SALT Blawg – State and Local Tax
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Chamberlain Hrdlicka Blawgs
By Paul Masters
The New York Division of Tax Appeals, an Administrative Court, recently ruled in Decision DTA Nos. 822750 and 822751 on the basis of whether the auditor properly used estimated techniques to determine the amount of tax due in connection with an audit of a full-service Japanese restaurant. The taxpayer, a full-service Japanese restaurant with small bar, was audited for the period of March 1, 2004 through November 30, 2006 in connection with sales and use tax. The audit period was subsequently amended to include that period through May 31, 2007. During the course of the audit, the auditor's analysis of the cash register tapes showed that the tapes had erroneous information regarding the date. The auditor was unable to correlate guest checks to the tapes for a particular month during the audit. There were are also guest checks located on days in which there were no entries on the tapes themselves, thus leading the auditor to conclude that the tapes could not be used for an audit. The auditor also looked at the sequence of the numbers used for the guest checks and noticed a wide variation in missing numbers for those checks, including large gaps.
Following an analysis of the cash deposits by the auditor, it was concluded that the restaurant had only deposited 5% to 13% of its cash receipts. The only information that the auditor believed to have a clear record was that of credit card sales, as a result of presumed-accurate third party information. The auditor then decided to use a single-day "observation test" to calculate the cash-to-credit ratio and then apply it to all credit card sales during the audit period. The date used by the auditor for this "observation test" was on a Saturday. The auditor was present one-half hour before opening until one-half hour after closing and recorded every sale, noting whether the purchase was by cash or credit card. The auditor found that during the observation period, cash sales constituted approximately 35.83% of sales while credit card sales constituted 64.17% of sales.
The taxpayer argued that the day selected for the audit was high, as compared to most days, because customers on weekends were generally couples and families, as opposed to business people. The taxpayer's theory was that business people would customarily use credit cards, while families would often use cash. Therefore, sampling should have been done during the business week to approximate the most common type of sale. The taxpayer also pointed to Matter of King Crab Rest. v. Chu, 134 A.D.2d 51 (NY App. Div. 1987), where the Court found that the auditor had failed to conduct an adequate investigation to determine if it could have conducted a complete audit. Also, taxpayer argued that the auditor failed to consider the payment of tips by credit card.
The Court found that the gap in checks was not explainable by pointing to any reasonable practice such as different books being used or books being used from different vendors due to the large member of gaps, the gaps not being divisible by 100, etc. The Court also found that the taxpayer's position would require the auditor to speculate as to undocumented sales as opposed to the requirement that there be an independently verifiable record of sales. The Court refused to side with the taxpayer despite noting "uncontradicted evidence" that the ratio of cash sales to credit card sales was higher on Saturdays. It found that a one-day observation test had been sustained in various court decisions. The Court also found little reason to credit taxpayer's evidence that the single day was not sufficient and favor the taxpayer's own analysis covering the period of several days as that analysis relied on the incomplete set of guest checks which had already been found to be unreliable. The Court noted that a taxpayer does not have a right to an expectation of "exactness" in the outcome of the audit method, when it is the taxpayer's failure to maintain proper records which prevents it.
This same analysis is applicable to estimated audits and other jurisdictions. Tax enforcement agencies often use estimated audits in the case of a taxpayer not maintaining adequate documentation. Enforcement agencies often turn to an observation-form of analysis to gross up amounts in order to assess tax, e.g., poor tests used in an estimated depletion analysis by Texas in connection with mixed beverage gross receipts tax audits (see, Hearing No. 46,687, STAR 200611875H (Nov. 8, 2006)). Further, where the lack of records is due to the fault of the taxpayer, the courts may favor an estimated approach of the enforcement agency, even when the number created as a result of such approach is inherently subject to a large variance. To protect against such an approach, taxpayers should maintain adequate books and records to document the reported numbers, and have contemporaneous documentation to explain any gaps.