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Sales Tax Audits: If Nothing Goes In, What Can Come Out?

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Courts were recently called upon once again to make rulings in the state of New York regarding taxpayers who questioned sales tax audit methodologies. In one of the recent cases, the auditor had little to work with. The owner refused to respond to calls, would not provide documentation or receipts or any form of sales invoices and basically made himself scarce. On the second visit to the business, the auditor found the location and office closed.

So the auditor did not have access to the taxpayer or a representative, nor access to adequate records to verify reported sales. Failing to gain any responsiveness from the owner, the auditor resorted to an indirect audit methodology. Once the audit was performed and the assessment delivered, the taxpayer went to court, appearing to “…take issue with the Division’s audit result because it is imprecise.” The court determined that even though the taxpayer eventually provided their sales journal to the auditor (five months after the scheduled audit), the “…record was clearly insufficient to verify taxable sales.” The court eventually found for the state.

In these kinds of situations, what is the auditor supposed to do? He can test the accuracy of existing sales tax returns for the periods in question. He can review federal income tax returns. He can review customer records, if available, for purchase trends. He can examine vendor sale information. He can look at the industry average for sales. But without complete sales information, he must extrapolate from the data available what the average sales were during the period and the expected sales tax revenues.

An indirect audit methodology is not always popular (with the auditor or the taxpayer), and is seldom the best method to use in establishing the sales tax liability. But at times it is the only method. Let’s take a quick look at the most common indirect audit method: Cost Plus Markup.

Cost Plus Markup Method

The “markup method” of tax auditing is most frequently employed in audits of grocery stores, liquor stores, gas stations and bar/restaurants. The basic process involves calculating an average markup and applying it to audited purchases for the period. A fairly basic concept, but like so many other things in life, the devil is in the details.

Take the calculation of the average markup: Unless the entire product line(s) is very homogeneous with a similar markup percentage, the auditor should/will compute an overall weighted markup or will compute and apply markups to each product line. Also, seasonal price changes, price changes related to special events (happy hour, entertainment, etc) and price changes over the audit period need to be accounted for.

The base to which the markup will be applied is audited purchases. Just as sales by product line need to be segregated, so too, do the purchases. Inventory fluctuations, self consumption and other factors should also be considered, if material. The end result will be purchases actually “sold” during the audit period.

Best audit practice is to compute a weighted markup for each year of the audit period and apply them to annual audited purchases. The results are then compared to recorded/reported sales. But what documentation will the auditor want/need to see when making these computations? Here’s a partial list and the reason for, and value of, each:

  1. Current price lists or examination of sales prices of products on the shelves - “shelf test” establishes the average selling price.
  2. Old price lists, advertising, sales invoices, register tapes, etc - these will support sales prices from prior periods.
  3. Advertising, sales invoices, register tapes, etc - these will support changes in prices for specific events (entertainment, happy hour, etc).
  4. Purchase journal, vendor invoices, check register, etc - these will obviously provide the cost of the items purchased for resale, but they will also help determine a “buying cycle.” This is an important concept because when applied correctly it leads to the proper weighting of items relative to one another and thus a better, more accurate overall weighted markup. A good auditor will also use this information to spot missing vendor invoices.
  5. Items and information other than documentation - these will vary between industries, but some examples are size of glasses and shot glasses in bars, written internal control procedures, employee turnover and anything thing else that could impact cash and inventory (the common thread among the industries where markup method is frequently applied).

There isn’t much a taxpayer can do to argue today’s markup - current prices are posted and current vendor invoices are readily available. But if the taxpayer wants the audit to correctly reflect different sales mixes and/or markups in the past, he would be well advised to make the information listed above available to the auditor.

Remember, cost plus markup is still an indirect auditing method for establishing sales and is only as good as the data and information that goes into it. Ideally it will only be used to verify recorded/reported sales and tax. The use of it to re-construct sales for the basis of an audit should be the last thing a taxpayer would wish for.

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