What to Do When Your California Sales Tax Audit Turns Criminal

No business is too small to avoid the gaze of the California Department of Tax and Fee Administration. As most California business owners, sellers, retailers, and CFOs know, the CDTFA is the body responsible for auditing California sales tax payments among the state’s restaurants, bars, liquor stores, salons, convenience stores, and other businesses.

The purpose of a sales tax audit is to determine if a retailer engaged in California has both collected and paid the correct amount of sales tax owed to the state for all taxable transactions. One is considered a retailer engaged in California if they are selling, delivering, installing, assembling, or taking orders regarding any tangible personal property. For businesses outside of California delivering products to California, sales tax will apply if sufficient economic contacts or if those businesses have any type of fingerprint in California related to warehouses, offices, representatives, agents, or delivery workers.

How Can a Seemingly Civil Audit Turn Criminal?

If a sales tax audit digs up significant amounts of suspected unreported cash basis sales, the CDTFA is likely to report its findings to both the California Franchise Tax Board and the IRS Criminal Investigation Division. Once a referral is made, the FTB either will adjust the business’s income tax return for the unreported sales or open an audit or criminal tax investigation. This can mean facing charges for felony tax evasion.

What Should Someone Do if They’re Worried?

It’s very important to seek the help of a sales tax attorney licensed in California if you’ve been the subject of a potentially criminal California sales tax audit. Sales tax evasion is a serious crime that carries risks for large penalties and jail time if you’re found guilty. Ideally, a person facing a sales tax audit in California will seek legal representation as soon as they get notice of the audit to try to use all legal resources possible to prevent California or federal criminal tax charges from being filed.

What Triggers a Sales Tax Audit in the First Place?

Businesses that get audited for sales tax evasion in California are almost always targeted by the CDTFA due to some kind of reporting inconsistency. The most common cause of a sales tax audits is a mismatch between returns filed with the CDTFA and the IRS and can cause complicated high-risk audit situations. There are a few common reasons sellers may get the unwanted attention of CDTFA auditors:

Sellers sometimes fail to charge sales tax to customers because they assume that paying sales tax to the original vendor satisfies the requirement. This is an easy trap to fall into because the state has technically already received its tax payment. However, the state is not receiving sales tax on any markup that is ultimately charged to the customer. It’s also important to confirm you’re providing the right exemption documentation proving that you’re eligible for an offset.
Failure to properly register a business is another common red flag that gets sellers audited.
Cash-intensive businesses are routinely targeted for audits due to a belief among CDTFA auditors that businesses that deal in cash are more likely to cheat. Having a history of cheating can also increase the odds of a business being audited. However, even a business with a clean tax record that just happens to operate in a high-risk industry may be targeted due to association. This mostly includes restaurants, gas stations, convenience stores, and liquor stores.

The CDTFA’s Approach

Most sales tax audits in California cover a look-back period of three years that subjects all business records to the reach of the audit. A CDTFA agent will commonly request access to receipts, bills, records on sales tax exempt items, invoices, register tapes, and other forms of documentation that can help to establish sales tax liability. To try to uncover unreported income, the CDTFA is comparing book sales versus sales reported on sales tax returns, comparing bank deposits with sales reported for sales tax returns, and focusing on a retailer’s internet-based sales.

The CDTFA commonly approaches sales tax audits using a frustrating estimation-based method known as a markup audit, whose purpose is to confirm suspected understated sales taxes stemming from unreported, often cash basis, sales. In a markup audit, the companies’ books are summarily set aside without any justification necessary. Instead, third parties are approached to determine what was sold to the entity under audit in the way of cost of goods sold. Once costs of goods sold is quantified, an industry markup percentage is used to estimate what taxable sales should have been as opposed to what was reported.

Often, an inference of fraud arises under this methodology, with the CDTFA insinuating that cash basis sales have not been reported. If greater than $100,000 of unreported sales is detected in a quarter, the FTB will receive a referral and will freely communicate with the IRS.

CDTFA auditors are also trained to spot skimming programs that cause figures regarding sales and costs of goods to simultaneously vanish from point-of-sale systems. If a retailer is discovered to have illegally skimmed cash, criminal tax evasion charges are likely. If an auditor asks for records that can be used to match up the dollar amount of goods sold versus the seller’s cost of goods sold for any specific period, it’s a telltale sign that they’re digging for signs of skimming. This technique allows auditors to look for unreported cash sales that have been hidden through underreporting of the related costs of goods sold.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

David Klasing is a California attorney and CPA with close to 30 years of professional experience who practices criminal tax defense and high risk federal and California tax controversy, planning, and compliance.