California Sales and Use Tax Audit Tips

The state of California has the highest state sales tax rate at 7.25%, and the eighth-highest average combined state and local tax rate at 8.68%, according to the Tax Foundation. This means sales tax mistakes in The Golden State are typically going to be much more costly than those made in others. Therefore, if you are audited, you want to ensure that you are prepared.  

Why You Might be Under Audit

Generally, a state has a system for how they select taxpayers for a Sales and Use tax audit. This can be triggered by many different reasons such as having a large presence in the state, amending returns, making late filings and payments, or even red flags auditors identified when they came across your business while auditing one of your suppliers or customers.

It is important to understand why your company may be under a Sales and Use tax audit. If you can understand why, it can help you have a clearer understanding of what the auditor is expecting from you during the time of your audit.

Having Appropriate Documentation

When a Sales and Use tax audit is conducted, it is important to ensure your invoices are being documented correctly. This means making sure you have everything that relates to the invoice readily available. For example, if you have freight charges, you should have a freight invoice or a work order showing how the freight charges were calculated.

Another example is to have exemption certificates readily available for your customers when there are exempt sales. It is important to ensure you have all the elements of a valid exemption certificate. If you are missing any of the elements of a valid certificate the auditor could easily reject it and increase your audit liability in the process. Listed below are the general requirements of a valid exemption certificate.

• The name and address of the purchaser's business.
• Reason for exemption (ex: resale, manufacturing, research, and development).
• The purchaser's seller's permit number or an explanation stating why the purchaser is not required to hold a seller's permit.
• A description of the property to be purchased.
• General description of tangible property purchased for resale (ex: parts to be resold)
• The date of the document (an otherwise valid resale certificate will not be considered invalid solely because it is undated).
• The signature of the purchaser, purchaser's employee, or authorized representative.

If you are unable to provide the auditor with the appropriate exemption certificates you may get asked to provide an alternative. In California, these are referred to as XYZ letters. These are letters that you send out to customers letting them know you are under audit in the state, and that the state is requiring them to provide the requested information to be filled out to remain compliant. This may cause complications if a customer you had during the audit period is no longer in operation. It may cause issues in receiving the information needed to complete.

Freight and Mileage Charges

A common issue that may arise during a California Sales and Use tax involves freight and mileage charges. This is an area that can reveal significant liability if not taken care of properly. It is important that you have everything labeled correctly. This will not only help you during the audit to ensure everything is being reviewed correctly but could also make things clearer to your customers about what they are being charged.

If you have freight charges, it is important that you determine what type is being examined. If it is a charge to your customer for the cost of shipping merchandise to your place of business, this is classified as freight-in. This is considered taxable in California. Freight-out is the transportation cost associated with the delivery of goods from a supplier to its customers. For this charge, it is important to keep records, such as freight bills that show the marked-up portion of freight because the marked-up portion is considered taxable.

Another element that is often evaluated is travel and mileage charges. It is important that you have this classified correctly due to tax complications. Separately stated, travel or mileage fees in connection with a repair of tangible personal property are not included in the measure of tax if the vendor does not furnish any tangible personal property or if the tangible personal property furnished by the repairer is as a "consumer" pursuant to Regulation 1546(b).

If the repairer also furnishes parts for items which it is also the retailer under Regulation 1546, the issue of whether part or all of the charge is included in the measure of tax depends on whether the charge is related to the parts, labor, or both. If the charge is related solely to parts, it is included in the measure; if related solely to labor, it is excluded; if it is related to both, it should be prorated in the respective ratio of the charges for parts and labor.

Audit the Auditor

Just because you are under Sales and Use tax audit does not mean you are in the wrong. It is important that you make sure you review all the auditor’s work while going through this process. While doing this, you might find mistakes such as mathematical errors when calculating liability, duplicated data, and parts of the audit failing to be updated.

While this may be time consuming and may even seem like duplicate work, it is important for you the taxpayer to ensure you are being assessed correctly during your audit. To ensure you are doing this to your full capacity, you must do your research on the issues being audited and make yourself an expert on the topics in question.  

Signing a Waiver

Sometimes the amount of work going into an audit can be enormously time consuming, especially considering most accounting professionals still have their day-to-day operations to worry about. This can leave items left on an audit that you were unable to fully investigate. You may have to answer: Should I sign a waiver extending the audit time?

Consider before signing if you believe it feasible to reduce the audit liability any further than it already is. It is also important to consider the interest rates that apply when extending the period. Something every taxpayer should do when under audit is run a cost benefit analysis of signing a waiver.

Additionally, you want to consider if the benefit of extension lies with the auditor or yourself. Many times, refusing to sign a waiver results in an auditor issuing a jeopardy assessment, or an estimate of taxes owed that is typically higher than what the reality would have been proved to be because the auditor must estimate on the areas they could not review or did not have evidence defending. However, if there is no indication of a potential assessment of that nature, then your business is within its rights to refuse the waiver.

Tips for the Taxpayer

A Sales & Use tax audit is complicated and time-consuming given the varying elements that go into one. Complexities exist throughout the life of the audit and can become stressful.

It is important that you keep your business organized and up to date on the reporting and tax requirements in the states you conduct business. Going forward during audits, it is always a great practice to note what was reviewed during this period. More than likely it will come up in future audits if not corrected.

How Can We Help?

Allyn’s tax team is staffed with seasoned tax professionals experienced in all aspects of Federal, multi-state and local tax compliance and consulting for large US and global corporations. We use that experience to your advantage.

Allyn files sales tax returns in every state with a sales tax in the US, and we often defend our work under audit. Some of our largest clients have tax obligations with CA, and we regularly reduce their audit liabilities there in addition to gaining refunds for tax overpayments.

Contact us and we can provide a customized cost-effective solution to meet your company’s needs. For further information on Allyn Tax services, please contact: tax@allynintl.com.

For More Information

If you are interested in learning more about this topic or other tax topics, please visit our Tax Publications under News & Publications at www.allynintl.com.

Contributor: Jacob Bowen

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About Allyn International

Allyn International is dedicated to providing high quality, customer centric services and solutions for the global marketplace. Allyn's core products include transportation management, logistics sourcing, freight forwarding, supply chain consulting, tax management and global trade compliance. Allyn clients range from small local businesses to Fortune 500 firms. Allyn conducts business in more than 20 languages and has extensive experience in both developed and emerging markets. Highly trained experts are positioned throughout North and South America, Europe and Asia. Allyn’s regional headquarters are strategically located in Fort Myers, Florida, U.S.A., Shanghai, P.R. China, Prague, Czech Republic, and Dubai, U.A.E. For more information, visit http://www.allynint.com