One of the stated policies of Sales Tax Audits according to the Board of Equalization Audit Manual is to promote accuracy in self assessment through "aid" extended to taxpayers with respect to the interpretation of the law and rules and regulations adopted thereunder. Of course it is no secret that this process more of­ten than not results in audit assessments. Sales Tax Auditors come in all different styles but common to most is the challenge of producing the much needed and highly desired large tax change audit. In a recent survey done by Vertex, Inc., 77% of the respondents agreed that the current state budget crises has con­tributed to state sales tax audit aggressiveness. The survey also showed that the ten most aggressive sales tax audit states (of which California was #1) also had budget crises. The same survey found that firms that protest the audits save nearly 40% of the original assessment or more than $16,000 per assessment. Understanding the audit process and the inherent weaknesses therein is important when building a case to rebut the findings.

The majority of audits can be categorized in two general types - The Markup Audit and the Exempt Sales Test Audit.

I. The Mark Up Audit

Mark up audits are done when auditors think reported sales are understated. An initial analysis is done comparing the cost of sales with the reported sales and if the mark up percentages are too low they proceed to a "shelf test." In the shelf test process, auditors pick a selection of items sold and compare the cost price with the sale price (from the "shelf.") This shelf test is normally performed using current costs and sell prices. A mark up is then computed and applied to the total cost of sales for the audit period. The result, audited taxable sales, is then compared to reported and the understated amount is considered ad­ditional taxable measure. The following short comings should be addressed:

1.) This method assumes that the current mark up is the same as the mark up for the three year audit period. A different pricing structure in the earlier periods may have resulted in a lower mark up during that period producing an unfair result overall.

2.) Cost of sales, as recorded may include supply items or con­tain non taxable purchases which should be removed before marking up.

3.) Different locations may have been opened and closed during the audit period which yielded lower mark ups.

4.) A percentage of error computed for a particular period may not apply to other periods when the attained or book mark up was greater.

5.) The shelf test itself may have been incorrectly weighted with greater weight given to higher mark up type items which may constitute a small percentage of taxable sales.

6.) The shelf test may not have taken special sales or loss leader type items into consideration.

7.) Cost of sales should be adjusted for pilferage and self con­sumed before marking up.

In a recent example, we reviewed a restaurant and bar mark up audit based on a current shelf test. The problem was that the location for which the shelf test was done had only been in exis­tence for the last year of the audit period. Prior to that, the taxpayer had a bar with no restaurant in a bad neighborhood. These were two totally different businesses with a different clientele. The auditor, however, applied the mark ups computed for the nicer restaurant and bar to both locations. Not only was the assumption that the current mark up was the same as that of three years prior but also the same for the two businesses. This was obviously not the case. In another example, an auditor com­puted a percentage of error based on the understatement for the last year of the audit. This percentage was then applied to the entire audit period. The problem was that in the first two years of the audit the books showed an acceptable mark up. Any error should have been isolated to the last year only.

A Word of Advice

An ounce of prevention is worth a pound of cure. This is cer­tainly true in these type of audits. In the case where taxpayers can show that their mark ups were less in the early years of the audit period we have no problem. The problem is that retail businesses that do not produce sales invoices and do not keep the detail cash register tapes can not prove what selling prices used to be. This, of course, is a necessary component of a markup computation. Likewise, ads for special sales and old price lists should be kept for support. The ounce of prevention is to keep all the records that support sale price. Since the burden of proof is always on the taxpayer, you are guilty till proven in­nocent even though their assumptions often do not reflect reality.

II. The Exempt Sales Test

This type of audit is done on any business that claims exempt sales. The exempt sales can be tested using statistical sample (the most preferred method) or a block sample (eg. a 3 month test). In some businesses an actual basis test may be done when appropriate. This usually occurs when the number of exempt transactions is small and the dollar amount is big (yacht dealers, airplane dealers, RV's, etc.). With regards to a sample test, the theory is that the sample is representative of the population from which is drawn. In a statistical sample, this theory is measured in terms of confidence levels and confidence intervals. In a block sample, this theory is not objectively measured. In either case, the same limitations can occur. One such limitation that occurs is an error in the sample which rep­resents a large dollar amount accounting for a disproportionate amount of the sample error. It may be that the dollar amount of the transaction is far greater than the average invoice amount and is not representative of the average sale. When this type of problem occurs, the taxpayer should consider stratifying the sample over a certain dollar amount. In other cases, an error in the sample might be an isolated event or type of transaction which is non recurring. If this is the case, negotiate with the auditor to remove that item from the projected error.

Use tax tests can be done using the same methods as tests for ex­empt sales and the same limitations discussed above apply.

Conclusion:

Audits should be analyzed in detail knowing that there is a good chance they can be reduced. A careful review of the auditors workpapers along with client interaction and involvement will be time well spent.