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Until recently, few accountants paid much attention to sales and use taxes. It seemed easy enough: sellers simply added a percentage to each sale and gave it to the state. In the past, rates were lower, enforcement was not as aggressive and income and other taxes made up a relatively larger segment of the overall tax burden. Accountants also weren't trained in this area, and they generally believed that it wasn't important.
In recent years, however, the state of California appears to be more aggressively pursuing income from sales and use tax audit and enforcement programs. The state's audit program has become more openly focused on raising money. Thus, the necessity for a deeper knowledge of the subject has become increasingly important. Therefore, if your small business sells tangible personal property, you should employ an accountant with expertise in reporting sales and use taxes.
Businesses that are particularly vulnerable to sales and use tax audits are: grocery and convenience stores; restaurants; bars; liquor stores; manufacturers; printers; advertising agencies; sellers of vehicles, vessels and aircraft; leasing companies; people in high tech industries, including sellers of computers, software, cell phones, etc.; and construction contractors (especially trades contractors, such as plumbing, heating and air conditioning and flooring). This article will give you an idea of some of the issues your accountant will encounter in helping you report your sales and use tax.
Every auditor looks for both sales and use tax, although the emphasis varies with the type of business. The sales tax side is governed by a simple equation: total sales less deductions equals taxable sales. Let's take a closer look at that equation. In California, the revenue reached by the law is gross receipts from sales of tangible personal property. Within the covered revenue, the law exempts specific types of transactions, including sales for resale, sales to the U.S. government, repair and installation labor and sales in interstate commerce. Once you subtract exempt revenue from your total sales of tangible personal property, all that can remain is sales subject to the tax.
Auditors often emphasize only one or two of the three factors in the sales tax equation. In a business where virtually all transactions are taxable, the auditor usually reconciles recorded figures to those reported, traces to original documents for a test period and makes an indirect cross check such as a markup test or a bank deposits analysis. If no discrepancy is found, the sales tax leg of the audit is concluded. If differences arise, they are presumed taxable unless you can provide evidence to the contrary.
In businesses where most receipts are exempt, the auditor first makes sure all recorded taxable sales were reported. Then nontaxable sales are sampled and traced to supporting documents. Unsupported deductions are projected throughout the audit period and developed into an assessment for additional taxable sales.
For most types of businesses, the search for additional use tax is more direct. Using asset registers, depreciation schedules or similar records, the auditor traces large additions of furniture, machinery and equipment to contracts, invoices and related documents. Any untaxed purchases of these items (usually from unregistered out-of-state vendors) are set up for assessment.
Taxable purchases other than fixed assets are examined on a test basis. Paid bills may be examined for a block of time (a year is common) or sampled throughout the audit period, which usually covers three years. Unreported purchases from out-of-state vendors are projected from the sample base to the audit population, unless the items were resold or are being held for sale.
When examining smaller California businesses, most auditors apply at least one indirect audit test -- tests that go "behind" the records -- in addition to their standard review of the books and records. Indirect methods include markup tests, bank-deposit reconciliations and various specialized techniques used for particular industry groups.
Markup tests. Markup tests are commonly used in audits of retail firms. Auditors compute composite markup factors by extending samples of invoiced purchases to selling prices. They then verify recorded costs of sales, adjust them as needed and multiply the costs by the composite markup factors to arrive at "audited" sales. Any significant differences between recorded sales and "audited" sales are attributed to unrecorded taxable sales and assessed and penalized accordingly.
Bank-deposit reconciliations. Bank-deposit reconciliations may be used either to support markup audits or to check for additional taxable sales where a markup test would not be feasible. The auditor gathers bank statements, adds up the deposits and compares them to reported sales. Nontaxable deposits, such as loan proceeds or stock sales proceeds, are adjusted out. Remaining differences are taxed as additional sales.
Dan Davis, CPA, CFE, is a partner with Associated Sales Tax Consultants in Sacramento. You can reach him at (916) 849-9111 or ddavis@astc.com.
Have a question for a CPA? Ask it here. In accordance with IRS Circular 230, the information on this website is not intended or written to be used, and cannot be used as or considered a "covered opinion" or other written tax advice and should not be relied upon for the purpose of avoiding tax-related penalties under the Internal Revenue Code; promoting, marketing, or recommending to another party any transaction or tax-related matter(s) addressed herein; for IRS audit, tax dispute or other purposes.
