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Sales Tax Audits: Is Your Business A Target?

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As a former auditor, I often heard the question “Is my business at risk?” The short answer was (and still is) “Yes.” That said - several factors can influence the chance of you being audited...

How Businesses Are Selected for Audit

First of all, realize that taxing jurisdictions need to have auditors pay for themselves. Therefore, the audit division will generally strive to identify businesses that have high risk or potential for assessments in order to generate a “profit.”

For three or four years while I was with the California Board of Equalization (back in the 1990's), I was responsible for selecting the accounts to be audited by our local office in the coming fiscal year. I’m sure the methods have changed somewhat, but the underlying logic remains the same today. A recent quote from the BOE states, “The program audits nearly one percent of active master accounts each year, concentrating on those considered most likely to be inaccurate in their tax reporting.”

But that begs the question of who is “considered most likely to be inaccurate in their tax reporting.” That question is answered by looking at:

  1. the industry involved;
  2. any past audit history for the business;
  3. the amount of total sales being reported;
  4. the amount of exempt sales being claimed;
  5. the ratio of exempt sales to total sales; and
  6. where the business is located.

Most of these factors are self evident. Companies with a history of “productive” audits (tax found exceeds the cost to find it) will get audited until they get their act together. Larger companies with high amount of sales, and those reporting a high amount of exempt sales as an absolute value, are obviously targeted more than companies with small sales volume or no exempt sales (the latter is why, even though the standard requirement is to report "total sales," some businesses net out their exempt sales and report only those which they taxed). A ratio of exempt to total sales will also raise a flag, especially if that ratio is out of line for the industry in general.

But let’s take a closer look at the other two factors.

The Industry Involved

The industry type can be “inaccurate in their reporting” in two ways. One is based purely on how the industry operates. Bars, restaurants, grocery and liquor stores are all cash-based businesses. And cash has a way of getting “lost,” so it is not uncommon for the sales behind that cash to not get reported.

The other way for an industry to be inaccurate is to simply not adhere to sales and use tax regulations. The main causes are lack of internal controls and not understanding the requirements. These factors most generally manifest themselves when it comes to supporting exempt sales and in reporting consumer’s use tax.

If gold is where you find it, then tax is where you look. Not only where, but how hard you have to look. Those cash-based businesses are relatively high potential audits, but the effort to find the tax can also be high. If you read my earlier blog about “mark up” audits, you will recall all the factors that must be considered when computing mark ups and that those factors are very fluid and difficult to tie down. So the effort may exceed the results.

In the 2009-2010 fiscal year (according to the CA BOE), the top three industries found to have large assessments in the state of California were:

  1. Manufacturers and wholesalers of store and office equipment;
  2. Publishers and Distributors of Light Industrial Equipment; and
  3. Producers and Distributors of Heavy Industrial Equipment.

This not a surprising result because the tax is easy to find. What these industries have in common is they all sell products that are easily accounted for, they sell to other businesses, they sell on credit, not cash, and they almost certainly have a straightforward sales invoicing system. In our computerized world, an auditor can easily get a data dump of sales in the audit period, confirm all sales are accounted for and easily pull a statistical sample of the non-taxed sales. Now the burden is on the taxpayer to support those sales. Any transactions left unsupported get extrapolated and voila, a productive audit.

Where the Business is Located

I don’t mean what part of town the business is in, but rather what town the business is in. For the best example, I again go back to the 1990’s. San Jose and the rest of “Silicon Valley” were in high gear with high tech start-ups flush with money. Brand new auditors could go out to one of them and easily find thousands of dollars in tax due on equipment purchased without tax.

At the same time, in a city like San Diego, where the major industries were tourism and the federal government, even reasonably senior auditors were assigned audits of the cash-based businesses because that’s what was available. So in terms of a liquor store being targeted for a sales tax audit, San Jose―good place (small chance); San Diego―bad place (large chance).

In summary, the profile of a business with a low chance of audit is a medium-sized cash-based business located in a city with a booming industry.

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