Small Business Taxes & Management

Special Report

Taxpayer Wins Sales Tax Audit Case


Small Business Taxes & ManagementTM--Copyright 2012, A/N Group, Inc.


Story of a Sales Tax Audit

The only thing that could be worse than an IRS audit is a sales tax audit. The facts below involve a restaurant that had a sales tax audit, fought the state before an Administrative Law Judge, and won. While states do vary in their procedures, many are aggressive when it comes to sales tax and the facts here are typical of what you might run into.

The taxpayer was a Greek diner which was open 24 hours a day, 7 days a week. The state requested all the books and records for the audit period of three years. The taxpayer produced for the auditor the last five months (some 10 to 15 boxes of material) which was viewed as a starting point.

The state learned that toward the end of the audit period the taxpayer installed a point of sale cash register system. The auditor ascertained that the taxpayer did not "z out" the register. When a z-tape was produced, the cash register printed the total sales and then reset to zero. The z-tapes can be created at the end of the day. They were sequentially numbered, which would have enabled the examiner to follow them from day to day in order to verify that all sales were recorded. However, the taxpayer made a practice of cashing out the register several times a day and the taxpayer did not z-out the register and the cash register was not reset to zero.

The auditor received guest checks, checking account statements, credit card merchant reports, sales tax returns, federal returns and some server reports for the last month of the audit and expense purchases from a related entity. The auditor quickly found that there were many gaps in the sequence of guest check numbers. The auditor was concerned about the missing guest checks. The auditor also attempted, without success, to match the amount shown on the server reports to the amounts reported on the sales tax return for May of 2007 (the end of the audit period). The auditor advised the taxpayer that he could not use the server reports by themselves without the corresponding guest checks because he did not know if all of the sales were included.

The state reported that the following were not available for review--sales journal tapes for the entire audit period, guest checks for the entire audit period, end-of-day cash out tapes showing time, date and cash out sequence number or guest check range, sales journal, and details of expense purchases from the related party. While the taxpayer had some of these records, they were not complete. No additional records were presented and an audit based on the actual documentation never proceeded beyond this point.

Purchases from the related party could not be verified because the invoices only showed a dollar amount. Details were omitted showing what was purchased and there was no backup. Moreover, the fact that business was owned by the taxpayer meant the transactions might not be at arm's length.

The state considered the sales records inadequate because it could not verify the accuracy of the sales tax returns through the backup the taxpayer presented. That meant the sales had to be determined by indirect methods.

The auditor first suggested performing an observation test. The plan was abandoned because the restaurant had changed to a point of sale system with multiple terminals. The state attempted to conduct an audit using the restaurant's utility bills and a utility markup study from Deloitte & Touche. Using this analysis, the amount of sales tax due was some $259,000. Concerns were raised about the accuracy of the utility markup because the restaurant was open 24 hours a day and there was no indication in the utility markup study that the markups were based on similar establishments.

The taxpayer, despite concerns about the propriety of an observation test, requested the state to perform such a test. The state agreed and, despite the fact that it usually does not tell the taxpayer in advance of an observation test in order to avoid the possibility that the results would become skewed, it did so in this case. The state used multiple observers but there were difficulties in completing the test. Some of the waiters were uncooperative and did not turn over their guest checks. One server thought that the observers were from another department that was interested in examining the amount of tips. The z-tapes were compared to the average Thursday (the test day of the week) in the audit period and an error rate of 36 percent was computed. The error rate was then multiplied by the reported sales in order to calculate the additional sales which, in turn, were multiplied by the tax rate in order to compute the amount of additional tax due. The state issued assessments along with penalties and interest that amounted to over $220,000. Additional penalties were imposed because of the inadequacy of the records and the amount of the tax due was more than 25 percent of what was reported.

The taxpayer argued before the Judge that during the audit period the restaurant was remodeled, the menu upgraded, a full-course bar added, and a patio dining area added. At the beginning of the audit period the restaurant employed about 40 people; after the renovation it had 65 to 70 employees. As a result, the observation test was not valid because the auditor failed to take into account changes in the operation of the restaurant. The taxpayer also maintained that the books and records were adequate and the state was precluded from an observation test.

The Administrative Law Judge noted that the taxpayer failed to deliver all of the requested records in the first and second request. In addition, the records that were produced presented numerous difficulties. The Judge noted records were kept in haphazard fashion. They were placed in unmarked boxes without any apparent order. The record of purchases lacked detail. The cash register tapes showed larger amounts than reported on the tax returns. The taxpayers argued there is no requirement that guest checks by numbered and used in sequence. The Judge rejected that argument and noted it has been recognized for a long time that an incomplete record of guest checks is an important factor in determining whether it is appropriate to resort to the use of external indices. The Judge noted that it was sufficient for the state to show that the restaurant was unable to produce a complete set of cash register tapes to justify the use of external indices.

Despite the above, the taxpayers won because they were able to show that the audit methodology was not reasonably calculated to determine the amount of sales and use taxes due. The Judge noted that the differences between the original and remodeled restaurant made the use of an observation test problematic.


Good Records Essential

While the taxpayer won, that's not usually the case. Both the IRS and the state can use alternative means to reconstruct your income if your records are inadequate. And the outcome can be very detrimental. In addition, it's hard to fight the reconstructed results. The courts generally don't have much sympathy on a taxpayer who didn't keep good records and then claims the government has overestimated his income or sales tax collected.

The state can use a number of approaches to reconstructing your sales. The most often used approach for a restaurant, deli, etc. is the observation method. Generally, it's the fastest and cheapest for the state. But it can produce terribly skewed results. Often only one day is selected and the results multiplied by the number of days the business is open during the year times the length of the audit period. If the day the state selects for audit turns out to be one with heavy volume, you could end up with a big bill. For some businesses (pizza parlors are a prime example, others include bars) the state may just find out how much flour you bought (sometimes by asking the suppliers) or how much electricity you use and applying a markup.

The first step is to keep good records--and make sure all the information is consistent. You don't want your total cash register tapes for the day to add up to more than the sales entry in your accounting program. Restaurants and retail establishments in general should keep all cash register tapes, indicate the date, and store them together. Keep all credit card information, even if you'll get a Form 1099-KG from the processor at the end of the year.

Invoices should be numbered and any gaps in the sequence kept to a minimum and explained. The same is true for purchase orders, if used. All checks, including voided ones, should be accounted for. Cash receipts for the day should match the bank deposits. In addition, keep all supporting documentation such as log books, invoices for asset and other purchases and services. Note, on a sales tax audit the state often audits not only sales but purchases to make sure sales tax was paid, where required, on purchases of supplies, assets, etc. For more information see our article Surviving a Sales Tax Audit.

Not sure of what to keep? Talk to your accountant or tax adviser. They should be able to help in your particular situation.


Copyright 2012 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. Articles in this publication are not intended to be used, and cannot be used, for the purpose of avoiding accuracy-related penalties that may be imposed on a taxpayer. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISBN 1089-1536

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--Last Update 08/16/12