CDTFA Tax Audit of a Used Car Dealership

CDTFA Sales Tax Audit of a Used Car Dealership:

The California Department of Tax and Fee Administration (CDTFA) oversees the collection of sales and use taxes in California related to used car dealerships. Used car dealerships are subject to unique scrutiny due to the complexity of their transactions, which involve retail sales, out of state sales and purchases, trade-ins, repossessions, and interactions with the Department of Motor Vehicles (DMV) and auto auction companies. A CDTFA sales tax audit can create a perilous tax situation for used car dealers particularly when discrepancies arise between reported sales tax returns and external data sources.

Understanding the CDTFA Tax Audit Process

The CDTFA is responsible for administering California’s sales and use tax laws, which apply to all retail sales of tangible personal property, including vehicles sold by used car dealerships. Sales tax is imposed on the retail sale of vehicles, while use tax applies to vehicles purchased for use in California without paying sales tax (e.g., out-of-state purchases). Used car dealerships are required to register with the CDTFA, obtain a seller’s permit, and file regular sales and use tax returns, reporting taxable sales and remitting the appropriate tax.

A CDTFA tax audit is initiated to verify the accuracy of a dealership’s reported sales and tax payments. Sales tax audits are often triggered by red flags, such as:

• Discrepancies between sales reported to the CDTFA and those recorded by the DMV.
• Sudden changes in sales volume, such as significant increases or decreases, which may indicate underreporting or errors.
• Used car dealership as profiled by the CDTFA have historical under-reporting sales data which have resulted in increased scrutiny by the CDTFA.

The sales tax audit process for used car dealerships typically cover a three-year period, though it may extend to eight years if fraud or significant underreporting is suspected. The goal is to ensure that all taxable transactions are accurately reported and that the correct amount of tax has been paid.

Key Data Sources in a CDTFA Audit

The CDTFA relies on multiple data sources to verify the accuracy of a dealership’s sales tax returns. The two primary external sources are the DMV and numerous auto auction companies, which provide critical information about vehicle sales and inventory. Below, we explore how these sources are used and reconciled with the dealership’s reported data.

1. Department of Motor Vehicles (DMV) Data

The DMV plays a pivotal role in CDTFA audits because it maintains detailed records of vehicle sales and registrations. Since January 1, 2021, under Assembly Bills 85 and 82, most used car dealers are required to pay sales tax directly to the DMV at the time of vehicle registration, rather than remitting it to the CDTFA with their sales tax returns. This change has increased the DMV’s role in tax compliance.

DMV Data Used in Audits:

• Report of Sale (ROS): Dealers submit a Report of Sale to the DMV for each retail vehicle sale, including the vehicle identification number (VIN), selling price, and sales tax paid. The CDTFA cross-references these records with the dealership’s sales tax returns to ensure consistency.
• Vehicle Registration Records: The DMV tracks the registration of vehicles, including the taxable sales price and any tax exemptions claimed (e.g., for out-of-state use).
• Dealer License Information: The CDTFA verifies the dealer’s license number and ensures that all sales are reported accurately.

How the CDTFA Uses DMV Data: The CDTFA compares the sales prices and tax amounts reported to the DMV with those reported on the dealership’s sales tax returns. Discrepancies, such as underreported sales or mismatched tax payments, can trigger further scrutiny. For example, let’s say a fictional company Socal Best Auto reports total sales to CDTFA for 1.5 million but CDTFA obtains records from DMV showing 3.8m, the CDTFA identified a $2.3 million discrepancy between the dealership’s reported sales ($1.5 million) and the DMV’s records ($3.8 million). The discrepancy would be a major red flag resulting in CDTFA Sales Tax Audit.

2. Auto Auction Companies

Auto auction companies, such as Manheim or Copart, are another critical data source. These companies provide records of vehicles purchased by dealers, which the CDTFA uses to track inventory and verify sales.

Auction Data Used in Audits:

• Purchase Records: Auction companies provide details of vehicles purchased by the dealership, including VINs, purchase prices, and dates.
• Wholesale Transactions: Since January 1, 2021, used vehicle auction houses must report detailed wholesale transaction information to the CDTFA, including VINs and selling prices.
• Resale Certificates: Dealers purchasing vehicles for resale must provide a resale certificate to avoid paying sales tax at the auction. The CDTFA verifies that these vehicles were subsequently sold at retail and that the appropriate sales tax was reported.

How the CDTFA Uses Auction Data: The CDTFA uses auction data to reconstruct the dealership’s inventory and sales activity. By comparing auction purchase records with DMV sales records and the dealership’s tax returns, auditors can identify unreported sales or instances where vehicles were sold without remitting sales tax. For example, if a dealer purchases a vehicle at auction but does not report a corresponding retail sale, the CDTFA may assume the vehicle was sold and tax is owed, unless the dealer provides evidence to the contrary (e.g., repossession or return).

3. Dealership Records

The CDTFA requests a variety of internal records from the dealership to verify reported sales and tax payments. These include:

• Deal Jackets: Detailed records for each vehicle sale, including contracts, invoices, financing agreements, and proof of tax payment.
• General Ledgers and Bank Statements: To verify cash flow and reconcile sales with deposits.
• Federal Income Tax Returns: To compare reported income with sales tax returns.
• Inventory Records: To track vehicles from purchase (e.g., at auction or via trade-in) to sale.
• Sales Tax Returns: To ensure all taxable transactions, including documentation fees and mandatory warranties, are reported.

Poor record-keeping is a common issue for used car dealers, particularly independent dealerships. The CDTFA expects dealers to maintain detailed records for at least four years (or eight years for certain exemptions). Failure to provide adequate documentation can lead to assumptions of non-compliance and additional tax assessments.

Reconciliation Process

The CDTFA’s reconciliation process involves cross-referencing data from the DMV, auto auction companies, and the dealership’s records to ensure that all taxable sales are accurately reported. The process can be broken down into the following steps:

1. Data Collection:
   • The CDTFA requests sales tax returns, deal jackets, bank statements, and other records from the dealership.
   • DMV data is obtained, including ROS records and registration details.
   • Auction data is collected to track vehicle purchases and inventory.
2. Comparison of Sales Data:
   • The CDTFA compares the total sales reported on the dealership’s tax returns (Line 1 of the CDTFA-401 form) with the sales reported to the DMV.
   • For example, if a dealership reports $1 million in sales to the CDTFA but the DMV records show $1.5 million in sales, the CDTFA will investigate the $500,000 discrepancy.
3. Inventory Reconciliation:
   • Using auction purchase records and DMV sales data, the CDTFA reconstructs the dealership’s inventory to ensure all purchased vehicles are accounted for (e.g., sold, repossessed, or held in inventory).
   • Unreported sales or vehicles that “disappear” from inventory without documentation may be treated as taxable sales.
4. Verification of Tax Payments:
   • The CDTFA verifies that sales tax paid to the DMV matches the amounts reported on the tax return. Since July 1, 2024, dealers paying tax to the DMV file quarterly returns with the CDTFA, while others file monthly.
   • Additional taxable charges, such as documentation fees or mandatory warranties, must be reported to the CDTFA, as these are not included in DMV tax payments.
5. Assessment of Discrepancies:
   • If discrepancies are found, the CDTFA may issue a Notice of Determination, outlining the additional tax, penalties, and interest owed. Dealers have 30 days to file a Petition for Redetermination to dispute the findings.

Table 1: Key Data Sources and Their Role in CDTFA Audits

Common Audit Issues for Used Car Dealerships

Used car dealerships face several challenges during CDTFA audits, often due to the complexity of their transactions and the scrutiny from multiple agencies. Below are some common issues and how they are addressed:

1. Unreported or Underreported Sales

• Issue: Dealers may fail to report all retail sales, either intentionally or due to poor record-keeping.
• CDTFA Response: The CDTFA assumes unreported sales are taxable unless the dealer provides evidence (e.g., proof of a refund or repossession). Auditors may use DMV data to estimate taxable sales.

2. Improper Handling of Unwinds and Repossessions

• Issue: An “unwind” occurs when a sale is canceled, and the vehicle is returned to the dealer. A “repossession” occurs when a financed vehicle is reclaimed due to non-payment. Repossessions do not negate sales tax, but dealers may attempt to treat them as unwinds to avoid tax liability.
• CDTFA Response: Auditors assume repossessions are taxable unless the dealer proves all payments were refunded. Dealers can claim a bad debt credit on federal returns for repossessed vehicles, but this requires documentation.
• Solution: Clearly document unwinds with refund receipts and repossession agreements. File for bad debt credits when applicable.

3. Overcharging or Undercharging Sales Tax

• Issue: Dealers may charge the wrong tax rate due to incorrect customer address data or miscalculate tax on the selling price. Overcharged tax must be refunded to the customer or remitted to the CDTFA, while undercharged tax results in a liability for the dealer.
• CDTFA Response: Auditors use DMV data to verify the tax rate applied based on the customer’s address. Overcharges or undercharges can lead to penalties.

4. Trade-Ins and Discounts

• Issue: Trade-ins and discounts must be clearly documented to avoid tax liability on the full sales price. If a trade-in is valued above fair market value, the excess is not deductible unless documented as a discount.
• CDTFA Response: Auditors review deal jackets to ensure trade-in values and discounts are properly recorded. Undocumented discounts may be treated as taxable.

Chart 1: Common Audit Issues and Their Impact

KEY FOCUS AREAS FOR CDTFA DURING A USED CAR DEALER TAX AUDIT

The CDTFA uses multiple sources to verify reported sales tax:

1. DMV Data:
   • Report of Sale (ROS): Includes VIN, selling price, and tax paid, cross-checked with CDTFA returns.
   • Registration Records: Verifies taxable sales and exemptions.
   • Example: In Eddie’s Auto World, a $2.3M discrepancy between DMV ($3.8M) and CDTFA ($1.5M) sales led to penalties due to poor documentation.
2. Auto Auction Data:
   • Tracks vehicle purchases (VINs, prices) to reconstruct inventory.
   • Verifies resale certificates for wholesale purchases.
   • Ensures retail sales are reported with tax.
3. Dealership Records:
   • Deal jackets, ledgers, bank statements, and tax returns verify sales and tax payments.
   • Poor records can lead to assumed taxable sales.

Reconciliation Steps:

1. Collect dealership records, DMV ROS, and auction data.
2. Compare sales reported to CDTFA (Line 1) with DMV records.
3. Reconstruct inventory to ensure all vehicles are accounted for.
4. Verify tax payments to DMV and CDTFA.
5. Issue assessments for discrepancies.

Common Used Car Dealer Sales Tax Audit Issues

1. Unreported Sales: Discrepancies between DMV and CDTFA data can lead to assessments.
2. Unwinds vs. Repossessions: Repossessions are taxable unless documented as refunds.
3. Incorrect Tax Rates: Over/undercharging tax based on customer address.
4. Trade-Ins/Discounts: Must be documented to avoid tax on full price.

Contac Us

A CDTFA tax audit of a used car dealership involves rigorous data reconciliation from the DMV, auto auctions, and dealership records. Discrepancies can result in significant liabilities. Contact us to discuss your case if you have been selected for CDTFA tax audit.