How to Handle Sales Tax Audit California Beer Brewers

CDTFA Sales Tax Audit: A Guide for California Beer Brewers

The craft beer industry in California, home to nearly a thousand breweries, is a vibrant and competitive sector. However, with this growth comes increased scrutiny from the California Department of Tax and Fee Administration (CDTFA), particularly through sales and use tax audits. For beer brewers, these audits can be complex, focusing on compliance with sales tax obligations, ingredient purchases, and equipment exemptions. This article is tailored for California beer brewers as a guide to understanding and navigating a CDTFA sales tax audit.

Understanding the CDTFA Sales Tax Audit Process

Brewers, as manufacturers and retailers, are subject to both sales tax (on retail sales) and use tax (on purchases used or stored in California). CDTFA Sales Tax Audits aim to ensure beer businesses correctly collect, report, and remit these taxes. For brewers, tax audits often target:

• Sales for resale versus retail sales.
• Exempt purchases of ingredients and equipment.
• Recordkeeping to substantiate exemptions or credits.
• Compliance with alcoholic beverage tax and licensing requirements.

Why Brewers Are Audited

Brewers are frequent audit targets due to:

• High volume of exempt sales: Sales of beer to distributors or retailers for resale are exempt, but improper documentation can trigger audit adjustments.
• Cash transactions: Taprooms and brewpubs often handle cash, raising red flags for underreporting.
• Sales tax exemption complexity: Ingredient and equipment purchases may qualify for exemptions, but misapplication can lead to tax liabilities.
• Beer Industry audit data: California breweries, based on prior tax audit data, have industry reputation for tax irregularities, prompting closer scrutiny.

Key Sales and Use Tax Obligations for Brewers

The CDTFA’s Tax Guide for Beer Brewers and Distributors outlines specific tax obligations, with the Ingredients section providing critical guidance on taxable versus exempt purchases. Below is a breakdown of key areas auditors focus on:

1. Sales Tax on Retail Sales

All retail sales of tangible personal property in California are subject to sales tax unless specifically exempt. For brewers:

• Retail sales include beer sold directly to consumers (e.g., in taprooms), glassware, merchandise, or equipment sold to non-resellers. These are taxable at the local sales tax rate, which varies by city and county (e.g., 7.25% to 10.25% as of 2025).
• Sales for resale (e.g., kegs to pubs or bottles to stores) are exempt, but brewers must maintain valid resale certificates (CDTFA-230) to prove the buyer intends to resell the product. Without these, auditors may reclassify sales as taxable.

Audit Risk: Auditors frequently examine sales for resale, using procedures like the CDTFA-504 series (“XYZ” Letters) to verify exempt sales when certificates are missing. Brewers must provide purchase invoices, bills of lading, or other records to avoid tax assessments.

2. Use Tax on Purchases

Use tax Applies to items purchased for use in California, such as out-of-state equipment or ingredients not intended for resale. Brewers must report and pay use tax unless an exemption applies. Common scenarios include:

• Ingredients: Purchases of grains, hops, or yeast for beer production are exempt as “food products” for human consumption. Non-food ingredients (e.g., chemicals to improve foaming or clarity) are exempt only if physically incorporated into the beer for resale.
• Equipment: Certain brewing equipment may qualify for a partial exemption under the Manufacturing and Research & Development Equipment Exemption, reducing the taxable amount.

Audit Risk: Auditors scrutinize ingredient purchases to ensure proper classification. If a brewer pays sales tax on exempt items (e.g., food products), they can claim a refund within the three-year statute of limitations by providing a resale certificate or evidence of incorporation into the finished product. Conversely, underpayment of use tax on non-exempt items (e.g., manufacturing aids like filters) can lead to penalties.

3. Alcoholic Beverage Tax and Licensing

Brewers must register for an alcoholic beverage tax account if they hold licenses from the Department of Alcoholic Beverage Control (ABC), such as:

• Beer Manufacturer (Type 01): For commercial beer production.
• Small Beer Manufacturer (Type 23): For breweries producing less than 60,000 barrels annually.
• Beer and Wine Importer (Types 09/10): For importing beer or wine.

The alcoholic beverage tax (e.g., $1.24 per barrel of 31 gallons) applies to beer sold in California, with exemptions for beer consumed by employees on bonded premises (not in a tavern) or destroyed with CDTFA approval.

Audit Risk: Auditors verify compliance with filing deadlines (e.g., monthly returns due by the 15th) and proper reporting of beer shipments or destruction. Late filings incur a penalty of 10% of the tax due or $50, whichever is greater.

Preparing for a CDTFA Sales Tax Audit

A CDTFA audit typically begins with an audit engagement letter requesting records and scheduling a meeting. Proper preparation is critical to avoid costly assessments.

1. Gather and Review Records

Auditors request:

• Books of account: Income statements, balance sheets, general ledgers, and tax returns.
• Original documents: Sales and purchase invoices for beer equipment and ingredients, contracts, bank statements.
• Exemption documentation: Resale certificates, bills of lading, CDTFA-775 forms for destroyed beer.
• Filed returns: Sales, use, and alcoholic beverage tax returns with supporting schedules.

Action: Review records for accuracy and reconciliation with filed returns. Ensure resale certificates are complete and match sales records. For ingredient purchases, verify whether items qualify as food products or resale components.

2. Understand Auditor Procedures

Auditors use detailed verification methods, especially for sales for resale, which is a common deduction. They may:

• Examine every transaction if the volume is low.
• Use statistical sampling for high-volume sales.
• Issue XYZ Letters to confirm exempt sales with buyers.

Action: Anticipate these methods and prepare supporting documentation, such as purchase orders or delivery records, to substantiate exemptions.

Action: Tax attorneys should attend all meetings, review auditor workpapers, and negotiate adjustments to minimize liabilities. If disputes persist, appeal to the CDTFA’s Taxpayers’ Rights Advocate or request a hearing.

Common Audit Pitfalls and How to Avoid Them

1. Inadequate Recordkeeping:
   • Issue: Missing resale certificates from ingredient providers or incomplete destruction records (CDTFA-775) can lead to disallowed exemptions or credits.
   • Solution: Implement robust accounting systems to track sales, purchases, and exemptions. Retain destruction approvals and supporting documents (e.g., TTB notices).
2. Misclassified Purchases:
   • Issue: Paying tax on exempt ingredients (e.g., hops) or failing to pay use tax on taxable items (e.g., filters) triggers adjustments.
   • Solution: Consult the CDTFA’s Ingredients guide and verify classifications with CDTFA’s Customer Service Center (1-800-400-7115) before filing.
3. Late or Incomplete Filings:
   • Issue: Missing deadlines for sales or alcoholic beverage tax returns incurs penalties.
   • Solution: File all returns online, even if no tax is due, using CDTFA’s Excel templates for accuracy.
4. CDTFA Tax Appeal Strategy: If audit findings are unfavorable, escalate through CDTFA’s appeal process or pursue litigation. Controlling case law: San Francisco Brewing Corporation v. Johnson (1952) for procedural compliance.

A CDTFA sales tax audit can be legally complex for California beer brewers, given the industry’s complicated tax obligations and high audit risk. By understanding the CDTFA’s Tax Guide for Beer Brewers and Distributors, particularly the Ingredients section, our sales tax lawyers can guide clients through compliance, recordkeeping, and audit defense.