Automotive repair businesses are frequently targeted for sales and use tax audits by the California Department of Tax and Fee Administration (CDFTA). The audit of an automotive repair business can present challenges for auditors as they may not be familiar with the business practices of many automotive repair businesses. This can lead to misunderstandings and a misapplication of common audit procedures that are used to verify that sales tax was correctly reported. An auditor’s lack of understanding of how an automotive repair business maintains its records and reports its sales tax obligation can often lead to significant frustrations for business owners and large, overstated audit liabilities.
One of the most common audit procedures utilized by the CDTFA is to evaluate the ratio of taxable sales to the cost of goods sold reported on a business’s federal income tax returns, also known as “the markup of a business.” In summary, the auditor compares the overall markup to the markup on a few individual parts by performing what is referred to as a “shelf test.” If the markup shown in the shelf test is higher than the markup that is shown in the recorded and reported summary amounts, the audit staff will generally assert that taxable sales are understated and issue an assessment.
Notwithstanding its inherent flaws, the markup approach is a commonly recognized audit procedure and it can be an accurate means of computing taxable sales if done properly. Unfortunately, auditors frequently do not understand the caveats of an automotive repair business and misapply the audit technique to the detriment of the business. One of the most common mistakes that an auditor makes is that they fail to understand that the markup on parts varies dramatically from one part to the other, based on a number of different factors. For example, generally the markup on a transmission is significantly less than the markup on an oil filter. If the auditor does not account for these differences in his or her computations, the audited sales may be significantly overstated.
Another common erroneous assumption that auditors make is that the cost of goods sold reported on the federal income tax returns only contains the actual cost of goods sold, i.e., auto parts. Oftentimes, a business will commingle other expenses that are not technically costs of goods sold because for income tax return purposes, the result is generally the same if an item is treated as part of cost of goods sold or as a line-item expense. In the context of a CDTFA markup analysis, however, the result is that audited sales maybe significantly overstated if non-part costs are not accounted for by the auditor. When an auditor does not account for oversights made in reporting cost of goods sold for income tax purposes in a sales and use tax audit, it can lead to a frustrating, costly and time-consuming experience for a business.
If you are currently undergoing an audit and need some advice on how to discuss these issues with the auditor, please feel free to contact us at firstname.lastname@example.org or at 855-995-6789 to receive a free consultation to see how we may be able to assist you. Our firm has helped dozens of automotive repair businesses work through these sorts of issues with the CDTFA audit staff.