Sales tax audits: income tax returns prove a valuable tool for sales tax auditors.

• Author: Davis, Dan

Sales and use tax auditors routinely ask for income tax returns as part of their initial records requests. If a taxpayer or CPA is reluctant to provide the returns, the Board of Equalization simply orders copies from the Franchise Tax Board or IRS. Why the interest in a taxpayer's income tax returns?

BOE AUDIT PROCEDURES

One of the first things tax auditors look for is consistent recording and reporting. Examiners get worried when sales reported to the BOE don't tie to sales recorded in the general ledger. They get even more worried if sales on the income tax returns don't match either one. Consequently, auditors look at sales on income tax returns to ensure that everything matches or any differences can be explained (BOE Audit Manual, Sec. 0406.50). If the differences can't be accounted for, the auditor will assume that the largest available numbers are the most accurate ones.

Besides reconciling total sales, most auditors review income tax returns as a whole. Do sales, inventory figures, costs of sales and expenses bear reasonable relationships to one another? Are the numbers in line with those noted in similarly situated businesses? Do the returns show reasonable net profits from year to year? If the auditor is working with individuals, do they have other sources of income and is their total income consistent with their lifestyle? Any "no" answer triggers a deeper investigation.

Auditors also examine income tax depreciation schedules and schedules of fixed asset sales in their search for unreported taxable sales of fixtures and equipment, as well as possible untaxed asset purchases from out-of-state vendors.

If the taxpayer has claimed a sales tax deduction for bad debts, the auditor is required to determine whether the same accounts were written off for income tax purposes. Many bad debts allowable as an income tax deduction have components that are not deductible for sales tax purposes. In such cases, the auditor must reconcile the differences. This generally occurs when the original sale was partly exempt, as in the case of an automobile repair that included both parts and labor.

RETAIL SELLERS

For any business making retail sales, the costs of sales on its income tax returns can quickly assume major importance in an audit, particularly for businesses whose records have been lost or destroyed, or where the records are unclear or incomplete. The reason is the BOE's widespread use of markup auditing.

According to the BOE's Audit Manual...