owed: You’ll receive a Notice of Refund if you’ve overpaid.

If you disagree with the audit findings, you have the right to appeal. This may include filing a petition for redetermination and presenting supporting documentation.

Engaging a tax attorney at this stage is strongly advised, especially if the audit involves multiple years, substantial liabilities, or complex exemptions.

California Sales Tax Audit Readiness Checklist

Recordkeeping:

  • Maintain 3+ years of sales tax returns and supporting documents
  • Organize invoices and receipts by date and transaction type
  • Retain copies of resale and exemption certificates

Sales Reporting:

  • Reconcile reported sales with POS and bank data
  • Verify correct local and district tax rates are applied
  • Confirm internet and out-of-state sales are properly reported

Compliance Controls:

  • Conduct internal audits at least annually
  • Train staff on sales tax collection rules
  • Use tax software for rate updates and filing accuracy

If Audited:

  • Respond to audit notice promptly
  • Provide a clean, organized audit package
  • Consult a tax attorney for strategy and representation

Final Thoughts

Sales tax audits in California are no longer rare, and they’re not limited to companies suspected of wrongdoing. In 2025, businesses that simply make filing errors, misclassify sales, or rely on outdated processes are at risk.

The best defense? Be proactive. Keep your records clean, your team informed, and your audit playbook ready.

If you’re facing an audit or want to prepare before one hits your inbox, contact Milikowsky Tax Law. We’ve helped California businesses navigate complex tax audits for over 15 years, and we’re ready to help you, too.