I can still remember my fiance's reaction when I totaled her new Mazda 626 with leather and sunroof. She loved that car. She insisted on driving all the time. And no, I didn't mind since I was driving my grandmothers tan Ford Tempo with no first gear.
Just like my fiancé, our client's stunned expression must have quickly turned to anger, followed by a rash of "What the heck happened!" (Although much more colorfully! I can still hear it just like it was yesterday). But, I was blinded by love as I ventured to a jewelry broker in a strange town to look for discount wedding bands. We were told it was the place to do business, strangely similar to why our client ventured into a new state looking for easy gold.
I made a blind turn onto a busy street ignoring the local law permitting a left turn on green arrow only. Ignorance to the law didn't save me in the crash nor our client regarding nexus in CA. My fiance even warned not to go, but... I'm a man! I can make it. Besides, I've seen the Mazda commercials, this baby's got plenty of power. I put the pedal to the floor, the car lurched forward, followed quickly by a screech of tires, the smashing of glass and the deflating of an ego!
CA Sales Tax Audit is Even Worse than Totaling a Car
Wrecking a car is bad enough. But getting slammed by a sales tax audit is even worse. As shocked as my bride-to-be was at seeing her beloved car totaled, it doesn't compare really to what our client experienced in an unexpected CA sales tax audit assessment well into six figures.
The cause of the problem in both instances was identical... turning into on coming traffic (i.e. the CA Dept. of Equalization Steamroller).
Our unsuspecting client, a software developer, was not registered in CA because they did not have any physical locations or employees in the State. The software they make is not off-the-shelf software you buy in a retail store and install yourself. They create a sophisticated software that is installed by their own technicians so that it integrates into existing systems and is customized as necessary.
They didn't realize that whenever you have contractors or employees who travel into another state to perform taxable services, nexus is generally created. In this case, our client traveled to several different states where the installation, maintenance and/or training of employees are taxable services. This is how they were initially discovered. One state audited our client’s customer and knew immediately that our client had nexus when they saw invoices for expenses (including travel to their customer’s site to install and to train employees) where no tax was collected. It was an easy find sitting right there in the customer’s fixed asset records. The state then sent a questionnaire to our client who confirmed their activities, which they previously thought were not taxable.
A couple of weeks later, our client received a notification of audit stating that their activities constituted nexus and requested tax returns going back seven* years. They received an initial assessment of over $300,000* prompting them to contact us to verify the state’s position and offer suggestions. Although we were able to find significant reductions, they were still left paying a lot of tax they could have collected at the time of the sale from their customer had they been registered and collecting the tax.
The Good News: I may have totaled her car, but there was a silver lining: I'm a great catch! And, the fact that I turned in the rattletrap Tempo for a Toyota 4x4 may have helped a little too, I'm sure. As for her and I? 15 years still happily married.
As for our client, we got them a 50% reduction of the assessment, handled their registration and now help them with compliance issues as needed.
In this case and in life, an ounce of prevention is always the best cure. For our client, understanding the taxability of sales made into new states and the knowing the obligation of collecting tax from the beginning would have avoided the problem. Letting it go seven years only compounded the liability. Fortunately they hadn’t gone 10 years before being discovered.
*Note: Upon registering your company, most states have laws allowing them to audit your company back to day one, because if you don't file returns, there is no statute of limitations. They can also add up to 50% penalty and compounded interest.