New Jersey Tax Court Addresses Challenge to Audit Sample
December 14, 2017
This case highlights the importance of managing the entire audit process, as taxpayers under audit can raise concerns over how the auditor conducts the audit.
By Jess Johannesen, SALT manager
When businesses receive a notice of intent to audit, the paramount concern is often gathering and organizing the requested information. However, once that information is provided to the auditor, a taxpayer should not just sit back, wait for the bill and then fight over taxability. While the procedures vary from state to state, auditors typically have a process that they follow depending on the type of audit, and issues can arise as to how an audit follows or does not follow that process.
The Tax Court of New Jersey recently issued a decision in a case that highlights the importance of managing all aspects of a sales/use tax audit.  The case involved the sampling procedures for a sales tax audit, and the point of contention was not whether a transaction was taxable, but rather whether a transaction was properly included in the sample.
The taxpayer was a cleaning and restoration service provider for properties that had suffered damages as a result of some sort of casualty. During a New Jersey sales tax audit, the auditor used what is referred to as “block sampling.” Block sampling requires the auditor to examine 100 percent of invoices/receipts for 100 percent of sales transactions that occurred during a selected sample period within the audit period. The audit period at issue was calendar year 2007 through 2010, and the New Jersey auditor used 2009 as the sample period. The error percentage found in the sample of 2009 is then extrapolated across the entire audit period to determine the sales tax assessment.
During the course of the taxpayer’s audit, the auditor found sales tax errors of $95,433 in 2009 (i.e., sales that the taxpayer treated as nontaxable but which the auditor viewed as taxable). In relation to the total 2009 sales, this represented an error rate of 3.49 percent, which was extrapolated across the entire audit period. However, of the $95,433 of sales that were deemed taxable, $55,683 was attributable to a single transaction that involved a related entity. This represented more than half of the total 2009 errors noted by the auditor. If this lone transaction was removed from the sample, the error rate would drop to 1.45 percent.
The taxpayer challenged that this transaction was a “one-time event not capable of repetition,” and therefore should be excluded from the sampling procedure as it did not represent recurring business that would reasonably be extrapolated across the audit period. The customer and the taxpayer were brother-sister entities, as the same individual controlled both entities. It was alleged that the property suffered significant damage from unruly tenants which required significant restoration, repair and remodeling.
New Jersey’s audit manual provides for the exclusion of items from a sample that are “extraordinary or nonrecurring,” which are defined as items that are “unusual and not routine in the normal course of the taxpayer’s business.” However, the Court noted that the manual does not provide any guidelines addressing when removal of a non-recurring item from the sample is appropriate.
Therefore, the Court referred to California’s Audit Manual that specifically addressed certain guidelines for determining when non-recurring items should be excluded from a sample: (1) the size of the item is much in excess of the normal item and occurs only at rare intervals; (2) the item was omitted or included due to some unusual circumstance and (3) the item sold is of the type not normally handled. The Court stated that the fact that the transaction was the only sale to a particular customer should not be the sole criteria for eliminating the transaction from the sample.
Ultimately, the Court concluded that the sale may be excludable due to the fact that the transaction represented more than half of the audited error in the sample and that the sale was to a related party controlled by the same principal. The Court stated that, “Including such a large non-recurring transaction may not merely be imperfect, but aberrant.” 
With careful audit planning and management throughout the entire audit process, a business may be able to address concerns before receiving the assessment. For example, as an auditor sets the parameters for sales and/or use tax sampling procedures, an advisor managing the audit on your behalf would review the results of the samples and be prepared to proactively raise areas of concern to the auditor.
Aprio’s SALT team has experience representing businesses in state tax audits across the country. We are able to manage the full audit process so that issues get spotted and addressed early, adjustments (if any) are minimized and the business does not have to devote its own personnel to these long and frustrating disruptions. 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.
This article was featured in the November/December 2017 SALT Newsletter.
 Statewide Commercial Cleaning, LLC v. Director, Division of Taxation, Docket No. 003504-2015, 10/20/2017.
 It is worth noting that the Court in this case was not actually deciding this issue on the merits, but was instead addressing whether there was sufficient evidence to allow the issue to be presented at trial (this is referred to as a Summary Judgment motion). In analyzing this motion, the Court was required to draw any reasonable inferences in favor of the taxpayer. Therefore, at trial, it is possible that, based on the evidence presented, the state may be permitted to keep the transaction at issue in the sample. However, the Court clearly has its doubts and stated, “At trial, the audit must stand upon a factual foundation which the taxpayer can attempt to topple. If the [state] does not present any merit or fact based rationale for including the [transaction], the [state’s] determination without any factual support may be insufficient to sustain the audit determination.”
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.