ASK THE CALIFORNIA EMPLOYMENT TAX AND PAYROLL TAX ATTORNEY – POOR RECORD KEEPING IS FATAL DURING A TAX AUDIT
By Robert S. Schriebman
Inadequate books and records can be your worst enemy during a tax audit. If you cannot keep journals or ledgers of your business transactions, taxing agencies, both State and Federal, have indirect methods of determining your gross income or gross sales. The hazards can go beyond an income or sales probe. For example, the EDD can issue an estimated assessment. This can put you in a bad spot. An estimated assessment cannot be resolved by way of settlement. Your case must go before an administrative law judge who has the power to send your case back to the audit unit for a thorough investigation. This can result in a high and inaccurate assessment together with penalties and interest.
A recent case decided by the Office of Tax Appeals (OTA) illustrates how the sales tax people can reconstruct your records by examining bank statements and other original source documentation. The case is important because it is a roadmap of what an auditor will look for and how taxes can be assessed in favor of the taxman leaving the taxpayer to scramble in order to counter a high estimated assessment. It is perfectly proper for the taxing agency to examine bank statements and related transactions in order to arrive at income or taxable sales. However, in that process there are certain items and certain transactions that must be taken into consideration in reducing the taxpayer’s exposure. Having said this, it is also vitally important that the taxpayer have the proper paperwork in order to prove these reductions.
This article will discuss the recent Angulo Partnership case and how important it is to have complete records of transactions that will protect you against a potentially high assessment. The Partnership of M. Angulo Sanchez and M. Cisneros Angulo, OTA Case No. 18093742, July 8, 2020.
The Angulo Case
Sanchez and Angulo owned and operated a used car dealership. The then SBE conducted an audit for the years 2009 through 2011. The taxpayers provided federal income tax returns, bank statements, and other related sales documentation to show the accuracy of the amounts of sales reported in those years. However, the partners did not provide sales tax journals. Those journals had been destroyed prior to the examination. That was a big mistake! The SBE conducted a bank deposit analysis as the best evidence of gross receipts from sales. They found unreported sales. The auditors deducted items such as tax refunds and loans to arrive at an assessment of $85,000 together with a negligence penalty of $8,500. The partners claimed that the auditors did not take into consideration several additional loans in order to show a reduction in unreported sales. The OTA disregarded additional proof of loans due to the inadequacy of the partners’ paperwork.
The case is instructive because it set forth a list of factors that taxpayers can use to prove to auditors that unreported sales or income was less than estimated.
The California Government’s Power to Conduct a Tax Audit
Here I will focus on sales tax audits, but, the basic rules can apply to an FTB income tax audit as well as an EDD payroll tax or worker status audit.
California imposes sales tax measured by a retailer’s gross receipts from the sales of tangible personal property. The taxes are imposed unless the sales transaction is exempt or excluded by law (&TC § 6051). It is the retailer’s responsibility to maintain complete and accurate records and to make those records available for audit. (R&TC §§7053 and 7054)
Burden of Proof
In a tax audit the government’s assessment is presumed to be correct. The taxing agency’s initial burden is minimal. The government basically has to show what steps it took in the audit process, and that those steps complied with standard operating procedures. Once this burden is met, the burden of proof shifts to the taxpayer to establish that a result differing from the government’s determination is warranted. See Riley B’s, Inc. v. State Bd. of Education (1976) 61 Cal.App. 3d 610. The taxpayer’s burden is much more difficult than the government’s burden.
Bank Deposit Analysis and Exclusions
Earlier in this article I discussed how the sales tax auditors had the right to estimate sales based on bank statements and bank deposits where the partnership had destroyed its journals or books of original entry. The following is a list of items that must be subtracted as not relating to sales or income generating activities:
- Tax refunds;
- Refunds of bank fees;
- Lines of Credit receipts;
- Receipts from revolving credits;
- Insurance proceeds;
- Bad debt losses; and
Bad debt losses can play an important part in reducing an auditor’s finding of unreported income or sales. These losses should be taken into account promptly by amending quarterly tax returns and filing claims for refunds.
Sanchez and Angulo argued before the OTA that the auditors failed to take into account additional loans. They offered as proof a ledger sheet showing loan dates. The OTA held that this was insufficient proof that loan proceeds were deposited in the business account or otherwise used in the business. The partners had no corporate minutes showing loans. They had no deposit slips, and no loan contracts. They claimed that Mr. X loaned them $150,000, but when contacted Mr. X stated that he only loaned them $15,000. Lying to an auditor is bad enough, but lying to a judge is far worse.
Bank statements play an important role in the audit process. While they can provide valuable information as to gross receipts, they are not, standing alone, absolute proof of sales or income. The Angulo case is important in illustrating what factors can be taken into account to reduce a taxpayer’s exposure to high estimated assessments.
Robert Schriebman has a successful practice in the Rolling Hills Estates area of Los Angeles County serving clients throughout California and the United States. He has successfully dedicated more than 40 years to helping individual taxpayers, business owners, CPAs, Enrolled Agents, and tax attorneys navigate the complicated tax systems of the federal and state governments. Mr. Schriebman is in private practice. He is not affiliated in any way with the EDD and he is not employed by the EDD or any other agency of the State of California.
Robert Schriebman has written the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure,” both published by Commerce Clearing House.
Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House.
Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House in addition to the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure,” both published by Commerce Clearing House.
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