In California sales and use tax audits, few issues create more exposure than the inability to substantiate sales reported as “for resale.” Even sophisticated businesses with otherwise strong compliance systems often discover, years later, that resale certificates were never obtained, were incomplete, or cannot be located. When that happens, the California Department of Tax and Fee Administration (“CDTFA”) frequently proposes to reclassify those sales as taxable retail sales.
In that context, taxpayers are often introduced to the concept of “XYZ letters.” While commonly referenced by auditors, XYZ letters are widely misunderstood and, when mishandled, can worsen a taxpayer’s audit posture. Used correctly, however, they can be an important evidentiary tool to mitigate proposed assessments.
This blog explains what XYZ letters are, why they arise in CDTFA audits, how auditors evaluate them, and how taxpayers should strategically approach their use.
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BACKGROUND: THE BURDEN OF PROOF IN CALIFORNIA SALES TAX AUDITS
California sales tax law places the burden squarely on the seller to prove that a sale is exempt from tax. Regulation 1668 requires sellers to timely obtain resale certificates taken in good faith. When a valid resale certificate is not in the seller’s records, CDTFA auditors are instructed to presume the sale is taxable unless the seller can provide “other evidence” sufficient to establish that the property was purchased for resale.
XYZ letters fall into this category of “other evidence.” They are not referenced in the statutes, but they have evolved as an administrative audit practice used by CDTFA staff when standard documentation is unavailable.
WHAT IS A CALIFORNIA XYZ LETTER
An XYZ letter is a written request sent to a customer asking that customer to confirm how specific items of tangible personal property were used after purchase. Typically, the letter references invoice numbers, dates, and descriptions of the property sold, and asks the purchaser to indicate whether the property was:
- resold,
- held for resale,
- incorporated into a product for resale,
- leased, consumed or used, or
- otherwise used in a taxable manner.
XYZ letters are not retroactive resale certificates. CDTFA is explicit that a resale certificate obtained after the sale does not, by itself, establish an exempt resale. Instead, XYZ responses are treated as testimonial evidence that may or may not be persuasive depending on the facts and circumstances.
WHY CALIFORNIA SALES TAX AUDITORS PROPOSE XYZ LETTERS
XYZ letters most commonly arise after an auditor has already identified a block of sales lacking valid resale certificates. Rather than immediately taxing those transactions, the auditor may offer XYZ letters as a way for the taxpayer to attempt to substantiate resale treatment.
From the auditor’s perspective, XYZ letters serve two purposes. First, they shift the administrative burden back to the taxpayer to prove exemption. Second, they allow CDTFA to independently verify customer representations, including whether the purchaser was registered, audited, or otherwise compliant.
HOW THE XYZ PROCESS WORKS IN PRACTICE
Although procedures vary by auditor, the typical XYZ process follows a predictable pattern.
First, the auditor identifies invoices or customers requiring substantiation. The auditor may provide CDTFA Form 504-A or allow a customized letter with pre-approval. The taxpayer is usually given a limited window, often 30 days, to send the letters and collect responses.
Second, the letters are sent to customers. Some auditors require that responses be returned directly to CDTFA, while others permit responses to be routed through the taxpayer. Each approach carries strategic implications.
Third, CDTFA reviews the responses. If the customer confirms resale or tax-paid status and the response is internally consistent and credible, the auditor may remove those sales from the measure of tax. If responses are incomplete, contradictory, or absent, the auditor will typically treat the sale as taxable.
DIRECT VS. INDIRECT RESPONSE ROUTING FOR CALIFORNIA SALES TAX AUDITS
Whether XYZ letters should be returned directly to CDTFA or through the taxpayer is not a trivial decision.
When responses go directly to CDTFA, the taxpayer avoids accusations of influence or selective disclosure. However, this also means the taxpayer loses visibility into non-responses or problematic answers until it is too late to correct them.
When responses are returned to the taxpayer first, the taxpayer can follow up with customers, clarify ambiguous responses, and ensure forms are fully completed. The risk, however, is that CDTFA may insist on direct verification or treat the responses with greater skepticism.
COMMON SCENARIOS WHERE XYZ LETTERS FAIL
XYZ letters often fail not because the underlying sale was taxable, but because the execution was poor. Common issues include:
- Customers who no longer exist or cannot be located;
- Vague responses such as “used in business” without specifying resale;
- Contradictions between XYZ responses and customer permit status; or
- Customers admitting taxable use, triggering expanded audit issues.
BEST PRACTICES FOR CALIFORNIA TAXPAYERS
XYZ letters should be used strategically and sparingly. Best practices include:
- Exhausting internal documentation before resorting to XYZ letters;
- Limiting letters to high-dollar or high-impact transactions;
- Customizing letters to specific facts rather than using generic language;
- Tracking responses aggressively and following up early; or
- Coordinating messaging with legal or tax advisors.
CONCLUSION
XYZ letters can act as a saving grace in a California sales tax audit. They are neither statutory safe harbors nor formalities. When handled carefully, they can help resolve documentation issues and mitigate audit exposure. When handled poorly, they can deepen assessments and extend audits.
Taxpayers facing a California sales tax audit involving resale issues should approach XYZ letters with a clear strategy, a realistic assessment of risk, and an understanding that CDTFA retains broad discretion in weighing this form of evidence.
With decades of specialized expertise, Sales Tax Helper LLC helps businesses overcome their California sales tax audit challenges effectively and affordably.
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