Sales Tax Audit! A word to the wise...

Wow!  I have to tell this story in case it can help any of you avoid trouble with sales tax.

A few months back I got a call from an auditor at the State Board of Equalization (California's state tax authority).  She said I was randomly selected for a tax audit and asked if I could schedule them in for a meeting.

Two auditors were at my door a few days later for our scheduled meeting.  There was a supervisor and a new tax auditor who chose me as the lucky one to do her first (or near first) tax audit.  Lucky me.

We sat down in my living room and the supervisor made it very clear that they would try to take as little of my time as possible and would try to keep the audit short and painless as long as everything I told them and showed them proved to be in line with the sales tax laws.

After about a half hour of questions from the supervisor I seemed to have proven that I understand exactly how I should be handling sales tax because he told me that he was impressed and that most photographers he's interviewed don't know as much as I did about the tax laws.  

I took some accounting and tax classes at CSUF and read the pamphlet that the State Board mailed out to me when I started my business in hopes I could avoid any mistakes and crazy penalties and interest.  My motto was always that I want to keep the money I make and not have to constantly look over my shoulder.  I decided early on that I would be completely honest about everything I do in my business, including the way I handled reporting income for taxes.  I claim every penny that comes through my studio including cash receipts and keep very accurate records.  So I thought...

After opening up my books to the auditors (e.g. bank statements, financial statements, tax returns, e-commerce receipts, shipping receipts, contracts, you name it) they were so quick to find discrepancies that were extremely shocking.  At one point, the auditor told me that I showed almost $300K in extra revenue that was not claimed in a particular audit period.  I couldn't help but laugh... and then I kinda got offended.  I said something like "Yeah right... I'm hiding $300K from you... what a joke!... You are joking right?"

It turns out I had made a big mistake... or actually Quickbooks (which I relied on heavily) had lead me astray and did not include all of my revenue in my sales tax liability report (which I was stupid enough to trust without reconciling it to my bank statements).

I had started fresh with a new company file in Quickbooks at the beginning of 2004 to try to re-organizing some accounts and invoice items to help my accountant out and the opening balances for some clients did not get marked as taxable income but were left in an unknown revenue account that didn't show up in my sales tax liability report.  

It wasn't $300K though... more like $40K... the remaining $240K turned out to be balance transfers to and from business savings accounts I had set aside for paying taxes.  The auditors were adding all deposits going into my business checking, disregarding that some were not actual revenue but simply transfers back into my checking account when it came time to pay bills.  They would have charged me tax on that amount if I couldn't furnish proof (savings account statements were proof enough) that they were transfers.  Crazy!  

Also I had a large number of out-of-state sales made up of my destination weddings, products sold to my out-of-state brides, and DVDs sold to out-of-state photographers.  They wanted proof that these were indeed out-of-state sales.  My online booking system and e-store did not qualify as proof even when I showed out-of-state shipping address and billing addresses in the system.  They wanted actual shipping labels and receipts from couriers like USPS, FedEx, and UPS.  They also wanted to call every bride and photographer who have paid me in the last 3 years to verify that they were out-of-state.  Thank God they settled for a third party report from Authorize.Net that verified these out-of-state sales!

They proceeded to move on to my non-taxable sales which "seemed extremely high considering I'm a wedding photographer who shouldn't have many sales that qualify as non-taxable.  Most of my non-taxable sales were made up of income from lectures, workshops, and endorsements.  They wanted proof that I was doing lectures and seminars so I had to show them contracts and even dig up press including screenshots of online promotional material, printed brochures, and magazine articles. 

This whole thing has been a learning experience!  Here are some key things I highly recommend you put into practice:

1.  Double and triple check your sales tax returns and reconcile them against your actual bank deposits before sending them off to your state tax authority

2.  Know your tax laws and make sure you are properly charging your clients.  I know many photographers who think they only need to charge tax on the "service" portion of their wedding photography package.  In California, the entire package is taxable.  Don't get stuck paying for sales tax that you should have charged your client!

3.  Keep extremely detailed records of all non-taxable and out-of-state transactions.  You may need tangible proof if you are ever audited.  This includes scans of shipping receipts and out-of-state checks.  A digital record in quickbooks is not enough.  The auditors won't even get close enough to look at your quickbooks because they don't want to be blamed for altering numbers or reports.

4.  Keep at least 3 years of bank statements, credit card statements, contracts, tax returns, and any other legal documents that provide information that you will need in the event of an audit.

5.  Be honest.  I can't tell you what a great feeling it is to be able to clearly explain and show proof of honest behavior in my tax reporting.  Auditors will see right through any lies.. that's what they're trained to do.  I know dozens of photographers who would be in big trouble if they were ever selected for an audit.

As for me... I have a final meeting with the auditors this Friday at 10am.  I'll be presenting my explanations and supporting documentation for the bank deposits discrepancies they were questioning.  According to my findings I owe about $3500 give or take in sales taxes I missed from my Quickbooks screw-up plus any interest and penalties which I'm hoping won't be astronomical.

Hope this helps someone out there!  As business owners we really have a lot to think about and a lot of hats to wear including the hat of a bookkeeper, accountant, and tax attorney.  Even if you hire these jobs out (and pay an arm and a leg), you still need to have a good understanding of them all if you want to make sure your practices will hold up in an audit.  It's not easy doing what we do!  It took me about a million and a half baby steps to get this far... but it's finally paying off!  Don't get discouraged!