One of the common audit procedures used by auditors in sales tax audits is the mark-up audit. This method is used when auditors suspect reported sales are understated. Initially an analysis is made comparing the cost of sales with the reported sales. 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 on the shelf. This shelf test is normally performed using current costs and current sale 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. These audits are full of pitfalls and are unfortunately being used by the State Board of Equalization more and more often. The following shortcomings should be addressed:

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

2.) Recorded cost of sales, may include supply items or con­tain non-taxable purchases which should be removed before applying a mark-up percentage.

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 if the attained (or book) mark-up in the other period 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 items into consideration.

7.) The shelf test may have incorrect costs & selling prices.

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

In the latest annual report, the fourth largest revenue producer was from mark-up audits. Formerly reserved primarily for businesses such as bars and liquor stores, we now see mark-up audits being used in virtually all businesses. Ironically enough, in cash businesses the auditors ask the business owner if they retain cash register tapes even though they are not looked at in determining audited sales. If these tapes are not maintained, however, it is presented as additional justification for using the mark-up method and justifying a negligence penalty.

What gives the State Board of Equalization the authority to set aside the records of the taxpayer and establish their own computation of sales via the mark-up method?

Revenue and Taxation Code Section 6481 states in relevant part, "If the Board is not satisfied with the return or returns of the tax or the amount of tax, or other amount, required to be paid to the state by any person, it may compute and determine the amount required to be paid upon the basis of the facts contained in the return or returns or upon the basis of any information within its possession or that may come into its possession."

Several court cases have upheld this method also. In People v. Schwartz (supra 31 Cal.2d59) the Supreme Court sustained a "behind the books" examination. Also in Riley B's Inc v. State Board of Equalization CA CT of Appeals (61 Cal App 3d 610 1976) the mark up method was upheld. The Judges concluded "we agree with Board that our affirmance of appellant's argument would allow an unscrupulous taxpayer to avoid his tax liability simply by maintaining inaccurate but voluminous and consistent records. Tax evasion would be facilitated and the Board's statutory duty to fairly administer and enforce the tax laws would be effectively thwarted."

Conclusion

The only way to reduce a mark-up audit is to pick it apart - detail by detail. The eight points raised above is a good starting place.