In a pair of decisions, each involving estimated sales tax assessments on restaurants, two separate New York State Administrative Law Judges struck down the audit methodologies used by the Department’s auditors. Matter of Richmond Deli & Bagels, Inc., and Nabila Hussain, DTA Nos. 823244 & 823250 (N.Y.S. Div. of Tax App., July 5, 2012) and Matter of Forestview Restaurant, LLC; Matter of George A. Peppes Officer of Forestview Restaurant, LLC, DTA Nos. 823465 & 823466 (N.Y.S. Div. of Tax App., June 28, 2012).

Both ALJs determined that the records provided by the restaurants’ owners during the audit were insufficient, and therefore the Department was within its rights to resort to an alternate audit methodology. However, both ALJs found in each case that the audit methodologies used were unreasonable and lacked a rational basis. Recognizing that the Department has a fair amount of leeway in choosing audit methodologies, in each case both ALJs nonetheless held that the audit methodology selected must be reasonably calculated to reflect the sales taxes due.

In Forestview Restaurant, the Department’s auditor attempted to determine a restaurant’s sales tax by observing the operations of the restaurant after it had been significantly remodeled. The remodeled restaurant was larger, more expensive, served alcoholic drinks, and employed more people than the original restaurant had employed. The ALJ concluded that using the estimated sales of the remodeled restaurant, which presumably were significantly larger, to estimate the sales of the original restaurant was not a method reasonably calculated to reflect the correct tax due, and accordingly the ALJ ruled that the sales tax assessment could not stand. In response to the Department’s claim that it had been the taxpayer that requested an observation test, the ALJ held that this did not relieve the Department of its obligation to employ a method reasonably calculated to reflect the tax due.

In the other decision, Richmond Deli & Bagels, after determining that the books and records were inadequate, the auditor estimated total sales based on prepaid cigarette credits claimed by a deli grocery store, reasoning that estimated cigarette sales were a certain percentage of the store’s total sales. Although the auditors claimed to rely on ratios of cigarette sales to total sales derived in two other audits of similar establishments, the Department did not offer any evidence regarding the facts in those audits. The ALJ found that, in this case, where the auditor had not observed the taxpayer’s business—or, for that matter, a similar business—the Department did not establish a rational basis for a percentage relationship between cigarette sales and total sales. As a result, the ALJ ordered that the sales tax assessment be cancelled.

Additional Insights. In general, considerable discretion is given to an auditor in choosing a method of estimating sales when a taxpayer fails to maintain sufficient records. Taxpayers will not be granted relief based on any imprecision that results from the use of an alternative method, provided such method is reasonable. These decisions demonstrate that, notwithstanding this discretion in choosing an alternative method, the method chosen must be rationally related to the operation of the taxpayer’s business.

Editor’s Note: As we went to press, yet another ALJ decision was issued cancelling an estimated sales tax assessment against a restaurant. Matter of J. Sahantadam, Inc. and John Gormel, DTA Nos. 823328 and 823329 (N.Y.S. Div. of Tax App., July 13, 2012). Once again, the ALJ held that while the taxpayer’s incomplete records allowed the Department to use an estimated methodology, the method used – this time based on data taken from an industry publication -- was not reasonably calculated to reflect the correct taxes due under the facts in the case.