New York State Sales and Use Tax Audits
Defending Clients’ Sales & Use Tax Audits Against NYS
By Deborah Weber
Various new enforcement initiatives have been undertaken by the New York State Tax Department in the past year with many enforcement initiatives focused on sales and use tax audit and collection. The purpose of this article is to provide the background and explanation of these new initiatives, discuss the legal requirements for record keeping for vendors subject to NYS sales tax and the alternative methods for audit where the taxpayer fails to maintain the required records.
The Tax Department estimates that it loses billions in tax revenue owed but not collected each year; this is referred to as the Tax Gap. To address this, in its 2007-2008 Strategic Plan, the Tax Department stated that it would aggressively address the Tax Gap through a variety of steps, including increased and coordinated criminal and civil enforcement initiatives. These new enforcement initiatives include the creation of new Special Investigations Units to combat tax abuse and evasion. These units are comprised of specially trained, multi-disciplinarian investigators statewide.
In the first six months of the fiscal year ’08-’09, these units have opened more cases than the last fiscal year and nearly twice as many as in physical year ’06-’07. From the practitioner’s perspective, however, the major problem in representing a taxpayer investigated by these Special Investigations Units is that it is unclear if the investigation is criminal or civil. This puts the practitioner at a disadvantage since the approach of the representative differs depending on the arena in which the case exists.
Obviously, in a criminal case the practitioner will generally shutdown the free flow of information between the government and the taxpayer. In a civil case, generally the flow of information is voluntary and forthcoming in an effort to resolve the matter with an agreement suitable for both parties. However, where a practitioner is unsure in which arena the case exists, the representative has no choice but to assume it is criminal since failure to do so could cost the client his or her freedom (not just money). The risk of doing this is that a case that may have stayed civil could become criminal due to lack of cooperation, but the practitioner has no way of knowing any of this at the very beginning.
Additionally, even if a case remains civil, if audited by the Special Investigations Unit, the proposed adjustment will likely include a fraud penalty and will likely include an adjustment for more than one type of tax liability (as the auditors are multi-disciplinary, meaning trained in audit techniques involving more than one type of tax).
Although the Special Investigations Units are designed to stop abuse and fraud, for any business operating in New York State, this means that chances of audit have increased dramatically in the past year and will likely only continue to increase in the future. So what can you advise your clients to avoid a significant adjustment, and, if selected for audit without proper records, how can you defend your clients?
Adequate Books and Records
The most important protection a business can have is knowledge about the records it is required to keep. A vendor is required to maintain accurate, complete and verifiable books and records and provide such records for audit upon request by the Tax Department. Ignorance of the law is no defense.
Tax Law §1135 states “A vendor is required to maintain accurate, complete and verifiable books and records and provide such records for audit upon request of the Division. Specifically, such records required to be maintained shall include a true copy of each sales slip, invoice, receipt, statement or memorandum upon which…the tax [must] be stated separately.”
The New York State Department of Taxation and Finance continues to refer to Technical Services Bureau Memo TSB-M-81(9)S for its definition of what records taxpayers must possess in order to have adequate books and records. If a practitioner representing a taxpayer has never read this Memo, a copy should be obtained and read in its entirety.
It has been established that the “State Tax Commission cannot simply ignore a taxpayer’s records and conduct a ‘test period’ audit if the taxpayer’s records are readily available and provide an adequate basis on which to determine the amount of tax due.” However, in the event that §1135(a)(1) is not adhered to, NY Tax Law §1138 allows the State to estimate the tax based on “external indices.”
Auditing Taxable Sales for Sales Tax
When a taxpayer is selected for audit, the auditor will review the books and records to verify taxable sales for the audit period, analyze sales invoices or other source documents on which tax has been charged, verify that the that proper amount of tax has been collected, trace selected source documents through the accounting systems to journals and ledgers, and record sales tax collection errors on work papers.
However, where the Tax Department follows the procedure and can demonstrate that records are inadequate, it may resort to external indices to estimate tax. The estimated methodology utilized is supposed to be reasonably calculated to reflect the taxes due. However exactness in the outcome of the audit method is not required and considerable latitude is given to an auditor’s method of estimating sales tax due.
Moreover, once the taxpayer’s records are determined to be “inadequate” the taxpayer bears the burden of proving with clear and convincing evidence that the assessment is erroneous or that the audit methodology is unreasonable. Numerous cases decided by the Division of Tax Appeals and Tax Appeals Tribunal find in favor the Tax Department, finding that any imprecision in the audit results arose as a result of the taxpayer’s failure to maintain adequate books and records.
Sampling of Methods of Sales Tax Audit
- Detailed audit
- Test period
- Mark Up of COGS
- Utility Factor
- Ratio of Credit Card to Total Sales
The Detailed Audit
The detailed audit is a complete and thorough review of all of the taxpayer’s books and records including a review of each and every guest check, receipt or register tape evidencing each sale. Where a vendor’s records are determined to be adequate, the vendor is entitled to an audit of the entirety of its books and records. Nevertheless, even with adequate books and records the taxpayer can consent to the use of either a Test Period or Statistical Sampling.
Test Period Audit
The test period audit can be used even where the taxpayer’s records are adequate, if consent to this method is obtained, or can be used without the taxpayer’s consent if the taxpayer’s books and records are inadequate. If this method is selected, the test period selected should be inclusive of the business attributes and conditions for the majority of the year. The auditor will obtain all purchase invoices for all items to be included in the test to insure accurate results, and reconcile total purchases from the vendor’s records to the Federal tax returns. The auditor will randomly check purchase invoices against Vendor’s books looking for names of, or other entries concerning, suppliers, compare invoices with merchandise and inventory and verify purchases with Vendor’s suppliers. Disparities are converted to error rates that are then applied to the entire audit period to arrive at the proposed adjustment.
Where a taxpayer’s records are determined to be inadequate, a mark-up method may be used to estimate gross sales. Generally, the Tax Department auditor will obtain and review all purchase invoices to determine the cost of goods sold (COGS). If the vendor lacks adequate records of purchases, the auditor can attempt to verify purchases with third party information; i.e. obtaining the purchases from the third party vendors. Cost of goods sold must then be reduced (when appropriate) by cost of the merchandise that is personally used by the Vendor, the amount of goods that are damaged, spoiled or otherwise unsellable and any other amounts that are relevant to the audit and can be established as appropriate to remove before applying the mark-up. This would also include any goods lost due to fire, theft or other natural disaster. Each industry has particular issues relevant to it and each business is unique. As such, the above is not an exhaustive list of the items that should be removed or the issues that should be analyzed at this phase of the audit. Suffice to say that final cost of goods sold is crucial to the end result of a mark up method audit and should adequately reflect all of the reductions to purchases that could otherwise result in overstated sales once a mark up percentage is applied.
The second phase of a mark-up audit is the determination and application of the actual mark-up to be applied to the final cost of goods sold. The Tax Department selects the mark-up percentage(s) through a number of different ways depending on the industry and the auditor. The vendor’s actual pricing can be used to determine a profit percentage for a test period with that amount then applied over the entire audit period. If the vendor had changes in pricing those changes can also be factored in to the equation. Alternatively, the Tax Department may resort to the use of standardized statistical data in the form of industry reports such as the Delotte and Touche Restaurant Report which the Tax Department commonly uses when auditing a restaurant it has determined to have inadequate books and records.
Obviously, challenges can relate to the COGS, the mark-up, or both. Knowledge of the taxpayer’s business is crucial at this phase.
More and more often the Tax Department is proposing an audit adjustment based on a one-day observation of the activities of the business. The sales of the Vendor for the day of the observation are compared with the sales of the vendor from the same day and month generally one year prior (which is within the audit period) and the difference between observed sales and reported sales are compared. The difference between observed sales and reported sales are then converted to an error factor that is applied to the entire audit period.
Since a one-day observation is often used, challenge can come in the form of day of the week, the week of the month or the month itself (in particular if the business is seasonal) or any other factors that explain the disparity between the sales on the observation day and the reported sales.
Statistical data of a particular industry regarding the percentage of gross revenue spent on utilities to operate the business is compared to the actual utilities of taxpayer. The difference is computed into an error factor that is then applied to the entire audit period to compute the adjustment to the total sales.
Challenge can come in the form of any objection that explains why the taxpayer’s utilities might be outside of a statistical percentage. For example, if the business is located inside an old drafty house on the East side and there is one meter and an apartment upstairs over the business; these things might explain a disparity. Additionally, it is important when using statistical data to make sure that the correct definitions are being applied. Each report is different and before agreeing to an adjustment based on a utility factor, what actually constitutes the utilities should be determined.
Ratio of Credit Card to total Cash Sales
There are a few ways in which the Tax Department can utilize this method. Credit Card sales can be compared to cash sales for the entire audit period and compared to a national average or industry average to determine if said amount is in line with the industry. Alternatively, and far more likely, similar to the Observation Method, one day of sales is analyzed to compare the percentage of credit card sales to total sales. Tips and tax charged to credit cards are removed. The percentage of credit card sales is then calculated and converted into an error factor which is then applied to the credit card sales for the entire audit period to arrive at the proposed adjustment to total sales.
When defending this type of audit, the first things to consider are similar to the considerations for the Observation method. For example, if the business is a pizzeria, the selection of a Tuesday or Wednesday will likely result in higher credit card percentage than a Friday when people are more likely to pay in cash since it is payday for many. This is not a universal truth – just a possibility that should be investigated. Second, the error factor should always be analyzed for mathematical accuracy since the use of the error rate, as opposed to straight percentages, can result in mathematically exaggerated numbers.
In addition to the assertion of additional tax and interest thereon, the Tax Department can also assert penalties on the tax determined to be due. Aside from increasing the amount the taxpayer will owe, the other significant relevance of the penalties in a sales tax audit is that penalties affect the amount of the interest charged. For sales tax, if penalties are waived, simple interest applies; however, if penalties are asserted, interest is compounded.
Many business owners and even some professionals don’t understand the requirement to keep every single guest check, sales slip or all register tapes. Clients object that they could never store all of this paper and resort to the use of keeping daily summaries instead. But by doing so they have left themselves at the mercy of the NYS Tax Department if selected for audit, and case law provides the Department with considerable latitude in selecting an audit methodology where records are inadequate.
As with most things in life, the best defense is a good offense: Advise your clients to maintain adequate books and records. If storage really is an issue, rent a storage garage for $100 a month; $1,200 a year is worthwhile insurance if their business is selected for audit. And in today’s enforcement climate, the chances of that happening have increased dramatically in the past year.