Sales Tax Audits: What to Know and How to Prepare
When businesses fail to pay taxes in California, the state does not hesitate to aggressively pursue what it’s owed. Most California businesses will have to endure an audit at some point. Even if your business has kept meticulous records and accurate ledgers for years, the audit process can be grueling.
Businesses that have closed can still be audited and held liable for back taxes, as well. The state’s Board of Equalization (BOE), the government body that collects and enforces California tax codes, imposes serious penalties on any business – open or closed – that does not turn over not only sales tax owed, but other specific state taxes, like those on the sale of fuel, alcohol, cigarettes, and more.
Whether the audit process goes smoothly or not can depend both on how well you prepare your business and the advice you receive from a tax attorney who can negotiate with the state on your behalf. All business owners should know what to expect in the event of an audit and the options available to them.
How Do Audits Begin?
California has a very direct interest in pursuing any tax money it’s owed. Tax money collected by businesses pays for a large portion of the state’s infrastructure, education system, public spaces, and state programs.
Audits typically begin with the BOE attempting to contact the business owner by phone or through an engagement letter. The initial contact will outline certain details, such as:
- The period of the audit (normally three years)
- Documentation and records the business will need to produce
- Terms of the audit
Auditors work either remotely or at your business. If an auditor works at your business, provide adequate accommodations and be professional. Promptly respond to all of the auditor’s initial requests, as the first interactions you have with the BOE are critical in establishing a productive, professional relationship.
Auditors are generally flexible about the start of an audit. It’s normal to request two to three weeks to prepare. The BOE has a standard three-year statute of limitations to follow. If a lengthy delay occurs and the BOE anticipates needing more than three years to investigate and charge back taxes, a Waiver of Limitation can be requested to extend the three-year limit.
Who is Likely to Be Audited?
Larger companies with high sales numbers are targeted more often than smaller businesses with lower sales volumes. This may seem obvious, but it’s important to note. Industries where high numbers of sales are exempt or much of the business is done in cash — such as restaurants and bars — are also audited more often. Any business in an industry that has history of tax problems is more likely to be audited. The ratio of exempt sales to total sales can play a role in whether a business is selected for an audit, as can where the business is located. A mid-sized business in a city rich in big tech companies is less likely to be audited than a similar company in a city where government is the main employer, for example.
How difficult a business might be to audit may come into play as well. The state may be aggressive in its search for back taxes, but it does not want to expend more resources in its search for unpaid taxes than it will eventually collect in the end.
According to the BOE, one of the industries with the highest annual assessments in California are wholesalers and manufacturers of office equipment. This is because the sales are on credit, not cash, and are also to other businesses, not individual consumers, making the necessary documentation easy to find.
What Does the BOE Look For?
The BOE is mainly concerned with whether your business has accurately reported its taxes and fees. Both underpayments and overpayments will be examined during an audit. Your business must provide records in accordance with BOE Regulation 1698. Records commonly examined include:
- Tax returns (both state and federal)
- Invoices for sales and purchases
- General ledgers
- Property tax statements
- Sales and use tax returns and worksheets
Auditors will be searching for both honest mistakes as well as blatant evasions or intentional misrepresentations. Some common questions you can expect to be asked include:
- Have you claimed deductions properly?
- Was sales tax properly applied?
- Were all necessary gross receipts reported?
- Were local taxes properly allocated?
- Were the correct tax rates used?
- Was the correct cost of business supplies and equipment reported?
When the Audit is Completed
Audits end with an exit conference with the auditor and the business owner or his or her representative. If you do not owe any additional money or fees, a letter stating the acceptance of your returns will be filed. Any proposed additional taxes owed or refunds will be detailed in a Report of Investigation or Report of Field Audit.
If you agree the audit’s findings are correct, you will be issued a bill by way of a Notice of Determination if you owe money. Those receiving refunds will be sent a Notice of Refund.
This is the first chance you will have to bring to light portions of the assessment you believe are inaccurate and to protest the audit’s findings. You’ll be given time to collect evidence to support your case. Those in disagreement with the BOE have the right to file an appeal.
If you choose to do so, it may be in your best interest to speak with an attorney. An attorney can represent you through the process. Because tax cases can be very complex, enlisting a professional may be the best way to seek a positive outcome in your audit.