After a careful review of an auditor’s attempts to compute taxable sales from external indices, a New York State Administrative Law Judge has largely upheld the auditor’s approach, although he significantly modified the calculations in several respects. Matter of Mad Den, Inc. and Matter of Brian Madden, DTA Nos. 823251 & 823252 (N.Y.S. Div. of Tax App., Sept. 22, 2011).
The taxpayer, Mad Den, had operated a restaurant from 1999 until it closed for substantial renovations on September 30, 2006. Thereafter, space that had long been leased by Mad Den, but which had remained empty, was used to double the size of the restaurant’s seating capacity, and the restaurant was sold by Mad Den to unrelated buyers, who reopened it in February 2007.
The Department audited Mad Den for the period from June 1, 2004 through May 31, 2007, and requested production of all available records. Mad Den produced federal income tax returns, a check book, bank statements, and sales figures written on envelopes.
The auditor was told that sales tax returns had been prepared by estimating gross sales from bank statements.
By the time the audit began in August 2007, the restaurant had been sold, disputes had developed with the purchasers, and Mad Den no longer had access to the point of sale computer system that recorded sales at the restaurant. Eventually, the disputes with the purchasers resulted in a lawsuit tried to a jury and, in September 2010, Mad Den was awarded damages against the purchasers for breach of the contract to purchase the restaurant.
The auditor noted significant discrepancies between Mad Den’s sales tax returns and its federal income tax returns and, given the lack of sales records, determined that the records were inadequate to perform a detailed sales audit. Instead, the auditor resorted to the use of a rent factor computed by reference to a Restaurant Industry Operations Report presenting operating results as amounts per restaurant seat and as ratios to total sales, and issued a Statement of Proposed Audit Change based on use of the Industry Report. Mad Den then filed amended sales tax returns, computed by reference to credit card receipts, showing an increase in taxable sales resulting in revised additional tax due of approximately $121,000, although no tax was paid. The Department then issued a Notice of Determination seeking the same $121,000 in additional tax, plus penalties and interest. Mad Den contested the assessment.
By the time of the ALJ hearing, Mad Den had obtained access to the point of sale records, and submitted snapshot summaries of each day’s sales, the guest checks for each order, and credit card receipts. After reviewing the records, the Department concluded that the totals on the snapshots did not match the guest checks; that credit card information and voided sales were missing; pages were missing; and that guest checks could not be tied into other documentation received on audit.
Use of External Indices Generally Upheld
The ALJ held that the Department’s resort to external indices was justified. The ALJ’s own review of one quarter’s records revealed discrepancies similar to those noted by the Department, and the ALJ found inconsistencies between the records produced and the amount of gross sales reported on the federal income tax returns. The ALJ also noted that Mad Den did not use the snapshot reports or the other documentation presented at the hearing to prepare its returns for the entire audit period.
However, the ALJ did reject a portion of the Department’s estimate. The auditor had estimated sales based on the seating capacity as it existed after Mad Den sold the restaurant. The ALJ noted that the seating had doubled at the time the restaurant was renovated and reopened by new owners, using the additional space next door. Although that space had been rented by Mad Den beginning prior to the audit period, with a plan to expand the restaurant when the owner had the necessary capital, the space was not in fact used as part of the restaurant during that time. The ALJ directed a recomputation of the gross sales using only the occupancy capacity for the original restaurant space. The ALJ also deemed the Department’s claim that it did not have knowledge of the sale of the business as “neither genuine nor credible,” noting in particular the court documents from the breach of contract trial, and directed the Department to recompute the tax to limit the audit period to the time the business was actually owned by Mad Den.
Finally, the ALJ upheld the penalties, stressing the fact that, although a point of sale computerized recordkeeping system had been available, those records were not used in filing the original returns, or in filing amended returns, which relied on credit card receipts.
Additional Insights. The importance of not only keeping careful records of taxable sales, but then actually using those records to file sales tax returns, is regularly reinforced by decisions like the one in Mad Den. Taxpayers who use casual estimates gleaned from bank records or other indirect sources run significant risks of being unable to substantiate their filings, and then facing both additional tax and penalties. Here, while the restaurant owner no longer had access to complete records when the audit began, he did have access during the majority of the audit period, and the ALJ upheld the tax as well as the penalties because those records – which even themselves did not seem entirely reliable – had not been used in filing returns. The Department frequently relies on the Industry Report used in this audit, and its reliance is generally upheld. See Matter of Crescent Beach, Inc., DTA Nos. 822080-822083 (N.Y.S. Tax App. Trib. Sept. 22, 2011).
However, the Mad Den decision also demonstrates that, even in the absence of properly filed returns, auditors must make proper adjustments, and cannot rely on demonstrably incorrect estimates of restaurant capacity and ownership periods when a taxpayer can demonstrate a significant change in facts.