I recently had the opportunity to help one of my clients navigate through a sales and use tax audit.  It was actually a good experience from my perspective since I was involved from the receipt of the first notification letter from the state Board of Equalization (“BOE”), through the signing of a waiver letter, to the final letter of no further procedures needed.  Don’t get me wrong, it was by no means an easy process and was quite stressful for my client’s staff.  The good part for me was that I gained valuable experience of the current BOE audit process and can better consult my clients on recordkeeping and information maintenance to avoid potential costly problems should they have the “good fortune” to find themselves the focal point of a BOE sales tax auditor’s attention for a week.  Mind you that this is just the Cliff’s Notes© version for a relatively standard wholesale company audit and that I would highly recommend that you consult your accountant or tax professional prior to any correspondence from your end with the BOE as each situation is unique and has its own set of circumstances.

Let’s start with the love note that the BOE sends to inform you that you and them have a date in the near future.  The information request list covers a three year period, which happens to be the standard sales tax audit period in California.  The list is as follows:

1. Sales and use tax returns, including any related worksheets.
2. General ledger and related journals.
3. Sales invoices and cash register tapes, if applicable.
4. Purchase invoices (paid bills) for consumable supplies and fixed assets (furniture, fixtures, equipment, computers, etc.)
5. Documentation supporting claimed exempt sales (resale certificates, freight bills, etc.)
6. Federal income tax returns, including depreciation schedules (in detail)
7. Property tax returns, including worksheets and corresponding statements.
8. Sales invoices for fixed assets sold during the audit period.

P.S. – The BOE also states that they may request information for additional filing periods or other records not previously requested after the Auditors review the information that was previously requested.  This basically means that the Auditors can request anything that they want to if they find something that is not to their liking.

The BOE will generally give you at least two weeks to prepare for the audit.  If you request additional time that would jeopardize any of the audit period by way of expiration of the statute of limitations (which is three years from the end of the period of any of the sales tax returns), the Auditor will request that you sign a waiver to extend the statute of limitations for the audit periods.  Don’t try and play hardball here.  If you don’t sign the waiver, the BOE assess tax on all of the company’s sales immediately and request payment.

I cannot underestimate the importance of keeping excellent and complete records for items 1 through 8 listed above.  The worst case scenario is that you cannot provide any of information (which would seem to be the best case scenario for the state conducting the audit) and all of your companies reported sales as shown on your federal income tax return are taxable in the state.  So fully taxable is your starting point, and you work backwards from there into your actual tax position which should reconcile exactly to your sales tax returns, which by the way are required at least once a year for all operations that have gross sales from all sources (whether taxable or not) of $100,000 or more.  They should be completed for all businesses that have sales that are subject to sales and use tax regardless of the level of sales volume.  For most of my clients that are strictly wholesalers sales tax is limited to the following transactions:

• Sales made during sample sales and warehouse sales,
• Sales to sales reps (inside and outside),
• Sales to employees,
• Promo items (yes everything that you give away is subject to sales tax since you became the end user when you gave it away and if you are a wholesaler you didn’t pay sales tax when you bought it.)
• Gift items from inventory stock (think employee allowances and presents).

Even if you are a wholesale operation you will definitely need the following (for the whole audit period):

• Resale certificates for all retailers that you sell to in California to evidence your exemption from collecting tax on the sales.  You should have them complete a resale card with all of the pertinent information on it then sign it and provide a copy of their valid resale certificate.
• For retailers that are not in California you should also have them complete a resale card and sign it and should get a copy of their resale certificate (not all states have them, so do a little research on the state before you harass the customer for it) or other proof that the shipment was sent to an interstate retailer.
• Note that a customer’s billing address (like on an invoice) is not considered evidence that they are out of state as many retailers have headquarters in a state and retail stores in many states.  If they have any shipping locations inside the state of the sales tax audit you will need a resale certificate.  I would recommend getting anything that you can from out of state customers to evidence that they are a retailer and maintain all shipping documents.

What the auditor will do is reconcile all of the sales tax returns to the federal income tax return to the company’s general ledger.  In theory these should all agree or have reconciliations of how they agree to each other.  The next step will be to select a series of sales transactions (the amount will vary by company size and auditor) from the general ledger and request all of the backup to support the transaction as to whether it was taxable or not.

The next part of the audit surrounds use tax and is primarily focused on the purchase of fixed assets and supplies.  The auditor will request copies of your annual property tax statements and detailed returns filed, your general ledger detail (for all fixed asset, supplies, and repairs & maintenance accounts), and the federal income tax return detailed depreciation schedules.  The auditor will once again reconcile these three source documents and in theory they should all agree to each other.  During this audit the auditor focused on office equipment (laptops, printers, copiers, office furniture, etc.) and supplies (printer paper, toner, ink, general supplies).  What the auditor is looking for are purchases from out of state vendors (Amazon, eBay, etc.) where no sales tax was paid so that they can assess use tax.  Any time a purchase is made from an out of state vendor the amount should be claimed on the sales and use tax return so that you can pay use tax on the purchases.  The auditor is generally not going to look at any vehicles that are licensed within the state under audit as the taxes and licenses are paid separately on those items.  The audit process was standard selection of purchases from the various accounts over the various years under audit.  Make sure you have all of the documentation supporting the purchase of major fixed assets.

The last part of the audit focused on disposals of fixed assets.  The auditor will want to ensure that for any disposals of assets that were by sale that sales tax was collected and paid on the sale.  This is generally not a large portion of wholesale operations so exposure might be lower here than other areas but make sure that you have supporting documentation nonetheless.

With most states hurting for tax revenue due to lower income taxes being collected the Auditors are looking to other sources.  One of those sources is ensuring that businesses are collecting and remitting the proper amount of sales and use tax.  Remember, this was a very straight forward wholesale operation with one location.  Sales and use tax can get extremely complex extremely quickly in cases where there are operations in multiple districts within a state and or within multiple states with each state having their own set of sales and use tax nexus requirements and regulations.  You would be well served to review the state BOE in each of the jurisdictions that your company operates to determine if you have a requirement to file there.  Not filing or filing an incorrect sales and use tax return can cause a ton of problems if you are facing an audit situation, I highly recommend contacting a tax professional should you have any situations that are out of your comfort zone.

Orion Barca, CPA

President

Barca Company, Inc.

Orion@BarcaCompany.com

949.235.6933

Circular 230 Disclaimer
Any tax advice contained in this communication, was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties that may be imposed on the taxpayer under the Internal Revenue Code or applicable state or local tax law or (ii) promoting, marketing or recommending to any other party any tax-related matter(s) addressed herein.