The use of a credit card test has become an increasingly popular audit methodology employed by the California Department of Tax and Fee Administration’s (CDTFA) audit staff. It used to be primarily utilized to estimate sales for restaurant and bar establishments but we are finding that the use of this test is becoming more prevalent in other industries as well.
The increased use of this methodology is for good reason. When preformed correctly, the test can produce a very accurate computation of a business’ gross receipts. The key to performing the test correctly, as with others, is making certain that the variables used within it are accurate. Failure to establish accurate variables, which occurs often, can lead to wildly inaccurate results. If taxpayers are unaware of how a credit card test works, they may fail to recognize errors that cause dramatically overstated tax liabilities.
In summary, the test is conducted by first establishing an average percentage of credit card sales transacted by the business. That percentage is then applied to the total credit card sales that were transacted by the business during the audit period to compute audited gross receipts.
Example: a business generates roughly 75% of its sales through credit card receipts and they have roughly $10 million in credit card sales transacted during the audit period. The $10 million in deposits is divided by the 75% credit card sales percentage to estimate gross receipts of $13.3 million for the audit period.
In the forgoing example, if 70% or 80% is used instead of 75%, the audit results fluctuate dramatically. This is why it is imperative that an accurate estimate of credit card sales be established for use in this test. Further, please keep in mind that the audit staff can generally obtain a 1099k directly from a merchant processor, without involvement from the business owner, which provides them with the credit card sales that were transacted by the business during the period of review. Because of this, we’ve seen an increased use of this test by the audit staff in estimating the taxable sales of a business. At times this review is even completed prior to the taxpayer being notified that they have been selected for audit.
Another variable that significantly impacts the outcome of the test are exempt sales. If a restaurant has sales for resale or cold food sold on a to-go basis, those exempt sales must be properly considered in the test in order to reach an accurate result.
In our experience, the audit staff is quick to estimate these variables, and in their haste, they end up utilizing percentages that are not representative of the businesses they are auditing. Factors such as the day of the week on which the observation is performed and failing to recognize natural fluctuations of percentages on a day-to-day basis can both have a material effect on the outcome of this test. That’s why it’s imperative that business owners understand this audit methodology and how the variables used within the test are established by the audit staff before the audit is billed. If you are confused or concerned by the audit staff’s use of this test in your audit, please contact us for a free consultation.
