The California Office of Tax Appeals (OTA) has been busy reviewing taxpayer challenges to various California Department of Taxes and Fees Administration (CDTFA) sales tax assessments. Many of these challenges relate to businesses in industries where sales tax audits are common such as restaurants, bars, car dealers, clothing retailers, and cannabis dispensaries. The cases below are good reminders for taxpayers that refuting the CDTFA’s determination after an audit can be a difficult, uphill climb. Sometimes, the best time to seek professional guidance and intervention is when you first receive notice of an upcoming CDTFA sales tax audit.
Using a representative during the audit process may be helpful when it comes to organizing records, sharing sensitive business information, and reaching a more tolerable settlement on tax liability. The CDTFA has access to a wide net of data to reach conclusions during an audit and has broad authority in its use of audit methods. For taxpayers, having access to tax professionals who regularly interact with the CDTFA can be an important resource in defending against unfair audit methods, contesting exaggerated sales tax determinations, and making informed business decisions about your available options.
Restaurants and Bars
In the Matter of La Morenita Restaurant: The OTA upheld a CDTFA determination against the taxpayer for sales tax totaling $186,561.32 (plus interest) based on nearly $2.5 million in unreported taxable sales. The taxpayer failed to provide complete records during the audit period, which led to CDTFA assumptions on owed tax through indirect methods including credit-card-sales-ratios and observation tests. Furthermore, the taxpayer never provided additional evidence or reasoning to refute the CDTFA’s assessed sales tax amounts from the indirect audit methods.
In the Matter of Suede Bar and Lounge: The OTA maintained the CDTFA’s sales tax determination notice of $83,950 for approximately $873,409 worth of unreported taxable sales. During the audit, the CDTFA observed differences between recorded versus reported sales in addition to substantially lower markup values based on data from the taxpayer’s federal income tax returns. The taxpayer was unable to offer sufficient cause to reduce the CDTFA’s assessment that used a markup basis.
In the Matter of Persian Grill: The OTA refused the taxpayer’s $232,596 deduction for alleged government-exempt sales, resulting in a notice of determination for $23,486.79. The taxpayer’s restaurant was near a naval base and argued individual sales to military personnel were exempt. However, the taxpayer had no contract or arrangement with the U.S. government or its agencies, and the OTA noted that California’s regulations explicitly apply tax to sales to persons in the armed services.
In the Matter of Nena’s Mexican Cuisine: The OTA declined to adjust the taxpayer’s notice of determination totaling $303,195.94 plus interest over a 3-year audit period. The taxpayer did not provide any source documentation (e.g., POS records, sales journals, guest checks, etc.) for the audit but provided tax returns and bank statements. During the audit, the CDTFA noted unusually low book markups and could not confirm COGS with the information given. As a result, the CDTFA used an indirect audit method (credit card sales ratio) to determine taxable sales using a 14-day sample period.
In the Matter of Sakana Japanese Sushi & Grill: The OTA upheld the CDTFA’s tax assessment of $184,734.01 and its negligence penalty of $18,473.46. During an audit, the CDTFA noted exceedingly low markups compared to expected markups exceeding 200 percent for a restaurant business. The CDTFA used the credit card sales ratio method to calculate taxable sales and assessed a penalty for the taxpayer’s failure to reasonably maintain records. Here, the taxpayer failed to keep a hard copy or backup of digital records from its POS system that was damaged.
Clothing Retail Stores
In the Matter of William B LLC: The OTA affirmed the CDTFA’s tax determination of $1,034,287 and negligence penalty of $103,428.11 due to underreporting taxable sales for its nine clothing stores. The taxpayer did not provide any records during the audit, and the CDTFA relied on federal income tax return information to note a discrepancy in the reported sales on the sales tax return. The OTA reasoned the negligence penalty was reasonable considering the taxpayer’s substantial underreporting along with failure to provide any books or records for the CDTFA to review during the audit.
Car Dealerships, Tire Sales, and Auto Repair Shops
In the Matter of Ramsey’s Body Shop Collision: The OTA confirmed the CDTFA’s notice of determination for $17,155 related to 13 unreported taxable car sales. The taxpayer argued the purchaser had verbally committed to paying and reporting the sales tax and that some of the sales were purchases for resale. However, the OTA declined to accept these arguments because the responsibility for remitting sales tax belongs to the seller, and the seller did not have resale exemption certificates from the purchasers to document the transactions.
In the Matter of A1 Auto and Truck Services, Inc.: The OTA declined to reduce the taxpayer’s notice of determination for $11,512.72. The CDTFA observed a negative book markup when comparing the taxpayer’s cost of goods sold and the reported sales price for various car parts. The taxpayer failed to provide complete records to justify the discrepancies, and the CDTFA calculated an audited markup of 25.08 percent, resulting in an increase in unreported taxable sales. The OTA refused to further reduce the markup percentage based on the taxpayer’s use of coupons to discount sales nor did it accept the taxpayer’s allegation of theft to justify reducing the taxable measure for pilferage.
In the Matter of La Puente Tire: The OTA refused to adjust the taxpayer’s notice of determination for $542,044.31 and their fraud penalty of $135,511.16 over a four-year audit period. During an audit, the CDTFA found unusually low markup percentages and differences between reported sales and bank deposits. The OTA upheld the fraud penalty based on the substantial amount of unreported taxable sales along with the fact that the taxpayer had been collecting sales tax from customers and filing SUTRs, which evidenced knowledge of tax obligations.
Medical Cannabis Dispensaries
In the Matter of MMD, Inc.: The OTA confirmed the taxpayer’s notice of determination for approximately $373,134.89 in tax for unreported sales over a 3-year period. Upon audit, the CDTFA found gaps in records from daily sale summaries the taxpayer maintained, which made the records unreliable and forced the CDTFA to use other audit methods. The CDTFA used observation tests to approximate the number of daily customers and determine estimated sales figures. The OTA declined to accept the taxpayer’s proposal for a bank deposit analysis because of the heavy cash usage and payroll records that raised doubts about the accuracy of bank records in showing total sales.
In the Matter of Strain Balboa Caregivers, Inc.: The OTA ordered the CDTFA to further reduce the audited measure of unreported tax totaling $1,193,574.00 but upheld the negligence penalty of $119,357.43. Although the OTA found the taxpayer did not provide adequate records for the CDTFA to review, it also found the CDTFA’s use of an observation test unfair because it focused on predictably busy time windows (four Friday afternoons). As a result, the OTA ordered the CDTFA to recalculate the measure of unreported tax by removing the Friday with the highest customer count.
Key Takeaways on Managing CDTFA Sales Tax Audits and Assessments
The cases above illustrate the challenges that businesses face when trying to defend against the CDTFA’s indirect audit methods and the notices of determination that follow. In all but one case, the OTA upheld the CDTFA’s position, many of which included negligence or fraud penalties for gross underreporting of taxable sales. The CDTFA has access to lots of information about your business and the industry that inform its auditing practices and provide creative options for estimating tax owed. For example, comparing your sales tax returns with your federal income tax returns or comparing purchase orders to monitor for unusually low markups on COGS.
Sometimes these measures are warranted and other times they unjustly reflect your taxable sales. For business owners facing an audit, taking a proactive role in the process can be necessary to protect your interests (i.e., your tax liability and ultimately, your company’s bottom line). A tax professional can be a useful part of that defense by informing you of available options and serving as a trusted intermediary between you and the CDTFA.
Schedule a consultation with Sales Tax Helper for California sales tax audit defense or other challenges to a CDTFA notice of determination.