California is currently initiating numerous sales tax audits of businesses located outside California: Last fall, more than 2,500 online retailers with out-of-state addresses received letters from California’s Department of Tax and Fee Administration informing them that they appeared to owe [California] sales tax.”[1]

The California Department of Tax and Fee Administration has an audit division exclusively devoted to conducting sales tax audits of out-of-state business.  The 2018 U.S. Supreme Court decision (South Dakota vs. Wayfair, Inc.)[2] will only embolden future out-of-state audit activity.  It is imperative that all out-of-state businesses with a significant volume of sales to California purchasers should assess audit exposure and employ strategies to minimize audit exposure.

1) Conduct An Audit Risk Analysis.

An analysis of current audit risks associated with the current business activities of the out-of-state business should be conducted. The California Tax law that applies to out-of-state businesses is fairly complicated and contains very precise language that can represent clear avoidable audit exposure. For example, the California sales tax statute specifically indicates that physical presence at a trade show for more that 15 days for any 12 month period will result in that business being liable to pay sales tax on all sales to California.[3] A business with even a fairly few employees traveling to Los Angeles could represent exposure to that business for having to pay sales tax on all California related sales even if the business is exclusively located outside California.

2) Formulate Audit Risk Minimization Strategies.

Once the issues of audit risk are identified, strategies to minimize the risks and/or impact of an out-of-state audit can be determined. In the above example, if the business has employees, agents and owners traveling to Los Angeles or other California locations for trade shows, a policy to limit the number of future trades show days could be employed. In addition, an analysis of all traveling activities and the preservation of documentary evidence substantiating the non-tax nature of the traveling should be considered. Certain entity structuring strategies could also be employed to minimize risks.

3) Consider California’s Voluntary Compliance Program.

California sales tax agency currently has a Voluntary Compliance Program that is available.[4] If an out-of-state business qualifies for the program, the business can avoid late filing and late payment penalties. It also can limit the time that California can assess overdue taxes to three years. It is important to know that the process can be conducted anonymously to protect the business in the event that the business does not qualify for the program.

4) Do Not Respond to any Questionnaires and Participate in Telephone Interviews.

Most importantly, we recommend that none of the employees, owners, accountants or any other fact witnesses related to the business respond to any written questionnaires or telephone interviews from any representatives of the California taxing  agencies.

We have seen numerous instances where a California sales tax audit could have been avoided. Consider the following scenario: an out-of-state manufacturing company receives a seemingly simple letter requesting that the company completes a questionnaire regarding activities with the state of California. The business assigns the response of the letter to the company’s payable clerk who manages the filing and payment of local sales taxes. The clerks fails to recognize what facts would cause the company to have a tax liability. The clerk inadvertently responds in a disadvantageous way. Then, the company’s accountant participates in a telephone interview. During the telephone interview, the accountant also inadvertently fails to recognize what facts would cause a tax liability. The accountant makes statements that further support the auditor’s determination that all the manufacturer’s sales to California are subject to sales tax.

While the business may ultimately win, it may cost the business a time consuming and costly appeal to resolve. In addition, a sales tax audit can also generate other tax audits by other taxing agencies such as a Los Angeles City Business Tax Audit or Federal income tax audit. Furthermore, it is very difficult to overcome the damage caused by an erroneous statement of fact made by an employee in the course of an audit.

Do not let this scenario happen to your business.  Get skilled legal advice to respond at the earliest time possible and avoid voluntarily giving a taxing agency access to facts, witnesses and documents which can hurt your business.

Author, David C. Holtz. David is a principal and former IRS Attorney with Holtz, Slavett & Drabkin, ALC. If you have any questions regarding the above article, then please feel free to contact him at (310) 550-6200.

[1] The Sacramento Bee, Online sales tax ruling could bring ‘hundreds of millions of dollars’ to California, July 2, 2018.

[2] 17 U.S. 494 (2018);

[3] California Revenue Code Section 6203;