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Who’s Ready for a Sales Tax Audit?

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.

 

 

by Barcaco on November 1, 2011
filed in Accounting, Business, Finance

The A B C’s of Entity Selection… or in this Case the C, S, and LLC’s… (Part II)

S Corporations

As noted in the first installment of the series, the three most widely used entity form alternatives in the apparel, action-sports, accessories, and hard-goods industries (essentially consumer products) are the; C corporation (“C-corp”), S corporation (“S-corp”), and Limited Liability Company (“LLC”).  Part I of the series focused on the C Corporation.  Part II focuses on S Corporations and can be used as a for basic informational and discussion purposes to provide a background on the S Corporation and summarizes the advantages and disadvantages of this type of entity form.  The information below is not an substitute for or intended to replace your business attorney and CPA whom both should be consulted thoroughly prior to making a decision to select a particular entity form for your business.

Background

S Corporations provide the liability protection of a C corporation without the disadvantage of being subject to double taxation of distributions/dividends.  S Corporations operate as pass through entities.  This means that income generated by an S Corporation is not taxed at the corporate level for Federal purposes but rather is passed through to the individual shareholders based on their ownership percentages and taxed at the shareholder’s individual level.  Consequently, distributions by an S Corporation to its shareholders generally does not result in additional tax.  Note however that individual states impose different taxation requirements on the net income of S Corporations.  For example, California imposes a 1.5% tax on the net income of S Corporations with a minimum of $800 up to a maximum corporate rate in New York City of 8.84% for net income derived from within the city.

Advantages

  • The primary advantage of an S corporation is that it is not subject to double taxation.  S corporation income is passed through to the individual shareholders to be taxed at their marginal tax rates (currently the maximum federal and California rates are 35% and 9.3%, respectively). California does impose a 1.5% tax on S corporation taxable income derived in California with an $800 minimum tax/franchise tax.
  • Another advantage of operating as an S corporation is that income passed through to the individual shareholders is not subject to self-employment tax.  Currently, employer and employee FICA taxes are imposed at 10.4% for Social Security/old age survival disability insurance (OASDI) and at 2.9% for Medicare/hospital insurance (HI), for a total tax of 13.3% on the first $106,800 (for 2011) of wages.  Employee owners of C and S corporations can control to a degree how much compensation they pay themselves and, therefore, can limit their exposure to the 2.9% HI premium. On the other hand, general partners and LLC members treated as general partners cannot control the amount of self-employment income taxable to them. Therefore, they could easily pay much more HI tax than would similarly situated owner-employees of C and S corporations. This creates a current advantage in favor of electing S status.
  • Another advantage is the avoidance of the corporate alternative minimum tax.  As discussed earlier, a C corporation pays tax on the higher of its regular income tax or its alternative minimum tax.  This tax is avoided by operating in S corporation form.  Note that S corporation shareholders are potentially subject to alternative minimum tax at the individual filing level based upon the shareholder’s individual circumstances.
  • S Corporation’s are not subject to unreasonable compensation adjustments by the IRS.  As a means to bail out corporate earnings and avoid double taxation, C corporations sometimes pay unreasonably high salaries to its shareholders.  The IRS can re-characterize the salaries as dividends thereby resulting in double taxation to the shareholder.  S corporations, by virtue of their income pass-through nature, avoid the unreasonable compensation issue.
  • Since all S corporation income is passed-through and taxed at the shareholder level, S corporations are not subject to the accumulated earnings tax.  S corporations are free to accumulate earnings within the corporation to any extent desired.
  • Unlike a C corporation, S corporations are allowed to use the cash method of accounting even if the average gross receipts in the prior three years exceeds $5,000,000 (if not precluded by other tax law requiring the use of the accrual method of accounting).
  • Unlike C corporations, the losses incurred during the initial years of a business may be passed through to the individual shareholders and used to offset other income thereby providing an immediate tax benefit.  The losses are subject to the normal limitations imposed by the passive loss, at-risk and basis rules.

Disadvantages

  • One of the primary disadvantages of operating as an S corporation are the restrictions on the ownership structure.  In order to qualify as an S corporation, the following restrictions apply:
  • 100 or fewer shareholders
  • Eligible shareholders are limited to US citizens or resident alien individuals
  • The corporation can only have one class of stock (no preference items), although voting and non-voting common stock is generally not considered separate classes.
  • Shareholders cannot be C Corporations, other S Corporations, LLC’s, Partnerships, or certain trusts
  • There is also a lack of flexibility in allocating income and losses to the shareholders.  In general, the income or losses generated by the S Corporation must be allocated to the shareholders based on their specific ownership percentages (pro-rata).  This is in contrast to LLC’s which are allowed to allocate income or losses without this restriction.Distributions from an S Corporation must also follow the ownership percentages, which can at times require distributions to shareholders who may not otherwise require a distribution.
  • For S Corporations that operate in multiple states, it can result in additional administrative burdens at the shareholder level since the shareholders may be required to file individual income tax returns in the various states that the S Corporation does business in.  This burden can be reduced to some extent through the filing of composite returns for the shareholders relieving them of the filing burden.
  • Unlike a C Corporation, shareholders that own more than 2% of an S Corporation generally are taxed on certain fringe benefits such as group-term life insurance, medical benefits, and meals and lodging.

Hopefully this gives you a high-level understanding of the advantages and disadvantages of a S Corporation as an entity selection option.  Part III of the series will go into the workings of the Limited Liability Company (LLC).  As stated in the intro paragraphs, the information above is not a substitute or replacement for in-depth consultations with your legal advisor and CPA prior to forming an entity.

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.

by Barcaco on January 25, 2011
filed in Accounting, Business, Legal

The A B C’s of Entity Selection… or in this Case the C, S, and LLC’s… (Part I)

It is important that business owners understand the A,B,C’s or advantages and disadvantages of a few of the primary entity forms available to them, if even at a very basic level.  I am consistently asked “Which type of entity is best for my [insert your business industry here…] company?”.  My first answer is always, “It really depends on…[insert plethora of questions here]” which is a completely true and relevant answer as there are a ton factors that influence a particular entity selection for a given situation.  A thorough evaluation of current ownership structure, anticipated future ownership structure, current operations, planned future operations, hopeful exit strategy and so on must be performed and taken into account before an entity type is selected and formed.

Business owners must then continually reassess whether the entity form selected is currently best choice for their business as the various taxation and economic environments are in constant flux.  Further, the best choice of entity form may also change as the business and its operations themselves evolve over time.  The importance of the appropriate entity selection cannot be emphasized enough.  In the intensely competitive business environment that we currently find ourselves in a well thought out and planned initial selection of entity form and constant monitoring of the entity form selected may give a business an edge against competitors.

The three most widely used entity form alternatives in the apparel, action-sports, accessories, and hard-goods industries (essentially consumer products) are the; C corporation (“C-corp”), S corporation (“S-corp”), and Limited Liability Company (“LLC”).  Below is Part I of a summary that can be used for basic informational and discussion purposes that provides background on the C-corp and summarizes the advantages and disadvantages of this type of entity form.  The information below is not an substitute for or intended to replace your business attorney and CPA whom both should be consulted thoroughly prior to making a decision to select a particular entity form for your business.

C Corporations

Tax Rate Summary

C corporations are a separate legal/taxable entity incorporated under a selected state’s law.  A C-corp is taxed at graduated federal corporate tax rates up to a maximum of 34% (35% on taxable income exceeding $10,000,000).  In addition to the federal corporate tax, California also imposes a corporate tax rate up of 8.84%.  Taxable income generated at the C-corp level does not pass-through to shareholders, it is taxed at the C-corp level first.  Let’s do a quick income tax calculation, $1,000,000 in pre-tax (taxable) income equals roughly $310,000* in federal income tax and $88,400* in California income tax for a total of $398,400* leaving about $602,000 of Net Income on the Company’s books.  Any retained earnings then distributed by the C-corp to its shareholders in the form of dividends is usually taxed again at the shareholder level as ordinary income. Let’s say that the whole $602,000 was available in cash to be distributed to the shareholders and that they were all individuals residing in California and all had a blended federal income tax rate of 15% and a blended California income tax rate of 8%, on the dividend income the individuals collectively would owe an additional $83,000* in federal tax and $48,000* for a total of $131,000*.  So to recap, on the $1,000,000 of taxable income at the C-corp level to get the income all the way to the shareholders total collective taxes of $529,400* were paid by the C-corp and shareholders.  In this hypothetical example the tax rate comes out to roughly 53% using dividends to get the earnings out of the C-corp.  It could very well be much higher depending on the particular income tax situation of the individual shareholder.  Welcome to the world of double taxation.   You might say “That’s easy we’ll just hold on to our earnings and avoid the double-tax…”  The taxing authorities would like you to meet the back of their hand, although any accumulated earnings (or “retained earnings”) that is not distributed by the C-corp is usually not subject to income taxes, if the accumulated earnings balance gets high enough to be deemed excessive or unreasonable it could be subject to an accumulated earnings tax.

Advantages

  • The shareholder’s of a C-corp are not usually personally held liable for the debts of the corporation by design.  The protection from liabilities of the C-corp is a key benefit of selecting the C-corp entity form.
  • Since the the C-corp is a separate tax paying entity and not a flow-through entity any fiscal tax year-end can be chosen.  This can be beneficial if the company’s natural business cycle does not follow a standard calendar year-end.
  • A shareholder who is also an employee of a C-corp may qualify for certain tax-free fringe benefits such as (just a few examples); healthcare benefits, meals, lodging, travel, home office, life insurance (group term policies up to certain dollar amounts of coverage).
  • Shares in a C-corp can be transferred between shareholders without generally impacting the C-corp.  There are no restrictions on the types or amount of shareholders that can own stock in the C-corp, the shareholders can be individuals or other entities, USA residents or not.
  • If structured properly C-corps can participate in tax-free reorganizations which allow them to acquire, consolidate/combine and, dispose of other corporate entities in a tax-free manner.
  • If properly set up C-corps are eligible to have qualified deferred compensation plans.

Disadvantages

  • During the initial years of a C-corp’s operations, net operating losses may be incurred.  Although these losses can be used to offset future income, they do not provide any current tax benefits to the corporation or its shareholders.
  • C-corps are also subject to the alternative minimum tax (or “AMT” – this would be the back side of the taxing authorities’ other hand.) at the corporate level.  As a separate tax paying entity a C-corp pays income tax on the higher of its regular income tax or its AMT.  The AMT changes the tax rate applied to taxable income as well as types and amounts of certain deductions that can be claimed.  AMT can increase a C-corp’s effective tax rate.
  • C-corps cannot usually use the cash basis method of accounting once their average gross receipts for the prior three years exceeds $5,000,000.
  • For an exit strategy, there are generally two ways to structure a sale of a C-corp.  A buyer can either purchase assets of the C-corp or purchase its outstanding stock (“shares”).  Buyers typically like to purchase the assets instead of the stock due to the ability of the buyer to be able to obtain a step-up in basis for the assets purchased as well as to avoid any legal liability associated with the C-corp and its “old” operations.  The step-up in basis for the buyer results in future tax depreciation and amortization deductions that can generate significant tax savings.  For the shareholders of the acquired C-corp, the sale of assets once again results in a double taxation situation because in most cases the C-corp would recognize a gain on the disposition of the assets and pay tax at the corporate rates.  The remaining earnings would then be distributed to the shareholders who would then pay individual tax on the dividends.

Hopefully this gives you a high-level understanding of the advantages and disadvantages of a C-corp as an entity selection option.  Part II of the series will go into the workings of the S-Corp, which is intermediary of sorts between the C-corp and the LLC.  As stated in the intro paragraphs, the information above is not a substitute or replacement for in-depth consultations with your legal advisor and CPA prior to forming an entity.

Orion Barca, CPA

President

Barca Company

orion@barcacompany.com

949.235.6933


*(Income tax scenarios and balances are for illustration and easy math purposes only. There are numerous treatments for income tax purposes of income and deductions that may be increase or decrease the federal income tax and corresponding state income tax.)

by Barcaco on October 7, 2010
filed in Accounting

Inventory Costing and Gross Profit Margins…

CPA, “So, where are you getting your goods made?”

Start-up, “We are getting everything made in China.”

CPA, “What are your gross profit percentages like?”

Start-up, “They are great! We are getting like 65% so far!”

CPA, “Wow! That is great! That’s like 15 to 20% higher than I would expect for a start-up.  Is your price point higher than the competition?”

Start-up, “No, we are right on the mark with our tee’s, shorts and denim.”

CPA, “This is your third season so I wouldn’t think that your volume is at a level where you are getting discounts from the factory.  Is that the case?”

Start-up, “No, we are a ways off from the volume discounts.  In fact, we are still required to put up 50% before they start production and the other 50% before they ship.”

CPA, “Speaking of shipping, how do you get your goods shipped over?  Is it all by sea or is there some air freight mixed in there?”

Start-up, “We try to get everything shipped by sea but if things are getting late then we have to go with air so that we don’t miss our delivery dates.  So, I guess it is about 50/50 since our shipments are usually held up because our payment to get the factory to ship is late.”

… and so goes the conversation hitting on various points of items above and beyond the actual unit price of an item that should be included in inventory under Generally Accepted Accounting Principles (“GAAP”) in the USA as issued by the Financial Accounting Standards Board (“FASB”).  To very, very briefly summarize the FASB’s point of view on inventory costing; inventories should include all costs, both direct and indirect, that are incurred to bring inventory to it’s current condition and location.  To actually put this into practice varies from a simple task say for inventory items that are purchased as finished goods from a local vendor (ex. screened tees from a local printer who supplies the blanks) to a complex exercise for inventory items that are manufactured in a company’s own factory overseas.  Most companies in the action sports industry will have a mix of inventory items that require different levels of costing analysis but they generally will not require the more complex calculation and allocation of the various types of direct and indirect costs associated with the manufacturing process (labor, utilities, rent, administrative expenses…) as production is outsourced to various vendors.

In the fabricated conversation above the point being made is that unless inventory costing is understood and properly performed, company management may have an inaccurate view of the company’s actual gross profit margins for its inventory items (think of a hoodie that is screened and imported from China, at a unit cost of $10 and a wholesale price of $20 based on a 50% gross margin).  This inaccurate view may drive inaccurate production decisions, pricing to customers, overall sales decisions, commissions, compensation, misstated financial statements, inaccurate income tax returns… the list can go on and on.  This is because inventory is the core of the business model for an action sports company whether it be apparel, accessories or hard goods and like the saying goes “garbage in, garbage out”.  (Now think of that same hoodie from the example before with a unit price of $10, now add in allocated per unit charges for customs, duties, broker charges, sea/air freight, insurance, and inland freight.  The actual cost is now up to $12 which for the same 50% gross profit would require a wholesale price of $24, but the company already committed to a $20 price to its customer, so now the actual gross profit percent on this item is down from 50% to 40%… and that is before other non-specific cost of goods sold items included in the income statement further drive down the company’s overall gross profit margin…)

So the moral to the story, once the design department is done hammering out every last detail on the cost sheet with regards to the actual production of the inventory, meet up with the accountant (some of us are actually pretty cool people…) and make sure the cost sheet includes line items for everything that is required under GAAP to fully cost the item.  This may sting a little up front and cause a little reworking to get to the margin where you want it if the price point is set but it is better than the alternative of thinking that you are killing it at market and then having your accountant break the news to you after everything is already sold.

Orion Barca, CPA

President

Barca Company, Inc.

949.235.6933

Orion@BarcaCompany.com

by Barcaco on August 2, 2010
filed in Accounting
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