A New York State Administrative Law Judge has rejected the maximum penalties imposed by the Department of Taxation and Finance on an alcoholic beverage wholesaler for failing to file information returns, finding that the Department failed to request records, that its use of an estimated method was improper, and that the company made great efforts to comply. Matter of Flair Beverages Corporation, DTA No. 826110 (N.Y.S. Div. of Tax App., Sept. 29, 2016).

Legal Background and Facts. Flair Beverages Corporation ("Flair") is a licensed alcoholic beverage wholesaler. Legislation enacted in 2009 required every alcoholic beverage wholesaler that is licensed to sell without collecting sales and use tax to file annual information returns. The information gathered from the wholesalers' information returns is used to analyze the sale of alcoholic beverages and determine the accuracy of income and sales tax returns filed by vendors who purchase from the wholesalers.

Paul Gagliardi, Flair's president, testified that after the 2009 legislation was enacted, he analyzed what would be required to complete the information returns. He estimated that Flair had approximately 300,000 sales transactions each year, handled by 12 cash registers, and that vendor information was accumulated on Flair's computer, but not by the cash registers. He sought assistance from Flair's CPA and determined that it would be necessary to manually enter all sales recorded by the sales registers into Flair's computer system, deducting soda, water, deposits, sales to exempt organizations, and sales to other wholesalers, since all the items appeared on the same sales receipt. Flair attempted to transcribe the necessary information and spent three months to compile one month's worth of information, which required six additional employees at a cost of $15,000. Mr. Gagliardi concluded it was physically impossible to continually report in the matter requested with his existing manual system and that it was so expensive that trying to electronically file complete returns might force the company out of business.

Issues. It was undisputed that Flair had failed to file the required reports for the tax periods ending in 2009 through 2013. A Notice of Determination was issued, assessing penalties for $10,000 for each period. In the Notice, the Department stated that because Flair had not provided books and records, it was imposing the maximum penalty amount permitted by law.

Flair challenged the penalties, arguing that the statute was not only unfair but unconstitutional, and that the Department did not have the right to force a business to purchase a new computer system costing several hundred thousand dollars in order to provide information used for the Department's own policing purposes.

ALJ Determination. With regard to the claims of unconstitutionality, the ALJ noted first that statutes are assumed to be constitutional in administrative proceedings, and the Division of Tax Appeals lacks jurisdiction to consider whether a statute is constitutional on its face. While it may consider whether tax statutes are being applied unconstitutionally, the ALJ found that there was no evidence that Flair was being treated any differently than other similarly situated taxpayers, so there was no merit to the constitutional challenge.

However, despite the fact that the Notice of Determination estimating the penalties stated that it was premised upon Flair's failure to provide information "as requested," the ALJ found that that the auditor had in fact never requested or examined Flair's books and records, never made a determination of whether those records could have provided the information sought by the Department, and never attempted to compile the needed information from Flair's records.

The statute imposing penalties for failure to file the information returns, Tax Law 1145(i), uses the same standard applicable under Article 28, the sales and use tax law. That standard, Tax Law 1138(a)(1), provides that the Department must first request and examine the taxpayer's records, and only if those records are inadequate may an estimate or other external method be used. Since the Department never requested, much less examined, Flair's records, the ALJ found that the use of an estimated method to determine penalties was "grossly improper."

The ALJ further found that Flair had not ignored its obligations, but that after expending a great deal of effort had determined it simply could not present the information as requested. Therefore, the ALJ reduced the penalties to the minimum set forth in the statute, of $500 per return, for a total of $2,500.

Additional Insights

As the ALJ recognized, the amount of tax properly due-- or, as in this case, penalties for failure to report--can be determined by the Department from the information available and can be estimated or based on external indices. However, the case law has clearly established that before estimation is permitted, the Department must request a taxpayer's records, and estimation may be used only if those records are inadequate. See, e.g., Matter of Your Own Choice, Inc., DTA No. 817104 (N.Y.S. Tax App. Trib., Feb. 20, 2003). Here, where no request was made for the taxpayer's books and records, resorting to any amount of estimated penalties, much less the maximum, was found to be unjustified. And, since Flair had taken careful action to try to comply, and found itself unable to do so without significant investment of time and money, the ALJ concluded that only minimum penalties were appropriate.