CDTFA Audit: What Interior Designers Need To Know About California Sales Tax Audits

Picture this: You’re in your studio, sipping your morning coffee, scrolling through your inbox when suddenly, there it is. A formal letter from the California Department of Tax and Fee Administration (CDTFA). Your heart sinks as you read that your business has been selected for a sales tax audit.

First, take a deep breath. This isn’t the end of the world, or your business.

As an interior designer or creative professional in California, a CDTFA audit might feel particularly daunting. The complex nature of our industry, where we’re providing both design services and tangible products, creates a unique sales tax landscape that can be tricky to manage.

That’s why I’m breaking down everything you need to know about CDTFA audits. By the end of this guide, you’ll have a clear understanding of what to expect and how to prepare, so you can face your audit with confidence.

WHAT IS A CDTFA AUDIT?

The CDTFA is California’s agency for administering sales and use tax laws. A CDTFA audit is their way of making sure your business has correctly reported and paid sales and use taxes. For interior designers, this process can be especially complex because our work often involves both non-taxable services and taxable products.

Why Might You Be Audited?

Being selected for a CDTFA audit doesn’t mean you’ve done anything wrong. Common triggers include:

• Random selection: Sometimes, it’s just your turn.
• Industry targeting: Interior design is often targeted due to historical tax reporting issues.
• Unusual patterns: Sudden changes or inconsistencies in your reported sales.
• Third-party information: Data from suppliers or clients.
• Prior audit history: Previous discrepancies can prompt follow-ups.

If you use platforms like Houzz Pro, remember that your digital records can help you stay organized-but they also provide a detailed trail for auditors to review. to review.

The Purpose of a CDTFA Audit

The CDTFA audit program aims to:

• Make sure businesses pay the correct sales and use tax.
• Deter tax evasion.
• Educate business owners on tax law compliance.

The CDTFA isn’t just looking for mistakes, they want to help you understand your obligations so you can avoid future problems.

WHAT TO EXPECT

Understanding the audit process timeline helps remove the mystery and reduces stress when facing a CDTFA review. Here’s a step-by-step breakdown of what happens from initial contact through conclusion, so you can prepare accordingly.

1. Initial Contact

The process begins with a phone call or letter explaining why you were selected and what happens next. You’ll receive:

• A list of required documents.
• Publications to help you understand the process.
• The auditor’s contact information.

You may also receive forms like:

• Record Update (CDTFA-80-RU)
• Authorization for Electronic Transmission of Data (CDTFA-82)
• Power of Attorney (CDTFA-392)
• Waiver of Limitation (CDTFA-122)

If you’re unsure about any forms, don’t hesitate to ask your auditor for clarification. This is also a good time to consider professional representation.

2. Records Preparation

This is a crucial step. The CDTFA will request access to various business records, such as:

• General Ledger (including tax or fee accrual details)
• Sales journals, purchase journals, etc.
• Federal income tax returns
• Bank statements and canceled checks
• Credit card statements and cash disbursement records
• State income tax returns and amended returns
• Purchase invoices for consumable supplies
• Purchase invoices for fixed assets (furniture, fixtures, and equipment)
• Purchase Orders
• Property tax statements
• Sales invoices for fixed assets sold during the audit period
• Sales invoices, contracts, and cash register tapes
• Sales and use tax returns, with related worksheets
• Documentation supporting claimed exempt sales
• Financial statements

If you use QuickBooks Online (QBO) or similar software, make sure your records are current and well-organized. Interior designers often have complex transactions, so clear documentation is essential.

3. The First Meeting

In your first meeting, the auditor will explain the audit steps and review your business practices. Be prepared to walk them through your typical project workflow, showing how you separate design services from product sales and when sales tax is applied.

4. The Examination Phase

The auditor will determine the audit method:

• Actual: Reviewing all documentation line by line.
• Test: Examining a sample period and extrapolating results.
• Mark-up Analysis: Comparing reported sales to cost of goods sold.

For interior designers, a test period audit is common. Detailed records for all projects are vital, even if only a few months are closely examined.

5. Sales Tax Audit Procedures

Auditors will focus on:

• Whether all taxable sales are reported.
• Properly claimed deductions.
• Correct allocation of local tax.
• Correct tax rates for special districts.

They’ll compare your books to your sales tax returns. For interior designers, the distinction between acting as a retailer (taxable) or agent (potentially non-taxable) is especially important.

6. Taxable Mark-up Analysis

For certain types of businesses, including interior design firms that sell products, the CDTFA might use a taxable mark-up analysis to verify your sales. This involves:

• Comparing your total sales to your cost of goods sold
• Calculating your gross profit (mark-up)
• Analyzing whether the mark-up seems reasonable for your industry

If you have both taxable and exempt sales (for example, design services vs. product sales), the mark-up for both categories must be examined separately.

How Mark-up Analysis Works in a CDTFA Audit

One of the key tools CDTFA auditors use, especially for businesses like interior design firms that sell tangible goods-is mark-up analysis. This method helps verify whether your reported sales make sense compared to your cost of goods sold (COGS).

• Example 1: Verifying Your Sales Using Mark-up Analysis

Suppose your records show:

• Recorded Sales: $37,500
• Cost of Goods Sold (COGS): $25,000
• Gross Profit: $12,500

To calculate your recorded mark-up:
Gross Profit ÷ COGS = Mark-up Percentage
$12,500 ÷ $25,000 = 50% Recorded Mark-up

In other words, for every dollar you spent on goods, you marked them up by 50% when selling to your clients.

• Example 2: Reported Taxable Sales Mark-up Analysis

Let’s say your reported sales are lower:

• Recorded Sales: $30,000
• Cost of Goods Sold: $25,000
• Gross Profit: $5,000

$5,000 ÷ $25,000 = 20% Recorded Mark-up

This lower mark-up might prompt the auditor to ask questions, especially if it’s below industry norms.

• Example 3: Comparison of Audited vs. Reported Taxable Sales

If the auditor’s calculations show higher sales than you reported, they’ll compare the two:

• Calculated (Audited) Taxable Sales: $37,500
• Taxable Sales Reported: $30,000
• Difference: $7,500

Additional Taxable Sales = $7,500

This difference could result in additional tax liability if the auditor determines that your reported sales were understated.

Why does this matter?

If your mark-up percentage is much lower than what’s typical for your industry, or if there’s a large gap between your recorded and reported sales, the CDTFA may dig deeper. This is why it’s crucial to:

• Keep accurate records of both sales and COGS.
• Be able to explain any unusual mark-ups (for example, if you sold items at cost as a favor to a client).
• Understand that the auditor may use these calculations to estimate your true sales if your records are incomplete.

What Should You Do?

• Regularly review your mark-up percentages to make sure they’re in line with your actual business practices and industry standards.
• If you have legitimate reasons for a lower mark-up, document these explanations so you’re ready to discuss them during an audit.
• Compare your internal numbers to what you report on your sales tax returns to catch discrepancies before the CDTFA does.

Using Prior Audit Percentages: A Potential Time-Saver

If your design business has been audited before, you might benefit from a streamlined approach. The CDTFA sometimes allows the use of prior audit percentages of error, which can:

• Save time and minimize disruption to your business operations
• Simplify the audit process when your business practices haven’t significantly changed

For this approach to work:

• It must be discussed and agreed upon at the start of the audit
• It’s limited to two subsequent audits after the initial one
• Your previous audit errors must not have been corrected
• There can’t be significant changes in:
  • The nature and operations of your design business
  • Your accounting procedures
  • Key personnel
  • Laws or regulations affecting interior design businesses

Many designers find this option appealing, but remember that the CDTFA must be able to statistically evaluate the results to make sure this method produces accurate findings in your current audit. Discuss this possibility with your auditor early in the process if you’ve been previously audited.

7. Use Tax Examination

The audit will also check if you’ve properly reported use tax on:

• Equipment and supplies bought out-of-state.
• Items withdrawn from resale inventory for business or personal use.

This is particularly relevant if you source unique items from out-of-state vendors.

8. Conclusion of the Audit

At the end, you’ll receive:

• Audit work papers
• Verification comments

If the audit results in additional tax owed, the auditor will conduct an exit conference to discuss:

• Any penalties applied
• Options for early payment to reduce interest
• The review process
• Your right to appeal

Before the audit is officially billed, you’ll receive an audit report letter detailing:

• The breakdown of tax, interest, and penalties
• A summary of audit results by area of noncompliance
• Audit comments
• Payment voucher and instructions

Other Audit Considerations

Depending on your business structure and circumstances, you might encounter these additional audit scenarios:

• Transferring the audit to another office: If you relocate your design studio or have multiple locations, your audit may be transferred to a more appropriate CDTFA office.
• Updating corporate offices: For designers operating under a corporate structure, keeping headquarters information current is essential.
• Auditing related accounts: If you have multiple business entities (perhaps separate LLCs for design services and product sales), the CDTFA may review related accounts.
• Third-party information requests: Auditors may contact your suppliers, contractors, or clients to verify transactions.

Be prepared for these possibilities, particularly if you operate in multiple locations or have a complex business structure.

COMMON PROBLEMS AND ERRORS IN CDTFA AUDITS

The most frequent issues include:

• Misunderstanding Sales and Use Tax Law: Especially common in industries like interior design, where the line between taxable products and non-taxable services is blurry.
• Lack of documentation: Poor recordkeeping makes it hard to verify reported sales and purchases.
• Use tax not accrued on out-of-state purchases: A common pitfall for designers sourcing items nationwide.
• Unsupported sales for resale: Missing or invalid resale certificates can lead to tax assessments.
• Discrepancies between records and reported sales: Any differences raise red flags.
• Mark-up errors: Mark-ups that differ from industry standards may prompt further scrutiny.

SPECIAL CONSIDERATIONS FOR INTERIOR DESIGNERS

Interior designers face unique sales tax challenges that other businesses don’t. The blending of creative services and physical goods makes taxes more complicated, and auditors look at it very carefully.

1. The Service vs. Product Dilemma

Determining what’s a service (non-taxable) versus a product (taxable) is a major challenge. For example:

• Design consultation: Service, generally not taxable.
• Furniture purchased for a client: Tangible property, taxable.

Gray areas arise when you mark up furniture or create custom designs. These are often focal points during an audit.

2. Lump Sum vs. Itemized Billing

How you invoice clients affects your tax liability:

• Lump sum contracts: One all-inclusive fee for services and products may still require you to pay tax on the product portion.
• Itemized billing: Separately stating design services and product charges makes it clear which items are taxable.

Project management tools like Houzz Pro can help you create clear, itemized invoices.

3. Acting as Retailer vs. Agent

Are you buying items for resale (retailer) or on behalf of your client (agent)?

• Retailer: You buy, mark up, and resell items, collecting sales tax on the total.
• Agent: You purchase on the client’s behalf; the client may be responsible for the tax.

The CDTFA will look at your contracts, invoices, and business practices to determine your role.

4. Multi-State Transactions

If you work with clients or vendors across state lines, you may need to:

• Accrue use tax on out-of-state purchases.
• Consider sales tax obligations in other states.
• Understand special rules for interstate commerce.

Professional tax guidance is invaluable for managing these complexities.

HOW TO PREPARE FOR A CDTFA AUDIT: A DESIGNER’S CHECKLIST

Before an audit begins, review your sales tax filing practices to identify and address potential issues proactively.

1. Organize Your Records

Gather and organize:

• Sales and purchase records for the audit period.
• Tax returns and supporting worksheets.
• Bank statements and financial records.
• Client contracts and invoices.
• Resale certificates.

If you use QBO, make sure transactions are categorized and accounts are reconciled.

2. Review Your Sales Tax Practices

Ask yourself:

• Are you consistently collecting tax on taxable items?
• Are you using the correct tax rates for all locations?
• Are exempt sales properly documented?
• Are you accruing use tax on out-of-state purchases?

3. Consider Professional Representation

A tax professional can:

• Clarify sales tax law nuances.
• Communicate with the auditor on your behalf.
• Spot potential issues before the auditor does.
• Present your case favorably.

4. Prepare Clear Explanations

Be ready to explain:

• How you determine what’s taxable.
• Your process for collecting and remitting sales tax.
• How you handle out-of-state purchases.
• Documentation for exempt sales.

Consistent, clear answers make the audit smoother.

5. Address Known Issues Proactively

If you’re aware of past errors:

• Prepare an explanation.
• Gather supporting documentation.
• Consider voluntary disclosure if appropriate.
• Being upfront can sometimes reduce penalties.

THE MANAGED AUDIT PROGRAM: TAKING CONTROL OF THE PROCESS

If you’re comfortable with your recordkeeping and want more control over the audit process, the CDTFA’s Managed Audit Program might be worth considering. This program allows you to essentially conduct a self-audit under CDTFA guidance.

Benefits of the Managed Audit Program:

• You conduct the audit at your own pace
• No prepayments are required during the audit period
• Any additional tax disclosed is subject to only half of the current interest rate
• You maintain more control over the process

Is Your Design Business a Good Candidate?

The program works best for businesses with:

• Few tax exemptions
• A small number of tax-related issues
• Good recordkeeping practices

For interior designers with straightforward business models and well-organized records, this can be an excellent option. However, if your business has complex transactions or you’re unsure about your tax obligations, a traditional audit might be more appropriate.

If you’re interested, discuss this option with your auditor during the initial contact phase. Remember that participation is voluntary and must be agreed upon by both you and the CDTFA.

KNOW YOUR RIGHTS DURING A CDTFA AUDIT

As an interior designer facing an audit, it’s crucial to understand that you have specific rights throughout the process. The CDTFA is required to:

• Conduct audits in a professional, courteous, and helpful manner
• Maintain confidentiality of your business information
• Provide competent audit services
• Fully disclose audit procedures and methodologies
• Provide written documentation, including audit work papers and verification comments

If at any point you feel these rights aren’t being respected, you can request to speak with the auditor’s supervisor or contact the CDTFA’s Taxpayers’ Rights Advocate Office.

Understanding your rights helps ensure the audit process is fair and transparent, allowing you to focus on resolving any issues rather than navigating procedural concerns.

RESOURCES FOR INTERIOR DESIGNERS FACING A CDTFA AUDIT

The CDTFA offers several publications that provide in-depth information about the audit process:

• Pub 76, Audits: A comprehensive guide to the audit process
• Pub 53, Managed Audit Program: Details about participating in a self-audit
• Pub 147, What to Expect in a Computer-Assisted Audit: Essential information for businesses with digital records
• Pub 17, Appeals Procedures: Sales and Use Taxes and Special Taxes and Fees: Your guide if you disagree with audit findings
• Pub 70, Understanding Your Rights as a California Taxpayer: An overview of taxpayer rights and protections

These resources are available on the CDTFA website and can provide valuable insights before, during, and after your audit. We recommend reviewing these publications as part of your audit preparation, especially if this is your first experience with a CDTFA audit.

Remember that the CDTFA’s “Get it in Writing” policy (available at https://www.cdtfa.ca.gov/email/ ) can help you document important communications throughout the audit process.

PROFESSIONAL SUPPORT AND INDUSTRY-SPECIFIC RESOURCES 

Beyond understanding the audit process, having the right resources and professional support can make all the difference in your audit outcome.

CDTFA Publication

This CDTFA publication was specifically created for interior designers, providing clear guidance on what and when to charge sales tax in our unique industry. This resource addresses the specific challenges we face and should be part of every designer’s tax compliance toolkit. 

The Power of Accurate Record-Keeping 

While the prospect of an audit can feel intimidating, there’s reassurance in proper preparation. At Logistics for Designers, our experience shows that when businesses maintain accurate sales tax filing records that align with their financials, they can successfully manage audits. With proper backup documentation and a detailed filing process, we’ve helped resolve audit concerns favorably 9 out of 10 times. This success rate underscores why our meticulous sales tax preparation process is so important, we file with the goal that if an audit occurs, you’re completely covered. 

Critical reminder: Never alter an invoice once sales tax has been filed for that period. Changing invoices after filing can disrupt your sales tax reports and cause collected taxes to be missed in future filings.

FACING A CDTFA AUDIT WITH CONFIDENCE

A CDTFA audit can feel intimidating, but with preparation and the right support, you can navigate it successfully. Remember:

• Stay organized.
• Understand the nuances of sales tax in your industry.
• Seek professional help if needed.

For more resources and support, visit our home page or contact us for a consultation. Facing an audit doesn’t have to be a nightmare-with the right tools and knowledge, you can turn it into an opportunity to strengthen your business practices.

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