A New York sales tax audit can become much more serious when the auditor concludes that your business records are incomplete or inadequate.
If your records allow the New York State Department of Taxation and Finance to verify your taxable sales, the Department generally should determine your sales tax liability from those records. But when the Department determines that the records are inadequate to conduct a complete audit, New York law allows it to estimate the amount of sales tax due using other available information.
That can result in an auditor reconstructing your business’s sales using methods such as purchase markups, observation tests, credit-card information, statistical sampling, or other indirect evidence.
For a business owner, the consequences can be substantial. An estimate based on a relatively short test period or a particular assumption may be projected over multiple sales tax quarters, potentially producing a large assessment of additional tax, penalties, and interest.
If the New York State Department of Taxation and Finance is proposing to estimate your sales, it is important to understand both when the Department is permitted to use an estimated audit methodology and how that estimate can be challenged.
When Can New York Estimate a Business’s Sales?
New York businesses registered to collect sales tax are required to maintain records sufficient to establish their sales, taxable sales, purchases, credits, and sales and use tax liability.
The records should contain enough detail to allow the taxable status of individual transactions to be independently determined.
If the business maintains and produces adequate records, the Department generally cannot simply disregard those records because an indirect method would be easier.
Before resorting to an estimated audit, the Department generally must request appropriate records and sufficiently examine them to determine whether they are capable of supporting a complete audit.
If the records are insufficient to verify taxable sales and conduct a complete audit, however, Tax Law § 1138(a)(1) permits the Department to determine the tax due from the information that is available.
This distinction can be critical.
The question is not simply whether the auditor would prefer to estimate your sales. The first issue may be whether the Department had a sufficient basis for concluding that your records could not support a complete audit.
What Makes Business Records Inadequate?
The Department’s current sales tax recordkeeping guidance identifies numerous circumstances in which records may be considered inadequate.
Problems can arise when records:
- do not verify sales receipts;
- do not establish whether receipts are taxable;
- lack individual transaction details;
- do not establish the taxable status of purchases;
- fail to show a reasonable relationship between purchases and sales;
- cannot be used to conduct a complete audit;
- are not provided to the auditor;
- are not maintained in an auditable form; or
- lack adequate internal controls to establish the accuracy and completeness of transactions.
For businesses using point-of-sale systems, retaining only daily summaries or “Z” tapes may not be enough. The Department expects sufficient transaction-level information and an audit trail that allows transactions to be traced.
Once the Department properly determines that the books and records are inadequate, the audit can move from examining actual transactions to reconstructing what the Department believes the business’s taxable sales should have been.
What Is an Estimated or Indirect Sales Tax Audit?
An estimated audit uses information other than—or in addition to—the taxpayer’s direct sales records to calculate taxable sales.
There is no single formula that applies to every business.
The method selected can depend on the type of business, what records remain available, the information available from third parties, and the particular deficiencies the auditor identifies.
The Department’s audit guidance recognizes several approaches, including detailed audits, test-period methods, and statistical sampling.
In practice, estimated sales tax audits may involve several different techniques.
- Purchase Markup Audits
One common approach is to estimate sales based upon the business’s purchases.
Suppose a restaurant’s sales records are incomplete, but the auditor obtains reasonably reliable records showing how much food and alcohol the restaurant purchased.
The auditor may analyze those purchases, determine or estimate the markup applied when the products were sold to customers, and use that relationship to reconstruct sales.
For example, if the Department determines that particular products purchased for $10 were ordinarily sold for $25, the auditor may use that relationship in estimating gross sales.
The problem is that the accuracy of the assessment can depend heavily on the assumptions used.
A business may need to examine whether the auditor properly accounted for factors such as:
- different markup percentages among products;
- changes in menu prices;
- discounts and promotions;
- employee meals;
- complimentary items;
- spoilage;
- waste;
- theft;
- inventory changes;
- seasonal pricing; and
- changes in the nature of the business during the audit period.
A seemingly small error in a markup calculation can become significant when projected over several years.
- Observation Tests
The Department may also use an observation test, particularly with restaurants, bars, retail establishments, and other businesses involving substantial cash transactions.
An auditor may observe business activity during a selected period and record information concerning transactions occurring during that period.
The Department may then use the observed relationship between different types of transactions to estimate sales during the broader audit period.
A good example is Matter of Hwang v. Tax Appeals Tribunal, 105 A.D.3d 1151 (3d Dep’t 2013).
There, the taxpayer’s restaurant records were found inadequate. The Department conducted a one-day observation testand calculated the relationship between cash and credit-card sales observed that day. Because reliable credit-card records existed for the audit period, the Department used the observed cash-to-credit-card relationship to estimate cash sales over the audit period.
The taxpayer challenged the use of the one-day observation period but was unsuccessful.
That case illustrates how important an observation test can become. A relatively short period of observed activity may potentially affect the calculation of sales over a much longer period.
- Credit-Card Sales and Cash-Sales Ratios
Credit-card processing records can provide auditors with an independent source of information.
If a business has reliable credit-card records but incomplete cash records, the auditor may attempt to determine the relationship between credit-card and cash transactions.
For example, if an observation test or other evidence suggests that credit cards represent 70% of the business’s sales, the Department may attempt to reconstruct the remaining 30% as cash sales.
Again, the assumptions matter.
The actual cash-to-credit-card ratio may vary by year, season, location, customer demographics, changes in technology, or changes in how the business operates.
A ratio observed during one period may not necessarily reflect another period.
The question becomes whether the Department’s methodology is reasonable under the particular facts of the audit.
- Test Periods and Projection
Rather than reviewing every transaction occurring over a three-year audit period, an auditor may examine a smaller test period and project the results.
For example, the auditor might examine selected months or quarters, calculate an error rate, and apply that error rate to a larger population.
New York courts have repeatedly recognized the use of test periods where a taxpayer’s records are insufficient.
But projection magnifies the importance of the test period.
If the period selected was unusual—for example, because of construction, seasonal fluctuations, a temporary closure, a change in ownership, an extraordinary event, or a major change in business operations—the taxpayer should consider whether it fairly represents the periods to which the Department seeks to apply the results.
- Statistical Sampling
New York also uses statistical sampling in appropriate audits.
Instead of examining every transaction, the auditor may select a sample from a larger population, determine errors within the sample, and use statistical techniques to project those results.
Sampling can be particularly useful for businesses with large transaction volumes.
But the taxpayer should understand the population being sampled, the sampling methodology, how errors are classified, and how the results are projected.
An error in identifying the population or categorizing transactions may affect the resulting assessment.
- Third-Party and External Information
The Department is not necessarily limited to records supplied by the business.
Depending upon the circumstances, auditors may have access to information from credit-card processors, vendors, suppliers, financial records, tax returns, or other third-party sources.
An auditor may compare those sources against reported sales.
For example, purchase records showing substantially greater inventory purchases than would reasonably correspond to reported sales may cause the auditor to question whether all sales were reported.
Similarly, discrepancies between sales tax returns, income tax returns, bank information, and merchant-processing records may lead to further examination.
A discrepancy does not necessarily establish unreported taxable sales. There may be legitimate explanations.
The important thing is to identify and document those explanations before the Department incorporates questionable assumptions into a multi-year assessment.
Does New York Have to Use the Most Accurate Possible Method?
This is an important point.
Once the Department has properly determined that the taxpayer’s records are inadequate, the taxpayer generally cannot defeat an assessment merely by showing that another method might have produced a more precise result.
New York courts have held that an otherwise acceptable audit methodology is not rendered unreasonable simply because another methodology might have generated a more accurate estimate.
That places taxpayers in a difficult position.
The better challenge is often not:
“The auditor could have done this differently.”
Instead, the taxpayer should examine whether the method actually used had a rational basis and whether particular assumptions or calculations caused the resulting assessment to be erroneous.
Who Has the Burden of Proof?
The burden can become particularly important once an indirect audit methodology has been properly employed.
New York courts have held that a taxpayer challenging an indirect audit generally bears the burden of establishing by clear and convincing evidence that the audit method or resulting assessment was erroneous.
That is a substantial burden.
In Matter of Hwang, for example, the taxpayer argued that a longer observation period might have produced a more accurate result. The court nevertheless upheld the assessment because the taxpayer failed to meet the heavy burden of establishing that the method actually used was unreasonable or inaccurate.
This is one reason businesses should address questionable audit assumptions during the audit, rather than waiting until a Notice of Determination has been issued.
How Can a Business Challenge an Estimated Audit?
An estimated assessment is not automatically correct.
A business and its representative should carefully examine how the auditor arrived at the proposed liability.
Depending on the audit, important questions may include:
- Did the Department properly determine that the records were inadequate?
- Did the auditor sufficiently examine the available books and records before rejecting them?
- Can supposedly missing records be recovered?
- Is the test period representative?
- Is the markup percentage accurate?
- Were different product categories improperly assigned the same markup?
- Did the auditor account for waste, spoilage, discounts, theft, or complimentary items?
- Were nontaxable sales included?
- Were credit-card tips incorrectly treated as sales?
- Were cash-to-credit-card ratios properly calculated?
- Did business conditions materially change during the audit period?
- Were mathematical errors made?
- Was the sample population properly constructed?
- Were results projected to periods that were not comparable?
These are factual questions. Developing documentation to support the answers can be critical.
What Should You Do If New York Is Estimating Your Sales?
Do not assume that an estimated assessment is inevitable simply because the auditor says your records are inadequate.
First, determine exactly why the Department considers the records inadequate.
Second, identify whether additional records can be obtained or reconstructed from accountants, POS providers, banks, credit-card processors, vendors, suppliers, or other sources.
Third, understand the methodology the auditor intends to use before accepting the resulting assessment.
If the Department proposes a test period, observation test, purchase markup, statistical sample, or other indirect method, examine the assumptions and determine whether the methodology fairly reflects how the business actually operated.
Finally, consider obtaining professional advice early when the potential assessment is substantial.
Once the Department issues a Notice of Determination, the taxpayer has formal protest rights, but statutory deadlines apply. Addressing the methodology while the audit remains open may provide opportunities to correct errors before they become part of a final assessment.
Speak With a New York Sales Tax Audit Attorney
Estimated sales tax audits can produce substantial assessments because assumptions derived from limited information may be projected across multiple tax periods.
At Thorgood Law Firm, we represent businesses and individuals in New York State sales tax audits, including disputes involving inadequate books and records, purchase markup audits, observation tests, statistical sampling, estimated assessments, responsible-person liability, and tax appeals.
If the New York State Department of Taxation and Finance is estimating your business’s sales because it believes your records are incomplete or inadequate, contact Thorgood Law Firm to discuss your audit and your options for challenging the proposed assessment.
Frequently Asked Questions
When can New York estimate my business’s sales during a sales tax audit?
New York may generally resort to an estimated or indirect audit methodology when the Department properly requests and examines the taxpayer’s records and determines that they are inadequate to verify taxable sales and conduct a complete audit.
How does New York estimate sales when records are missing?
Depending on the circumstances, the Department may use purchase markups, observation tests, cash-to-credit-card ratios, test periods, statistical sampling, third-party information, or other available evidence to estimate taxable sales.
Can New York use an observation test to estimate sales?
Yes. Observation tests may be used when appropriate. New York courts have upheld indirect audits in which information obtained during an observation period was used to estimate sales over a broader audit period when the taxpayer’s underlying records were inadequate.
Can New York use my credit-card sales to estimate cash sales?
Potentially. If reliable credit-card information exists, the Department may use other evidence, such as an observation test, to establish a relationship between credit-card and cash sales and use that relationship to estimate unreported cash sales.
Can New York estimate sales based on my purchases?
Yes. Purchase records may be used in an indirect audit. An auditor may analyze purchases and apply markup information to reconstruct estimated sales. The assumptions underlying the markup calculation can be important in determining whether the resulting assessment is reasonable.
Does the Tax Department have to use the most accurate audit method?
Not necessarily. New York courts have held that an otherwise reasonable audit method does not become unreasonable merely because another methodology might produce a more precise estimate.
Can I challenge an estimated New York sales tax assessment?
Yes. Depending on the facts, a taxpayer may challenge whether the Department was entitled to use an estimated method, whether the methodology had a rational basis, and whether particular assumptions or calculations caused the assessment to be erroneous.
Who has the burden of proof when challenging an indirect sales tax audit?
Once an indirect audit methodology has been properly employed, New York courts generally place a substantial burden on the taxpayer. The taxpayer may be required to establish by clear and convincing evidence that the audit methodology or assessment was erroneous.
Should I hire an attorney if New York is estimating my sales?
Consider obtaining legal advice when an estimated audit could result in substantial liability, particularly when the dispute involves inadequate records, observation tests, markup methodologies, large alleged cash sales, personal liability, or possible civil or criminal penalties.