WHO IS SUBJECT TO THE TAX?
The California sales and use tax law applies to all retailers doing business in California. This includes those businesses that are not located within the boundaries of the state, if they enjoy sufficient connection to the state or enjoy its protections. A business located outside of the state that is nonetheless found to be subject to the tax will be required to collect the use tax from its customers. The penalty for failing to collect the tax is equal to the tax due, and must be paid by the retailer.
As long ago as 1939 the U. S. Supreme Court stated that the use of rented offices and the existence of two general agents in California was sufficient to attract the obligation to collect the use tax. (Felt & Tarrant Mfg. Co. v. Gallagher et al., 306 U.S. 62) Again in 1977 the same court stated that maintenance of two offices in the state is also sufficient. (National Geographic Society v. California Board of Equalization, 430 U.S. 551)
There are no "black letter" tests to determine just what amounts to a sufficient connection to the state. The U. S. Supreme Court described the minimum contacts as those that do "... not offend traditional notions of fair play and substantial justice." (International Shoe Co. v. Washington, 326 U.S. 310) (1945). Recently, the members of the multi-state compact have become much more aggressive in their attempts to require retailers in all states to collect the use tax. The U.S. Supreme Court has acted to discourage this approach, however, in Quill Corp v. North Dakota, 112 U.S. 1904 (1992), at least if the only contact with a state is through the mails.
Due to the difficulty in qualifying for an exemption from the tax, even out of state retailers should remain sensitive to their obligations to the state of California re: payment of the sales tax and collection of the use tax.
SUMMARY OF THE SALES AND USE TAX LAW
The law itself is quite detailed and, in some cases, it is applied in a fashion that could be described as counter-intuitive. Since the tax applies at a rate of up to 8.5% of the gross amount of sales, it is entirely possible that a failure to properly apply the tax could easily generate an assessment large enough to require that the business be liquidated. Further, even if the business is incorporated, it may not be possible for the owner to avoid personal liability for the tax.
The following is a very general over-view of portions of the sales and use tax law and some examples of its application. A broad outline of the usual audit program followed by State Board of Equalization auditors and a description of the appeals process is also included below. All references are to the California Revenue and Taxation Code, unless otherwise noted.
Retailers who make sales of tangible personal property to consumers in California (unless specifically exempt) are required to pay sales tax at a rate up to 8.5% of the gross amount of those sales. Retailers may, but are not required to, reimburse themselves by collecting the tax from their customers. Retailers must report and pay over the tax periodically (annually, quarterly or monthly depending upon volume). Reporting is on an accrual basis and penalties apply, normally at the rate of ten percent of the tax, for failure to timely report and pay over the tax. (Section 6051)
Retailers are those sellers who make more than two sales of tangible personal property in California during any twelve month period. (Sections 6006.5, 6014, 6015)
Sales are defined to include any transfers (including most leases) of title or possession for a consideration. (Section 6006)
Delivery of the product to the purchaser or to his agent within the state of California is sufficient to subject the transaction to the tax. (Section 6051)
Tangible personal property is that which can be seen, felt, weighed or otherwise measured. In certain restricted cases such as an author's original manuscript, custom software and in certain cases, patented materials, the tangible personal property is considered merely incidental to the transfer of intangible information and portions of the transaction will not be subject to the tax. In addition, transfers of real property and such intangible property as currency, stocks, bonds, etc. are not taxable. (Section 6016)
Sales to California buyers who will not resell the property and who are not otherwise exempt are sales to consumers, and are therefore taxable. (Section 6007)
Certain transfers that would otherwise be subject to the tax are nonetheless granted specific exemptions.
Exempt tangible property includes:
Cold Food (Section 6359)
Prescription Medicines (Section 6369)
Animals raised as human food (Section 6358)
Feed given to animals raised as human food (Section 6358)
Certain utility products (Section 6353)
Exempt purchasers include:
U. S. Government
Instrumentalities of the U. S. Government
Out-of-state purchasers with delivery via common carrier
Retailers who will resell the property prior to use.
(Sections 6352, 6381, 6396 & 6091)
The tax is imposed upon the retailer for the privilege of making sales at retail within the state of California. The basic rate is 6%, and an added rate of up to 2.5% is assessed to support certain local transit districts. Retailers must pay the tax even if they are not able to collect it from their customers. (Section 6051)
The retailer is required to report the measure of the tax on a yearly, quarterly or monthly basis. This reporting must be done on an accrual basis, and the tax must be paid with the tax return even if the purchaser has not yet paid the purchase price to the retailer. (Sections 6451 - 6459)
A 10% penalty may be assessed for negligent failure to properly report or for any failure to pay over the tax. A 25% penalty applies for fraudulent failures to timely report and pay the taxes over to the state. Finally, a 50% penalty may be assessed in cases of intentional failure to apply for a seller's permit if the failure is intended to evade the tax. (Sections 6484 - 6485.1)
Persons who regularly consume tangible personal property in California, unless specifically exempt, are required to pay use tax at a rate of up to 8.5% of the cost to them if the sales tax was not paid when the property was purchased. (Section 6201)
Typically, this obligation to report the use tax measure arises in circumstances wherein tangible personal property which will not be resold is purchased from out-of-state suppliers who do not collect the sales or use tax. The purchaser's obligation to report and pay the use tax directly to the state also arises when property originally purchased for resale from a California retailer is instead used by the purchaser. (Section 6202)
With regard to the transactions most likely to generate the maximum unexpected tax, the following are a few very brief examples:
Transfers of assets, together will liabilities, to or from subsidiaries will typically be subject to the tax. The fact that subsidiaries, even wholly owned subsidiaries, are involved does not protect such transfers from the tax. A very specific exemption available for transfers with no substantial change in ownership is available, but its requirements are usually not met:
at least 80% of the assets of the transferor must be transferred. This requirement may be met in a reorganization situation, but clearly it will not be met in the day-to-day type of transfers between subsidiaries.
Purchases of costly assets such as autos, aircraft and yachts purchased outside of the state will attract the tax if brought into the state within 90 days of the date that the asset is placed in service.
Sale of subsidiaries or other companies will be subject to the tax if the assets are sold; there is, however, no tax on intangibles such as common stock. A simple sale of the stock instead of assets avoids the tax. If there is a concern about unknown liabilities, the assets (but not the liabilities) can be transferred to a newly formed corporation for sale to the buyer.
Leasing companies sometimes have difficulties because of the fact that they are given the choice of whether to calculate the sales tax based upon the cost to them of the assets leased to others or upon the lease receipts generated by those assets. The problem is that this election must be made at the time that the asset is placed in service. A late election can cause problems since the wrong reporting method may be applicable.
Retailers are required to keep and maintain adequate books and records. Retailers are also required to allow representatives of the California State Board of Equalization to review those books and records to verify that the proper measure of sales and use tax transactions has been reported to the state. (Section 7053)
The statute of limitations for such review is generally three years from the date that the taxpayer files his tax return. This period is extended to cover eight years if a return is not filed, or if fraud is involved. There are also criminal penalties for fraudulent failures to pay the tax. (Section 6487)
During the audit of a taxpayer's books and records, the auditor will be primarily interested in those transactions most likely to generate under-reporting of the tax, but almost all areas of record keeping will be subjected to at least a cursory review.
A generalized outline of the audit process will include:
Gross Sales. All categories of sales will be reconciled to both the sales tax return worksheets and to the federal income tax returns of the taxpayer to insure that all sales are reported, even those that will be claimed as exempt transactions.
Tax Accrual Account. The sales and use tax accrual accounts will be reconciled to the sales and use tax return worksheets to insure that all taxes that have been accrued are in fact paid over to the state. Any over-accruals, and any journal entries to correct the balances in these accounts will be very carefully scrutinized.
Fixed Assets. All changes in all categories of fixed assets will be reviewed in detail. Sales or other transfers of such assets out of these accounts will be reconciled to the sales tax return work sheets to insure proper reporting of the sales taxes. Additions to these accounts will be traced to the original purchase invoices or contracts to insure that the sales or use taxes were paid when the assets were purchased.
General Journal Entries. All general journal entries will be reviewed in detail to discover potential under-reporting of the sales or use taxes. Special interest will be given to transfers between subsidiaries and to transfers of inventory items to other accounts, particularly engineering or fixed asset accounts.
Sales Journals. Unusual or non-recurring transactions reflected in the sales journals, and in all of the journals, will be given careful review. In addition, the auditor will test the mechanical accuracy of the postings from original sales invoices to the journals and of the clerical accuracy of the journals themselves.
Sales Invoices. A statistical test of the sales invoices issued during the audit period (typically a three year period beginning approximately thirty-nine to forty-two months prior to the present) will then be chosen for detailed inspection. Depending upon the type and nature of the sales made, it is possible that multiple stratified tests will be necessary.
Resale Classification. Each invoice that purports to represent a sale for resale will be checked to determine whether or not it is supported by a properly completed and executed resale certificate. The relevant purchase orders will also be reviewed to insure that the purchaser did not designate that particular purchase as taxable.
Governmental Sales. Any sales to the U.S. Government or any of its instrumentalities must also be properly supported with complete documentation.
Inter-State Sales. Sales in inter-state commerce will be checked to insure that the shipping documents verify that the items purchased were in fact shipped out of the state of California via common carrier or other facilities of the seller. The property must be delivered outside of the state pursuant to the terms of the contract to qualify for the exemption.
Other Exemptions & Records. Any other exemptions claimed will also receive a detailed review to insure that the transaction was in fact exempt from the tax. In all areas of the audit, it is very, very important that complete and accurate records be maintained. The taxpayer is required to prove that a transaction is not subject to the tax. The auditor is granted a presumption that all sales are taxable, and it is the taxpayer's obligation to overcome that presumption.
Purchase Invoices. The auditor will also review a representative sample of the purchases made by the taxpayer during one or more of the years covered by the audit period. This review is intended to uncover instances in which property subject to the tax (that is, property not actually resold prior to use) was purchased without payment of the sales or use taxes.
California Vendors. Purchases of property subject to the tax from California vendors will be checked to insure that the taxpayer did not issue a resale certificate for the purchase in question. If such a certificate was issued, or if the property was shipped F.O.B. at an out of state location, the purchaser has accepted liability for payment of any use taxes due. If no resale certificate was issued, the auditor will prepare a report of that transaction which will then be filed in the seller's file for consideration when that seller is audited.
Out-of-State Vendors. Purchases of property subject to the tax from vendors located outside of the state will be checked to insure that either the taxes were paid to properly licensed out-of-state vendors or that the purchases were reflected on the sales and use tax worksheets for the proper period.
Inter-Department Transfers. If transfers of tangible personal property between divisions or departments are reflected by vouchers, these will also be reviewed for proper treatment.
Contracts Files. The contents of any material contracts will be reviewed, at least quickly, to determine whether or not there is any under-reported taxes connected with the transactions reflected in the contracts.
Correspondence Files. Similarly, the correspondence files will be reviewed to insure that no unreported transactions are indicated.
Federal and State Income Tax Returns. The taxpayer's income tax returns will also be reviewed to insure that there are no unreported transactions indicated.
Personnel Interviews. One of the most important areas of inquiry to be pursued by the auditor is the interview process. If given a free hand, the auditor will wander around the premises questioning any and all of the employees. Due to the very real danger that inaccurate and possibly misleading information may be passed to the auditor by such employees in a good-faith attempt to be helpful, it is strongly recommended that the auditor be accompanied by a sophisticated member of management at all such times.
Other Information. In general, the auditor will concern himself or herself with any type or kind of information source available within the business. Taxpayers are, of course, required to make relevant information available to the auditor, but care should be taken that the inquiry remains focused.
If the taxpayer does not agree with the results of the audit, there is a formal appeal procedure beginning with the auditor's immediate supervisor and proceeding through a series of hearings to a final hearing before the elected members of the State Board of Equalization. The format of each of the appeals hearings except that before the Board itself is very informal. There are no rules of evidence, and there is no formal record made of the proceedings. If all of these appeals are unsuccessful, the taxpayer must pay the taxes, interest and penalties assessed. A refund must then be claimed, and when denied, the taxpayer may file a lawsuit for the return of taxes said to have been over-paid.
Auditor in the field
The appeal begins with auditor relations. The auditor has great discretion re: scope of the investigation and application of the tax. Consequently, the taxpayer has the greatest opportunity to affect the course of the audit during this phase of the enquiry.
Auditor's supervisor in the field
Once the audit is completed and turned in, the auditor's supervisor will attempt to settle any disputes concerning mechanical aspects of the audit. The auditor's supervisor will contact the client within 1 to 2 weeks of the completion of the auditor's work in the field to attempt to resolve any disputes.
Office Hearing with the District Principal Auditor
The client will next receive a 10 day letter, also known as a 79A letter, stating that the District Principal Auditor must be contacted within 10 days of the date of the letter to arrange for an office hearing. The 79A letter will be sent within approximately 60 days of the discussion with the auditor's supervisor. The office hearing will be set within 2 months of the date the client contacts the district principal auditor.
There are no formalities required of the office hearing. No recorder is present and no rules of evidence apply. The taxpayer is asked to present his objections and his arguments. The district principal auditor takes notes and asks questions for clarification. There is no requirement that points and authorities be submitted, but I recommend it. The district principal auditor may miss some of your arguments as he furiously makes notes on his yellow pad.
Following the office hearing, the auditor may be sent back into the field to do additional work. Any additional work will begin within a few days of the office hearing. The district principal auditor may recommend no changes. In that case, the file is sent to Sacramento for billing. The determination will issue within about 2 weeks of the completion of the office hearing. In either case, the district principal auditor will prepare a report of office hearing that describes his understanding of the controversy and supports his findings and recommendations. Ask for a copy of that report. It is very helpful.
The client will next receive a report of determination of taxes due, together with a bill for the tax, interest, and any penalty that has been assessed. The determination states that it must either be paid or appealed within 30 days of the date of the billing. Failure to do either will generate an additional 10% failure to pay penalty. The petition for redetermination must be submitted within 30 days of the date of the determination notification.
The petition should state which of the assessed items the taxpayer objects to, and the grounds upon which the objection is made. Additional objections can be raised later.
Hearing Officer Hearing
A hearing with a hearing officer from Sacramento will be scheduled within 12 to 18 months of the date of the petition for redetermination. There are no formalities required of the hearing. No recorder is present and no rules of evidence apply. The taxpayer is asked to present his objections and his arguments. The hearing officer takes notes and asks questions for clarification. There is no requirement that points and authorities be submitted, but I recommend it. The auditor may be sent back into the field to do additional work following the hearing. Any additional work will begin within a few days of the hearing. The hearing officer may recommend no changes. In that case, a notice of redetermination is sent with no changes recommended.
The determination will issue within about 10 weeks of the completion of the hearing. In either case, the hearing officer will prepare a report of his findings that describes his understanding of the controversy and supports his findings and recommendations.
The client will be given a copy of that report.
Board of Equalization Hearing
The client will receive a notice of redetermination following the completion of any additional field work. A petition for a hearing before the Board of Equalization must be submitted within 30 days of the date of the notice of redetermination. The hearing will be scheduled before the Board within about a year. If a transcript is desired, it must be requested before the hearing. Once again, no rules of evidence govern. The Board's lawyer will first summarize the controversy and the auditor's position, then the client is allowed to make his argument directly to the Board. He can call and swear witnesses, and he can offer additional evidence. The decision of the Board will rarely be made from the bench. It is usual for the matter to be taken under advisement. A decision will usually issue within 90 days of the hearing.
The client will receive yet another notice of redetermination which must be paid within 30 days of issuance to avoid the 10% failure to pay penalty. Once the assessment is paid, a claim for refund must be made by the later: of 6 months of the date paid, or 6 months of the last day to pay the determination, or 3 years of the due date of the relevant tax return.
The Board must either grant or deny the claim for refund, or it is deemed denied upon the expiration of 6 months from the date of the claim.
A suit for refund of the tax must be filed within 90 days of the date upon which the claim is either denied or deemed denied. File in any county in which the Attorney General has an office. Regular rules of evidence apply, but the case must be tried to a judge, without a jury, and the lawsuit is limited to those matters included in the claim for refund as submitted to the Board.
The sales and use tax law continues to be a little-known area of California taxation. It seems to be considered in a similar light as property taxes: merely an occasional annoyance. Unfortunately, it is very expensive to learn the finer points of this taxation scheme at the hands of an auditor. A careful review of operations and a detailed analysis of planning opportunities available prior to structuring unusual or non recurring transactions will usually result in non-taxable options.