Alabama and New York Rule that Purchase Mark-Up Method Allowed for Sales Tax Audits without Adequate Sales Records

If companies do not maintain adequate supporting records of their sales, they may be subjected to an alternative audit methodology which can produce an unfavorable outcome.

By Tina Chunn, SALT senior manager

We are often asked how to prepare for a sales and use tax audit. One of the keys to a successful audit is to have maintained adequate supporting records of your sales and the computations used for your sales tax returns. Inability to supply this information will result in the auditor needing to use an alternative method to compute the sales tax liability due. This issue was addressed in recent tribunal decisions in Alabama and New York, where a purchase mark-up method was used by the auditor to compute the gross sales during the audit period since sufficient sales records were not provided. [1]

In Alabama, a convenience store operator was only able to provide sales and purchase records after he took over the business, which represented the last four months of the audit period. The previous owner had not provided any documentation of sales and purchases prior to the purchase date. Additionally, while examining the cash register receipts available, the auditor noted that only 56 percent of taxable sales were reported on the filed tax returns for the last four months of the audit period.

Alabama law requires that retailers subject to Alabama sales tax keep adequate and complete sales, purchase and other records to compute the sales tax liability in the event of an audit. If the taxpayer cannot substantiate the amounts reported on the sales tax returns, the auditor is authorized to compute the sales tax liability using the most accurate and complete information available.

In this case, the auditor used the last four months of purchase invoices that were provided by the taxpayer, as well as invoices obtained from the taxpayer’s vendors, and applied a reasonable retail mark-up based on industry standard to estimate retail sales for the entire audit period. In determining the mark-up, the auditor looked at the taxpayer’s mark-up based on available purchase and sales data. Then, in order to determine if such mark-up was reasonable, the auditor looked at IRS mark-up percentages for similar items/businesses.

The taxpayer argued that the auditor overestimated the sales because they were based on purchase data for the last four months of the audit, during which time taxpayer had made significant purchases to restock the store after his acquisition of the business. Therefore, the purchases and sales determined by the auditor for the entire audit period based on this method did not properly reflect actual sales activity for the period. However, the court ruled that the taxpayer cannot argue about the specific method used by the auditor when the taxpayer does not have sufficient records, as long as such method is reasonable and computed based on the most accurate and complete information available.

A similar case in New York also ruled that the purchase mark-up method is adequate for computing the sales tax liability when sufficient records are not provided during an audit. In this case, a 24-hour deli and grocery store was unable to provide any sales documents, as these items were not maintained by the business. Cash register receipts did not identify taxable vs. nontaxable items and were not properly maintained. Sales tax returns were prepared using bank deposits and purchase information and did not match the monthly worksheets provided. Additionally, general ledger detail was also not available. Finally, the taxpayer refused to sign a waiver of the statute of limitations and to allow a physical observation of the business operations.

After repeated requests for sales detail and complete purchase records, the auditor used invoices of third-party purchases as a 12-month sample of the audit period for estimating sales tax liability for beer, soda, other beverages and cigarettes. The auditor computed the monthly average of purchases and applied this estimate to the remaining periods of the audit. These amounts were then marked up based on the retail mark-up amounts reflected in two years of income tax returns filed prior to the audit period to calculate gross sales.

The taxpayer argued that the auditor had not adequately taken into account all the information that was provided in computing the sales tax liability due. However, the tribunal found that the method used by the auditor was adequate and that the taxpayer could not support its assertion that the tax was erroneously calculated since it had failed to provide adequate books and records. It was further noted that any imprecision in the audit results were the direct result of the taxpayer’s failure to keep and maintain adequate records of all its sales as required by New York Law. [2]

As you can see, when good supporting records are not provided during an audit, the taxpayer is open to an alternative audit methodology as selected by the auditor to determine the sales tax liability due. In many cases, these methodologies will not provide in a favorable result for the taxpayer. However, without adequate records, it is likely difficult to sustain any arguments to reduce the assessment under appeal.

The SALT team at Aprio is experienced at assisting our clients with audit preparation and defense. Specifically, we help clients understand that audit preparation does not begin when the audit notice is received; rather, proper preparation occurs throughout the period, by maintaining sufficient records of sales and purchases as well as exemption certificate documentation. Our team will review your sales/use tax processes, and we will recommend changes that will better prepare your business to comply with sales tax rules and to obtain a favorable result in the event of an audit. We constantly monitor these and other important state tax issues, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

Contact Tina Chunn at tina.chunn@aprio.com or Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at jeff.glickman@aprio.com for more information.

This article was featured in the June 2017 SALT Newsletter. You can view the full newsletter here.

[1] Jai Shanidev Inc v. Ala. Dept. Rev., Ala. Tax Tribunal, Dkt. No. S. 16-449, 4/27/2017; In the Matter of the Petition of Majestic Deli Grocery, Inc., NYS Tax Appeals Tribunal, Division of Tax Appeals Nos. 825624 and 825625, 4/14/2017.

[2] It is worth noting that the tribunal did strike down the auditor’s use of the “observation method” with regard to estimating sales tax liability for sales of prepared food. Under this method, the auditor literally observed the taxpayer making four to five such sales during a 15-minute period and extrapolated that for the whole audit period. The tribunal thought the observation period was too short, but it did state that a one-day observation for a multi-year audit period has been upheld as reasonable in other cases.

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.