CDTFA Sales Tax Audit of Grocery Stores

Grocery stores in California have to operate in a tax environment with changing allocation of taxable and nontaxable sales items due to constant changes in California’s sales and use tax regulations. The California Department of Tax and Fee Administration (CDTFA) sales tax audits of grocery stores tend to focus on the proper categorization of taxable and non-taxable items as it relates to reporting and remittance of sales tax. In addition, California grocery stores with high transaction volumes and reliance on point-of-sale (POS) systems are subject to regular spot checks by the CDTFA to verify that the grocer’s internal systems are properly aligned with CDTFA sales tax codes.

Scope of CDTFA Sales Tax Audits

The CDTFA audits businesses to verify compliance with California’s sales and use tax laws. For grocery stores in California, audits are onerous and intricate due to the mix of taxable and exempt items, high transaction volumes, and reliance on point-of-sale (POS) systems. The CDTFA requires that grocery stores must correctly categorize sales, maintain detailed records, and address issues like cold food exemptions, discounts, and vending machine sales. These requirements can be very foreign and difficult to manage for family run grocery stores with limited resources.

Why are Grocery stores frequent tax audit targets:

• High Sales Volume: Large transaction volumes increase the risk of errors in tax reporting.
• Mixed Taxability: Food items are generally exempt, but prepared foods, nonfood items, and certain beverages are taxable, creating complexity.
• Cash Transactions: Cash-heavy operations may raise red flags for underreporting.
• Industry-Specific Risks: The CDTFA targets industries with known compliance issues, and grocery stores’ unique tax rules make them a focus.
• Due to high level of non-english speaker owners of grocery stores, CDTFA may consider them to be easier targets

Common triggers for sales tax audit:

• Significant deviations from industry averages in taxable-to-nontaxable sales ratios.
• Underreported sales compared to purchase records or bank deposits.
• Failure to remit use tax on taxable purchases (e.g., equipment or supplies).
• Prior audit history with unresolved issues.
• Tips or complaints from employees, customers, or competitors.

Key Areas of Focus in a CDTFA Grocery Store Audit

CDTFA auditors examine specific areas to ensure compliance.

1. Taxable vs. Nontaxable Sales: Grocery stores sell a mix of exempt and taxable items.

• Exempt Items: Most cold food products for home consumption (e.g., bread, milk, vegetables) are nontaxable, except when sold as part of a taxable transaction (e.g., hot prepared foods).
• Taxable Items: Hot foods, prepared foods (e.g., hot deli sandwiches), nonfood items (e.g., cleaning supplies, cosmetics), and certain beverages (e.g., soda, alcoholic drinks) are taxable.
• Combination Sales: Items sold together (e.g., a sandwich with a taxable soda) may require tax allocation based on the taxable portion.

Audit Focus: Auditors verify that POS systems correctly categorize items. Errors in programming (e.g., taxing exempt items or exempting taxable ones) are common issues.

2. Recordkeeping and Documentation

Generally CDTFA recommends maintaining accurate records for at least four years (or longer if an audit is pending). CDTFA Auditors usually request the following:

• Sales records (e.g., POS reports, cash register tapes, daily sales summaries).
• Purchase invoices for inventory and supplies.
• Exemption certificates for nontaxable sales (e.g., resale certificates).
• Bank statements and deposit records to verify reported sales.
• Tax returns and worksheets.

Audit Focus: Auditors compare reported sales to purchase records of inventory, bank deposits, and physical inventory. Discrepancies (e.g., higher purchases than sales) may suggest underreporting.

3. Prepared Foods and Hot Foods

Prepared foods are a significant audit focus due to their taxability.

• Hot Foods: Foods sold hot (e.g., rotisserie chicken, pizza) are taxable, regardless of whether consumed on-site.
• Prepared Foods: Cold prepared foods (e.g., salads, sushi) are taxable if intended for immediate consumption.
• Bakery Items: Bakery goods are nontaxable if sold cold and not for immediate consumption, but hot bakery items are taxable.

CDTFA Audit Focus: Auditors check whether stores correctly tax hot and prepared foods. Errors often arise from inconsistent definitions of “hot” or “prepared.”

4. Discounts, Coupons, Promotions.

Manufacturer Coupons: Tax is based on the full price before the coupon discount.

• Store Coupons/Discounts: Tax is based on the discounted price paid by the customer.
• Buy-One-Get-One (BOGO) Offers: Tax applies to the amount paid, prorated across taxable items.

Audit Focus: Auditors verify that discounts are correctly applied and documented. Errors in POS programming can lead to over- or under-taxation.

5. Vending Machines and Self-Service Areas

Vending machine sales are taxable unless selling exempt items (e.g., milk). Grocery stores with vending machines must track and report these sales separately.

Audit Focus: Auditors check for unreported vending machine revenue or failure to tax sales.

What to do when you receive CDTFA Tax Audit Letter:

Conduct an Internal Tax Review

• Sales Tax Compliance: Verify that POS systems correctly categorize taxable and nontaxable items. Test transactions to identify errors.
• Recordkeeping: Ensure all required records are organized and accessible. Digitize paper records for efficiency.
• Tax Ratios: Compare taxable-to-nontaxable sales ratios to industry norms. Significant deviations may trigger further scrutiny.
• Acknowledge the audit notice and provide requested documents on time.
• Avoid volunteering unsolicited information that could expand the audit.

Post-Audit Considerations

After the audit, the CDTFA issues a report detailing findings. Possible outcomes include:

• No Adjustments: Compliance is verified, and no further action is needed.
• Additional Tax Liability: The auditor identifies underreported tax, plus interest and penalties.
• Refund Opportunity: Overpaid taxes may be refunded if documented.

Appealing Audit Findings

If you disagree with the assessment:

1. Request an Informal Review: Discuss findings with the auditor or supervisor.
2. File a Formal Appeal: Submit a written appeal to the CDTFA’s Office of Appeals within 30 days.
3. Seek Legal Counsel: A tax attorney can strengthen your case, especially for significant liabilities.

CDTFA sales tax audits of grocery stores creates high level of stress and uncertainty because many of these stores are operated by immigrant families unfamiliar with American legal system. You can consult with a tax lawyer to get proper guidance if you have received CDTFA tax audit letter.