A New York State Administrative Law Judge has canceled an assessment to one of two related restaurants, finding that the method used by the auditor to estimate taxable sales lacked a rational basis. Matter of 3152 Restaurant, Inc., Matter of On the Boardwalk Café, Inc., Matter of Tatiana Varzar, & Matter of Lev Blinder, DTA Nos. 827174-827177 (N.Y.S. Div. of Tax App., Dec. 28, 2017). Facts and Audit Issues. Petitioner 3152 Restaurant, Inc. (the “Restaurant”) operated a restaurant and nightclub on the boardwalk in Brighton Beach, New York. Petitioner On the Boardwalk Café (the “Café”) operated a casual restaurant next door. On May 25, 2011, prior to beginning the audit of the Restaurant, an auditor with the Department of Taxation and Finance surveyed the premises and had lunch at the Restaurant. She took a photograph of her guest check, which included itemization for the food purchased, gratuity, and sales tax, and bore an order number of 742. The Department then commenced an audit of the Restaurant for the period December 1, 2008, through August 31, 2011, and requested all of its books and records related to sales and use tax. After reviewing bank records, the auditor determined that taxable sales had been under-reported by over $750,000. The auditor also obtained the Restaurant’s electronic sales records from its point of sale (“POS”) system and was unable to find an entry corresponding to her May 25 lunch. The Restaurant was able to produce a receipt matching the date and amounts listed, but it bore an order number of 715, different from the 742 the auditor had originally photographed. The auditor did not provide a copy of her guest check to the Restaurant’s representative, ask for an explanation, or do any further investigation.
Based on the discrepancy in the order numbers, the auditor deemed the Restaurant’s records to be unreliable and resorted to an estimated methodology. She utilized the amount of gross sales to which the Restaurant had consented in an earlier proceeding before the Bureau of Conciliation and Mediation Services (“BCMS”) for a prior audit period, and obtained the rent amounts from that prior period to estimate a rent factor of 4%. She then applied that 4% factor to the Restaurant’s rent expense from its federal income tax returns for the current audit period, and determined that the Restaurant had under- reported taxable sales by over $6.3 million rather than the $750,000 originally determined. Based on this calculation, a notice of determination was issued to the Restaurant asserting tax due of over $552,000 plus interest and penalty.
During the same period, the auditor also audited the Café. Similarly, before beginning the audit, she purchased a meal and photographed her guest check, and then she requested the Café’s books and records. This time, she was able to locate a copy of her guest check in the Café’s POS system, so she deemed the Café’s records to be reliable. However, after reconciling the POS sales records with sales tax returns, the auditor found additional unreported sales of nearly $255,000, and the Department issued a separate assessment against the Café of approximately $22,000 plus interest and penalties.
The Restaurant and the Café challenged the assessments. Both the president and the manager of the Restaurant testified that they had never agreed to use the estimated method applied by the auditor. The Restaurant also presented the testimony of the owner of Super PC Systems, a dealer of the POS system used by the Restaurant. The owner, while noting differences between the guest check given to the auditor and the receipt in the POS system, testified that the orders were identical since they showed the same items, amounts, number of guests, station number, table number, and server name. He explained that if orders preceding the auditor’s order were canceled by a server, for example if a customer had changed his or her order, the order number of all subsequent records would have been changed when the database was compacted, which the system provider recommended be done periodically, since it allows for faster data processing. He also conceded that it is possible electronic sales records could be deleted by using a database tool.
Another witness, an employee of the Restaurant’s and the Café’s representative, testified that while he believed the electronic sales record was tamperproof, he was relying on the Restaurant’s computer operator for his instructions. He also testified that, based upon his review, the Restaurant had under-reported sales by over $932,000.
Finally, the Restaurant presented the testimony of Gary Rosen, a CPA, certified valuation analyst, and certified fraud examiner. Mr. Rosen had been engaged to examine the Department’s rent factor. After searching a database containing data on 4.5 million establishments, Mr. Rosen testified that rent as a percentage of sales for restaurants with sales similar to the Restaurant’s averaged 7.1%; that, based on the Restaurant’s location in New York, the factor should be higher than that average; and that the 4% factor used by the Department overestimated the Restaurant’s sales.
The Decision. First, the ALJ reviewed the standard for the application of an estimated method, which requires the Department to request and thoroughly examine the taxpayer’s books and records and, if it finds the records incomplete or inadequate, select a method reasonably calculated to reflect the tax due, after which the burden rests on the taxpayer to demonstrate the method or amount of the assessment was erroneous. Matter of Your Own Choice, Inc., DTA No. 817104 (N.Y.S. Tax App. Trib., Feb. 20, 2003). Here the ALJ found that, while there was testimony explaining the change in order numbers, there is “some credence” to the Department’s concern that the ability to delete orders and renumber guest checks impacts the overall reliability of the records. However, the ALJ noted that the Restaurant had not been given a copy of the auditor’s guest check at the time of audit so that it could provide an explanation, and the auditor made no further investigation before deeming the records unreliable. The ALJ concluded that, under these circumstances, the Department should have made further inquiry.
The ALJ also found that, whether or not the records were sufficiently unreliable that resorting to an estimated methodology was justified, the method used by the auditor “lack[ed] a rational basis.” He held that use of a gross sales amount from a matter settled before the BCMS cannot be used in another audit period in the absence of an agreement by the taxpayer, and that any discussions or proposed adjustments made at conciliation conferences are in the nature of settlement negotiations and may not be considered as precedent or relied upon in subsequent administrative proceedings, citing Tax Law § 170(3-a)(f). In addition, the auditor was unable to detail how the settlement figures were derived. Therefore, while the ALJ found there was “no serious dispute” that the Restaurant’s sales had been under-reported based upon the auditor’s analysis of credit card deposits and the Restaurant’s own concession, there was no way to tell if the audit determination had a rational basis. Therefore, the notices of determination issued to the Restaurant and to its manager as a responsible person were canceled.
Since no evidence or testimony had been presented regarding the Café, that notice of determination was sustained against both the Café and Tatiana Varzar, who had been assessed as a responsible party.
As the ALJ recognized, it is well established that, when the Department concludes upon audit that a vendor’s records are inadequate, it may resort to an estimation to determine the correct amount of tax due, but that estimation needs to be reasonable and supported by evidence. Generally, estimated assessments are based upon external indices and can be traced to publicly available records and databases, or to bank records or other third-party documents. Here, where the auditor appeared to rely solely on the results of a settlement at BCMS for earlier years and also seemed unable to explain exactly how the numbers were derived from those settlement figures, the necessary evidentiary support was missing. This case also highlights the important point that settlements for one audit cycle, whether on audit or at BCMS, should never be regarded as binding for later audit cycles, and that evidence of prior settlements is not admissible in a contested case for different periods.