Streamline your sales audit procedures for supervision

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hi thank you for joining us and welcome to this installment of david w clossing's clarifying tax situations what are the common issues that you as a business owner can face when dealing with a sales tax audit well i would begin by telling you that if you're facing a sales tax audit you're not alone in recent years the board of equalization has conducted over 60 000 audits in california over sales tax issues and this has led to millions of dollars of revenue for the state of california it's legal for them to force you to hold collect and remit sales taxes the state of california ever since 2008 the economy in california has been in a slump this has put a lot of pressure on the state of california to raise revenue one of the ways they're doing that is by ramping up their efforts at enforcing sales tax collection and remission therefore sales tax audits are up in the state of california unfortunately for most residents in the state of california the board of equalization uses these audits for more than just raising revenue they're using it as a compliance check on federal and california income taxes as well the really really bad news here is that a california sales tax audit can lead to at best civil assessments of additional state and federal income taxes we'll get to how that happens shortly or at worst to criminal investigation either for sales taxes or for income taxes both at the state level or possibly even at the federal level moreover if the state of california happens to hit pay dirt in your sales tax audit the auditors are taught to look for large sales tax assessments in the past when selecting the current round of sales tax audit so if you paid large amount of sales taxes in a prior sales tax audit you are virtually assured of a subsequent or future sales tax audit well if you're sitting there with a sales tax examination notice or questionnaire ordinarily it begins with a questionnaire that they send you they want you to fill out and you're not even sure you're being audited but that questionnaire is the lead into an audit you might want to at this point know why you're being audited the state of california audits businesses in california both randomly and based on triggering events those triggering events stem back to your business's history of sales and use tax compliance the most common reason for a sales tax audit is when they add up your four sales tax returns for a year it doesn't tie to the reported sales on your income tax return for that year in ergo you're audited a consistent pattern of filing your sales and use tax returns late can also lead to an audit if you consistently report substantial sums of exempt transactions in other words sales that you didn't subject to sales tax that can lead to a sales tax audit if you've had problems in your past sales tax audits in other words you've owed money in the past that could most likely been what caused the current sales tax audit if you've been audited for sales tax issues in the past and had to write large checks that often explains why they're back for another round you could be audited for sales taxes because one of your vendors could have been recently audited and that flags something regarding your compliance you could be audited because you're in an industry where the government has found substantial amounts of non-compliance in their past or other audits what are the typical audit procedures employed by the board of equalization well the main thing they're looking for is sales that should have been subjected to sales tax that weren't to this end the government's going to compare your book sales to the sales tax returns for a period and look for a variance the government's also going to reconcile your bank deposits to your reported sales to look for variances engaging in large amount of internet purchases or internet sales can lead to a sales tax audit and this activity will be looked at at the outset of an audit you're given a questionnaire that's going to ask for specific information on your business your industry and your sales reporting transactions the auditor is going to want to see your income tax returns both your federal and your state your general ledger your sales ledgers your invoices your receipts your purchases and sales journals your bank statements and depreciation schedules among other things all income tax filing documents will be reviewed here's where things really get scary the california state board of equalization works hand in hand with the franchise tax board of the state of california and with the irs in certain circumstances unfortunately the board equalization conducting a sales tax audit can lead to the discovery of income tax fraud or understatements of federal or state income tax the scary part here is if the board of equalization auditor discovers indications of fraud they will most likely not give you any indication of this and make a quiet referral to either franchise tax board or irs criminal investigation functions moreover sales tax fraud can be prosecuted directly by the state of california even if the auditor doesn't see any indications of fraud in your fact pattern they can and do refer if there are indications of income tax understatement as discovered as part of the sales tax audit either federal or state for this reason it is imperative to contest faulty sales tax audits that rely on the wrong facts the wrong laws because the damage done by the franchise tax board of the irs in its wake often make this much more cost effective what is surprising to a lot of my clients is that the port of equalization goes after people for sales tax you might not expect not just business owners it's anybody that was involved in the sales tax compliance cycle that may be deemed responsible for the non-compliance therefore the board of equalization can access directors officers shareholders or any other person who supervise the filing of sales tax returns or the paying of sales tax this can even include a part-time bookkeeper or comptroller okay here's the part of california sales tax audits that i find the most aggravating as your representative the state of california is statutorily authorized to set aside your books and records no matter how pristine they are and determine your sales tax liability based on the following method what i'm going to discuss called the markup methodology the authority for this is found in revenue and tax code section 6481 which provides in pertinent part that if the board is not satisfied with the return or returns of the of the tax or the amount of tax or any other amount required to be paid it may compute and determine the amount required to be paid upon the basis of the facts contained in the return or returns or upon the basis of any information within its possession or that may come into his possession the most frustrating part for me is there's virtually no method that i've determined or anybody else that i know is determined to talk the state of california out of using the markup methodology what's most frustrating is if you argue that the markup methodology itself is the reason you're being hit with sales tax liability that you shouldn't be responsible for then all of the appeals functions that follow will rubber stamp the actions of the auditor that used it including the board of equalization itself the board of equalization was authorized to use this methodology whenever it had good reason to suspect a company's books but frankly i've seen them use it on every audit i've ever faced of certain type of cash based intensive businesses the state of california will walk away from a direct audit approach and your records upon a whim upon a change in wind direction with no rationalization whatsoever all that is required is for them to dream up a reason to suspect that your books are accurate the markup methodology starts with this the government suspects cost of goods sold on certain businesses certain businesses understate their income tax liability and their sales tax liability by dropping cost of goods sold off of their books and the associated sales related to them in various fashions of course what i'm describing is fraud the auditors will reach out to a company's vendors and they'll discount the cost of goods sold recorded on your books go straight to the folks that sold you inventory for the entire year and say for 2012 for example what was the total of goods that you sold xyz business if the government through xyz letters determines that you have large amount of cost of goods sold that has been omitted off your books they will interpolate that there's been a large amount of sales related that cost of goods sold that has also been dropped off your books they're also not stupid they also realize that cash-based businesses will often use cash to pay for their cost of goods sold as a way of keeping it off their books this is fraud with a capital f if this is your fact pattern you need someone like me or they're going to hang you out to dry boe auditors realize that if they can't determine what the cost of goods sold for the year was then they can't use a markup percentage to determine what the related sales on that cost of goods sold should have been for this reason certain types of businesses are incredibly susceptible to markup audits frankly the board of equalization and the franchise tax board believe that cash-based businesses as a matter of route understate their sales and understate their cost of goods sold in order to cheat worse yet a company that overstates its cost of goods sold and understates its sales is he more fraudulent the following types of businesses are extremely susceptible to markup audits bars restaurants gas stations convenience stores liquor stores these types of businesses are cash intensive and very susceptible to markup audits if this is your business and you know you've been skimming you need to call me the markup calculation is where they determine the market percentages that you use to get for what you paid for an item of inventory to its sales price example you buy something for a dollar you sell it for three dollars the market percentage is 300 so if they determine your proper cost of goods sold they can take cost of goods sold times 300 percent to come up with your what your sales should have been for the year this is done for each item of major inventory that you sell so to reiterate the board of equalization analyzes your purchases of inventory for the year figures out what your market percentages were on each out of inventory extrapolates that out once they identify what cost of goods sold is to what your sales that should have been reported are the difference between your reported sales and the sales they calculate is going to be the deficiency which can be caused by simple accounting oversight or fraud depending upon the government's attitude toward you in my extensive sales tax experience the marked up calculation of sales is invariably always higher than the reported sales on the sales tax return as a matter of course across the board i need you to keep in mind that even if you completely trust your point of sale system your accounting system and you really feel that all of your sales are proper it's irrelevant here you're you're faced with this methodology whether it makes sense to you or not what i find most infuriating is based on my experience the markup methodology used by the board of equalization is flawed and you're left with fighting the fight to convince them that it's not and that's an uphill battle even with someone as talented as myself on your team what you realize at the end of the day if they accuse you of unreported sales through a markup methodology at best you're looking at sales tax at worst you're looking at criminal exposure additional income taxes both at the federal and state level at the end of the day it's the taxpayer's responsibility to prove to the board of equalization and the markup audit as applied to your facts and circumstances reach an incorrect result it's for this reason that i use an export of equalization auditor on my team there's no better way to fight off a sales tax audit with the opinion of a seasoned sales tax auditor that's now on your side of the fence in your corner who better to find the flaws in their methodology than someone who understands their methodology for the reasons just stated it's imperative that you hire an experienced sales tax attorney to have on your team if you're faced with a board of legalization markup audit the attorney will be on your side to help you navigate the complex laws of the port equalization sales tax folks and to keep the board of equalization's audit procedures and tactics in check a sales tax attorney in your corner can help make sure the boarding utilization does not overstep their bounds and apply the complex law in their favor to your disadvantage and help prevent the board of equalization from making unfair rationalizations that help them and hurt you in my opinion and a lot of people i know and respect it is simply wrong for the board of equalization to overstep their bounds simply because the state of california needs money furthermore this attitude in california that cash-based businesses routinely understate their income is very dangerous and toxic to you if you have a cash-based business it can result in tax fraud if it allowed to be proven here's an example of some scary things that i've seen developed in sales tax audits in one of my audits there was a cocktail waitress that was running her own under the table business she was pocketing all half of the sales that she made for the evening and it was discovered her investment was discovered and it was found that the owner of that business was still liable on the sales tax that was charged to the customer on that underlying activity even though the business owner never saw penny of that revenue being forced to pay the sales tax on underlying embezzlement in your business adds insult to injury but unfortunately there's lots of case law in california that will support that treatment by the border equalization lately we've been representing lots of cash-based businesses in california that have what we view as criminal tax exposure for the unreported sales that were allegedly identified through board of equalization markup audits the exposure stems from the fact that the board of equalization routinely reports any one quarter where they find a hundred thousand dollars or more of unreported sales in that quarter to the franchise tax board who may in turn refer it over to the irs the franchise tax board when it receives this information can either automatically assess the business on the unreported sales or open its own criminal investigation or make a referral to the irs's criminal investigation division over the unreported sales lastly the board of equalization in very egregious cases can bring criminal charges on its own for felony sales tax evasion in california this is serious stuff what's very frustrating in this area is there are several weaknesses in the markup methodology used by the board of equalization the existence of these admitted weaknesses is the largest reason you need a tax attorney on your team if faced with a boe markup audit you need to protect yourself from the state of california at best overreaching for sales tax at worst creating criminal tax liability where none should lie in order to prevail in a sales tax audit we need to be able to prove to the board of equalization there were errors in the logic used to conduct the audit the way we do that is we combat a sales tax auditor with our own ex-sales tax auditor our ex sales tax auditor has a master's degree in taxation she's a cpa she has 13 years of experience and she's a rock star she also has me behind her for example in markup audits the auditor is very prone to expect that one markup percentage was utilized for the entire period under audit unfortunately this doesn't allow for companies that change their pricing often what about sales what about happy hour in a bar what about comps none of this is taken into consideration state another way the markup methodology often ignores a prior existing pricing structure often to the detriment of the business owner oftentimes in a markup audit the auditors will conduct a shelf test to determine what the markup percentages are for items off of a shelf in a retail store or a poor test where they look at the amount of alcohol that's ordinarily included in a drink in a bar the shelf test can often have incorrect prices associated with it or the poor test can be improperly weighted the board of equalization's official audit manual that it gives to all its auditors even states to the auditors directly from headquarters don't rely too heavily on markup audit results because these results can be very time consuming to obtain and often give very little real world meaning unfortunately the foregoing is the reason you need a qualified sales tax attorney on your team to make sure that the auditor's assumptions methods and conclusions are proper and lead to a proper end result for your audit legal counsel and their staff can dismantle the methodology used in the markup audit to undo the harm that came out of your audit in the first place we have managed to do this on several occasions in the past this next subject may explain some of the behavior of your auditor you observe during your sales tax audit or will observe in your sales tax audit it has become known to the board of equalization that some companies are using a product called a zapper a zapper is a legal program that will make sales and the corresponding cost of goods sold related to those sales disappear based on a program that interfaces with a company's point of sale system the idea at the end of the day is that the business owner pockets a certain amount of cash to hide the transactions that were removed from their records this problem is so prevalent in california that in october of 2013 governor jerry brown signed assembly bill number 781 into law which makes it a crime to knowingly purchase use transfer or sell any automated cell suppression device or zapper or phantomware with the intent to defeat or evade the determination of california sales or use taxes by falsifying records to this end the board of equalization estimates that sales tax fraud costs the state of california over 210 million dollars of revenue each year if you're using a zapper software and you're under audit you need to hire someone like me the state of california will stop at nothing to prosecute you for the use of that and the person who sold it to you and the person who installed it anybody associated with that zapper software is toast if the government learns of its use in fact by way of example one family that i know of is facing a combined 123 years in prison for the use of zapper software to skim cash off their business and commit sales and income tax fraud the zapper program is software that surreptitiously alters transactions and sales a zapper program is typically loaded onto a point of sale system via usb interface zapper programs are known to be most effective in a cash-based business because cash transactions don't create a record of a transaction in and of itself when a transaction is paid for by a debit or credit card sale on the other hand a record is created and zappers won't eliminate those transactions because of the surrounding paper trail fraudulent taxpayers in the state of california have also been known to use photoshop to edit invoices and records to hide their tax fraud any person found guilty of utilizing a sales suppression device selling it installing it a zapper program can be convicted and spend up to three years in county not state jail county jail where it's been known that some county jails you could spend 23 hours a day in a cage with one hour on the yard a day this is supposed to be the hardest time known in california that you could spend in jail plus you'll be found guilty for the restitution for the interest penalties and taxes related to the fraud even if you weren't the owner of the business that utilized the software program criminal liability can also come out of the improper use of a california resale certificate the exposure surrounding resale certificates can go both to the seller and the buyer depending on who's committing the fraud the seller can be held liable for honoring the resale certificates of buyers where they have knowledge that the goods bought are not for resale when you utilize a resale certificate to purchase inventory what you're saying to the seller is that i am not the ultimate user of the inventory i'm buying it for sale to the ultimate user the customer therefore i'm not going to pay sales tax the person who buys the inventory for me is going to pay sales tax therefore i'm not paying it to you if a seller has knowledge that the purchaser is the ultimate user of the inventory and allows them to use a resale certificate anyways they can have liability for that on the other hand the purchaser utilizing the resale certificate if they are buying goods for their business where they are the ultimate consumer of those goods and not paying sales tax by representing that they're selling those goods to third parties they can have criminal liability for that as well for the reasons soon to be discussed and previously discussed caution must be used in filling out a resale certificate it can be deemed fraudulent to utilize a resale certificate if a taxpayer utilizes a resale certificate to purchase inventory items that they know will not be ultimately sold to customers in due course they can be liable for the following the amount of sales tax that would have been paid had the resale certificate not be used along with penalties and interest the improper purchases of inventory using a resale certificate can result in your seller's permit being cancelled you can be forced to pay a 10 penalty on the improper purchases in addition you can be assessed at 25 penalty of the additional tax for fraud they get you for a thousand dollars of sales tax you'll pay 1 250 finally if the state of california so desires they can accuse you and prosecute you for a misdemeanor which can result in one year in jail if a resale certificate is used in bad faith in order to avoid paying sales tax where someone should have paid sales tax the auditor that discovers it will prepare board of legalization form 1164 which basically indicates that the resale certificate was issued in bad faith one way the auditor identifies this is to compare the items purchased on a resale certificate to the types of items a person would utilize in the business in which they're in so if the items purchased are not the typical types of items that are sold in that business in the regular course of business such as where a jewelry store uses a resale certificate to buy gardening equipment fraud has occurred form 1164 can form the basis of a criminal investigation for sales tax fraud okay if you're considering buying a business in california one things you must do is make sure you don't become personally liable for any taxes due by that business for activity that may have occurred before you ever came into the picture the way to do this is to request a tax clearance certificate from the state of california the clearance certificate basically guarantees that there's no taxes penalties and interests owed by the business that you don't know about however if you learn about a pending tax liability and you're the buyer of that business you're required to withhold from the amount you pay to the seller the sales tax penalties and interest that's owed or you become personally liable for those amounts also if you don't request the clearance certificate you can become liable for things that are discovered in audits on your watch for activity that you had nothing to do with because you didn't request a tax clearance certificate the board of equalization has up to three years from the date they're first notified that businesses sold to come after the successor for sales tax liability this exposure for success or liability for taxes in california almost guarantees that you're going to get a sales tax audit in the year that you sell matter of fact if the state of california is an approach they find out from the escrow company themselves that there's a very large amount of money sitting in escrow waiting for the sale of business to close they see that as low hanging fruit they will open up a sales tax audit at that point knowing that the funds are already in an escrow account available for them to come get so you're at high risk for a sales tax audit even if you've never had one if you go to sell your business oftentimes it takes a guy like me to come in get that sales tax audit close because they're not going to give you money until you settle on that sales tax audit and it's extortion nothing short okay if you're thinking about getting me involved and you've already gone through a sales tax audit what i need to tell you is i often see an auditor's assessment being let's say a hundred dollars okay let's be more realistic a hundred thousand dollars then that auditor's assessment goes into management review i see it coming back with a factor of three all the time where all of a sudden that winning 100 000 comes out at 300 000 so don't think you're out of the woods there's a factor of three that i've seen applied in many many occasions so if you disagree with the auditor at the conclusion of an audit what can you do about it well step one you can sit down and discuss with the auditor the issues that came up during the audit how they reach their conclusions and try and reason with them your ability to get this done is practically nil because most auditors take personal pride at the work they do if you challenge them they get challenged all the time they may take it personally in a matter of personal upfront that you're questioning their work product ego gets in the way but that's not true in every case sometimes just having a straightforward conversation with the auditor is all it takes to get you a resolution in the case this is where we often make good inroads the second step if you can't reach resolution with the auditor themselves is to take up the issue with the board of equalization audit supervisor in this meeting you're talking to somebody that actually has the power to negotiate a settlement to the dispute and reach a resolution you should discuss what problems you have with the auditor's findings and what the potential solutions are to the dispute the supervisor in their own discretion can negotiate a settlement after they present these adjustments or concessions to you you still don't have to accept the situation as it says shortly after this meeting the supervisor will issue a report of field audit or report of an investigation if they're looking to criminally which is the auditor's statements of findings and recommendations or determination following the issuance of the field audit report you can meet with a board representative if you so choose at that time you have 10 days from the issuance of the field audit report to request a meeting with your board supervisor if your matter still remains unresolved the state of california will issue a notice of determination at that time within 30 days of receiving the notice of determination you have to file a petition for redetermination to continue to contest your matter form boe 416 is used for this purpose the process of filing all these documents in an appeal can be read about in boe publication 17. on your petition you should indicate whether an appeals hearing in addition to the appeals conference is necessary normally you're required to go to appeals conference even if you didn't specifically request one after an appeals conference the appeals division will prepare a decision and recommendation containing the analysis conclusion and recommendations for the resolution of your case fourth after your formal appeal along with your petition for redetermination you can request a hearing with the entire board of equalization at that time the board hearing is your opportunity to resolve unresolved matters but frankly on average you're given 20 minutes to make your case no matter how complicated your issue is your attorney your accountant or any other representative can appear and represent you the board will make its decision within 45 days of that hearing if you dispute their notice of determination you can file a petition for rehearing their ultimate notice of redetermination indicates whether you owe tax penalties and interest fifth if you haven't reached a resolution up at this point you have the option of paying all the tax they're demanding of you and then filing a claim for refund six if the board of equalization denies your claim for refund you're left to finally a petition in a court of law to hear your issue you must file your refund suit within 90 days after the board mails its notice of denial of claim for refund so if you think that you're about to face a sales tax audit that could lead to fraud or tax evasion charges with either the boe the franchise tax board of the irs you need to call me what you need to remember is the board of equalization communicates with both the irs the franchise tax board and if they find badges of fraud both the irs and the franchise tax board have their own independent criminal investigation departments the prosecutor of all three of these agencies are experienced motivated and aggressively pursue convictions you deserve to have an experienced strategic and knowledgeable tax attorney cpa in your corner please contact us today to schedule your reduce rate initial consultation thank you for watching this video thank you so much again for your time and interest in how we may be able to help you please don't hesitate to call if something is worrying you we would be very happy to help just call or email for a reduced rate consultation