Cash Audits and the Mark-Up Methodology

Why should you care about cash audits?

You should know that the Division of Taxation has created 21 field audit teams strategically located throughout the State of New Jersey. These “in-state field audit” teams are responsible for the examination of taxpayer’s books and records to insure compliance with existing laws and regulations. Audits are usually performed on site at the taxpayer’s place of business or at a site provided by the taxpayer’s representative. Audits are comprehensive in nature and intend to include all taxes administered by the Division of Taxation, however, their primary focus is on sales and use tax and corporation business tax.

Additionally that the Division, and now the IRS, has recently placed a special emphasis on the audit of smaller “cash” businesses. The initiation of the cash audit program is intended to strengthen compliance in collection efforts as well as level the playing field for compliance of businesses.

New Jersey Case Law

Since 2005, there have been two key decisions that have been decided on which the Division of Taxation relies. The first is Yiolmaz, Inc. v. The Director, 22 N.J. Tax 204 (2005); affirmed on appeal 390 N.J. Super. 433 (2007) and Charlie O’s, Inc. v. The Director, 23 N.J. Tax 171 (2006).
Both of these cases were “cash audit cases.”
The underlying question in these cases were the propriety of the auditor adding additional sales to the taxpayer’s records in order to determine the amount of sales tax due.

When a taxpayer challenges an assessment of sales tax by the Division of Taxation based on an audit of a cash business involving only factual issues and a method employed by the Director, the taxpayer can rebut the presumption that the assessment is correct only by “cogent evidence that is definitive, positive and certain in qualify and quantity to overcome the presumption.” In the absence of evidence that the amount of the assessment is “far wide of the mark,” the taxpayer cannot overcome the presumption simply by attacking the Director’s methodology. Under our statutes, the Director is given broad authority to determine the tax from any available information, and, if necessary, to estimate the tax from external indices. N.J.S.A. §54:32B-19. The taxpayer’s evidence must focus on the reasonableness of the underlying data used by the Director and the reasonableness of the methodology used. An aberrant methodology will overcome the presumption of correctness. An imperfect methodology will not.

In Yiolmaz, the taxpayer operated a restaurant.
The taxpayer had virtually no record of its receipts for the 1995 through 1998 audit period as required by the statute from which to verify the gross receipts reported on its tax returns; it did not retain cash register receipts, did not use guest checks and did not maintain summary records of sales.1 Accordingly, the Director's auditor used an indirect "markup" procedure to reconstruct the income and receipts of taxpayer's cash business and determine the sales tax assessment and deficiency and resulting increases in the corporate business tax (CBT) and gross income tax (GIT) withholding assessments. Under this methodology, the auditor selected a test period, which in this case was the calendar year 1997. The auditor then compared the cost of goods sold by the taxpayer for that period, as developed from invoices and the records of suppliers, to the menu prices, developing a ratio of selling price to cost, or "markup." The auditor then applied that ratio to the cost of purchases for each year covered by the audit to arrive at an estimate of gross receipts subject to sales tax for the audit period.2

Using the gross sales determined from his markup analysis, the auditor computed a sales tax deficiency and recomputed taxpayer's CBT for 1995, 1996 and 1997 and computed the tax for 1998 because no return had been filed for that year, and made assessments for all of the audit years. He also made an assessment of additional GIT (withholding) based on his calculation of adjusted employee wages and estimated salary attributed to Mr. Yilmaz. In the absence of any documentation or evidence presented by the taxpayer to support the information reported on the returns, the Director issued a notice of assessment.

The principal issue at trial was the "reasonableness of the methods employed by the Director for an audit period where the taxpayer had virtually no records of its receipts." The Tax Court began its analysis with the well settled principle that the Director's assessments of tax are presumed to be correct and the taxpayer has the burden of overcoming the presumption.3 These cases have recognized that the "naked assertions" of the taxpayer, without supporting records or documentation, are insufficient to rebut the Director's presumption.4 The court noted, however, that the extent of the burden of proof placed on the taxpayer to overcome the presumption was ill-defined, and the case law needed a specific, workable standard.
When a taxpayer challenges an assessment by the Director based on an audit of a cash business, involving only factual issues and the methods employed by the Director, the taxpayer can rebut the presumption that the assessment is correct only by cogent evidence that is "definite, positive and certain in quality and quantity to overcome the presumption."5

In the absence of evidence that the amount of the assessment is "far wide of the mark," the taxpayer cannot overcome the presumption simply by attacking the Director's methodology.6 As the court noted, the Director is given broad authority to determine the tax from any available information and, if necessary, to estimate the tax from external indices. See N.J.S.A. 54:32B-19. The court rejected the taxpayer's suggestion that the onus should be on the Director to establish that it used "the most reasonable means available" or "the best possible method" to estimate the taxpayer's receipts. The court reasoned that it would be contrary to the purpose of the recordkeeping statute to place such a high burden and expense on the Director when it was taxpayer's own failure to maintain proper records that "forced the Director to resort to the markup method in the first place."7

The taxpayer's evidence must focus on the reasonableness of the underlying data used by the Director and the reasonableness of the methodology used. An "aberrant" methodology will overcome the presumption of correctness. An imperfect methodology will not.

A similar case was that of Charlie O’s, Inc. v. Division of Taxation, 23 N.J. Tax 171(2006). In Charlie O’s, the taxpayer was a New Jersey corporation that operated a restaurant. The taxpayer’s corporate business tax returns consistently reported larger amounts of gross receipts than did the taxpayer’s sales tax returns. The Director conducted an audit and determined that additional sales and use tax was due. The court found that since the CBT returns and sales tax reports reporting wholly different gross receipts, the auditor had sufficient authority under N.J.S.A. §54:32B-19 to use the mark up method to determine whether the taxpayer had underreported its gross receipts on the sales tax returns.

The methodology employed by the auditor, however, was aberrant, in that he conformed gross receipts for sales tax purposes with the gross receipts as reported on the CBT returns increasing the purchases made by the taxpayer by an arbitrary amount which, when multiplied by the mark up ratio, produced estimated gross receipts that conforming with those reported on the C.B.T. returns. At trial, the auditor when confronted with the difference in the C.B.T. returns and sales tax returns the court noted that it warranted a closed examination and the auditor had a wide latitude to make a determination regarding sales tax that are due using one or more several methodologies as he saw fit. The court noted this authority, however, is not unlimited. The court found that there was no authority for the auditor to adopt the gross receipts as reported on the C.B.T. returns rather than the gross receipts as reported on the sales tax returns merely because it was more convenient to do so or because the use of the gross receipts reported on the C.B.T. return produced a larger sales tax liability. The basis which the auditor used for making this conclusion was because the taxpayer lacked any cash register tapes through which receipts could be verified. His concern was that the taxpayer did not report all of its receipts in the bank. The court pointed out that N.J.S.A. 54:32B-16 requires vendors to keep records of every purchase in the form that the Director may, by regulation, require. “Such records shall include a true copy of each sales slip, invoice, receipt, statement or a memorandum” showing the amount of separately stated tax.

A true copy of all sales slips, invoices, receipts, statements, memoranda of price, or cash register tapes,8 issued to any customer by a vendor who is required to be registered pursuant to the provisions of the Sales and Use Tax Act (N.J.S.A. 54:32B-1 et seq.) and records of every purchase and purchase for lease must be available for inspection and examination at any time upon demand by the Director, Division of Taxation, or his or her duly authorized agent or employee and shall be preserved for a period of four years from the filing date of the quarterly period for the filing of sales tax returns to which such records pertain.

In addition, N.J.A.C. 18:24-2.4(a) provides that when a taxpayer maintains summary records showing total receipts and taxable receipts, the taxpayer may dispose of individual sales slips, invoices, receipts, statements, memoranda of price or cash register tapes. The taxpayer’s cash receipts and cash disbursements journals were summary records. Under the Director's regulations, taxpayer's records were deemed to be adequate.

A key point was the fact that the taxpayer’s expert was able to demonstrate that the entries in the cash receipts and disbursement journal corresponded with bank statements and a spreadsheet which reconstructed the taxpayer’s records. The spreadsheet showed that the taxpayer’s gross receipts were overstated on the CBT prepared by the taxpayer’s prior accountant. The court, based on the evidence presented, agreed with the taxpayer and reduced the tax consistent with the taxpayer’s records.9

Analysis

As these cases demonstrate a cash audit of a small business can be a very devastating event where the taxpayer fails to maintain proper records. The problem is that taxpayers often do not have cash register tapes or the tapes are incomplete. This is one strike against the taxpayer. The second strike is the failure to maintain proper original books of entry such as journals and ledgers; the third strike is the failure to maintain summary records.

Couple the failure to maintain records with the ability of the auditor to use any reasonable means to determine the taxpayer’s gross sales and often there will be a significant sales tax deficiency as well as an income tax liability. The auditor will often also look at other aspects of the taxpayer’s business including expenditures, salaries, draw and non-deductible business expenses, travel and entertainment, cars and other personal use vehicles, and in some cases, an examination of the taxpayer’s residence and lifestyle.

Taxpayer should be well advised that in the event he or she is notified of a cash audit they should not take it lightly. They should be prepared. They should have their tax professional review all of their records to substantiate their reported corporate income tax and sales tax. A “red flag” is often the difference between the reported CBT income and the sum total of the sales tax reported.

In addition to a potential increase in sales tax, a cash business also faces the issue of an increase in the use tax. The use tax is paid on items purchased for which no sales tax was paid. An auditor will examine a taxpayer’s records to isolate these transactions, compute the appropriate use tax. This includes looking at credit card receipts, checks written, etc.

As part of the taxpayer’s records, the taxpayer should maintain appropriate certificates such as resale certificates for property sold to others who in turn are going to be reselling the property, form ST-3, or if the property is going to be used for exempt use then purchaser must complete form ST-4 and such records must be maintained by the taxpayer.

If a taxpayer is making capital improvements, then form ST-8 must be completed by the property owner and maintained by the taxpayer. If the taxpayer is a contractor and making a purchase for erecting structures or building, etc. for exempt purchases then form ST-13 must be completed.

These are some of the forms that need to be maintained by the taxpayer in order to have proper records in the event of an audit.

Not only has New Jersey stepped up in enforcement provisions and along with that the courts decisions which provide wide latitude to State auditors, but in addition in the event of increase and the underlying tax, penalties and interest provisions will apply. There are penalties for failure to file tax returns on time which is 5% per month up to a maximum of 25%. There is a penalty for underpayment of tax required to be shown on a return which unless there is reasonable cause will amount to 5% of the underpayment of the tax, and there is interest on the deficiency which is charged at 3% plus the prime rate assessed for each month compounded annually at the end of each calendar year. There are also penalties for fraud, etc.

Accordingly, cash based taxpayers would be well advised to maintain good records and remit their taxes timely. In the past, taxpayers could rely on the “audit lottery” and if they were caught they grudgingly would pay the tax penalties and interest. But with the increased enforcement, better auditing tools plus case law in favor of the State, the audit lottery is no longer a good “bet.”

The IRS Cash Audit Guide

The IRS has posted an Audit Techniques Guide (ATG) to provide guidance to its agents on how to examine income in a cash intensive business.10 While the ATG is not an official pronouncement of the law or IRS's position and cannot be used, cited, or relied upon as such, it does provide valuable information to practitioners and taxpayers on how IRS audits cash intensive businesses including specific types of cash businesses.

The ATG is presented in several chapters.

The ATG notes that the individual income tax “gap” is thought to be in the hundreds of billion of dollars. In part, this may be because there is an increasing underreporting of income by those taxpayers with the ability to determine their own reported income, such as businesses that receive most of their income in cash. Cash transactions are anonymous, leaving no trail to connect the purchaser to the seller, which may lead some individuals to believe that cash receipts can be unreported and escape detection.

Ways cash is misappropriated. The ATG observes that there are three main ways to misappropriate cash from a business:
... It can be skimmed from receipts before it is recorded.
... It can be stolen after it has been recorded.
... A fraudulent disbursement can be created.

Indicators of underreported income. The ATG states that the most significant indicator that income has been underreported is a consistent pattern of losses or low profit percentages that seem insufficient to sustain the business or its owners. Other indicators of unreported income include:
... A life style or cost of living that can't be supported by the income reported.
... A business that continues to operate despite losses year after year, with no apparent solution to correct the situation.
... Application of the Cash Transaction examination method (Cash T) shows a deficit of funds.
... Bank balances, debit card balances and liquid investments increase annually despite reporting of low net profits or losses.
... Accumulated assets increase even though the reported net profits are low or there's a loss.
... Debt balances decrease, remain relatively low or don't increase, but low profits or losses are reported.
... A significant difference exists between the taxpayer's gross profit margin and that of his industry.
... Unusually low annual sales for the type of business.

Examination techniques. The ATG stresses that examination techniques must be tailored to provide for the best analysis of a specific taxpayer's possible income stream. There are several techniques that can be used successfully when working with cash intensive businesses. First, a financial status analysis including both business and personal financial activities should be done, the ATG advises. This is a required minimum income probe. If it shows an imbalance in the cash flows indicative of underreported income, an examiner is told to request clarification or explanation from the taxpayer before beginning the use of an Indirect Method (Financial Status Audit Techniques).

Indirect methods, such as a fully developed Cash T, percentage mark-up, source and application of funds or bank deposit and cash expenditures analysis, can then be used to confirm the amount of any understatement. The ATG says that the most critical aspects to successfully examining a cash intensive businesses is the examiner's ability and skill in gathering information about how the taxpayer conducts business, documenting cash inflows and outflows, and conducting a detailed interview with the owner of the business relating to business and non-business cash receipts and cash expenditures.

Cash intensive business. A cash intensive business is one that receives a significant amount of receipts in cash. This can be a business such as a restaurant, grocery or convenience store, that handles a high volume of small dollar transactions. It can also be an industry that provides cash payments for services, such as construction or trucking, where independent contract workers are generally paid in cash.

A careful practitioner should closely examine the ATG pronouncement and look for signs of underreporting of income before the client is audited.
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1. See N.J.S.A. 54:32B-16 requiring records of sales to be retained for examination and inspection by the Division for a three-year period from the filing of the return, or longer if required by the Director); N.J.A.C. 18:24-2.3(a)(requiring the retention of cash register tapes for three years, amended effective June 1, 1998 to require a four-year retention period, 30 N.J.R. 2070(b)(June 1, 1998)); N.J.A.C. 18:24-2.4(a), (b) (permitting cash register tapes to be discarded after a certain period where summary records of sales are maintained; the summary records must be retained for four years).

2.In developing his markup ratio, the auditor reduced taxpayer's audited gross receipts by various allowances for discounts, giveaways and specials.

3. Atlantic City Transp. Co. v. Dir., Div. of Taxation, 12 N.J. 130, 146, 95 A.2d 895 (1953).

4. TAS Lakewood, Inc. v. Dir., Div. of Taxation, 19 N.J. Tax 131, 140 (Tax 2000); Ridolfi v. Dir., Div. of Taxation, 1 N.J. Tax 198, 202-03 (Tax 1980).

5. Pantasote, supra, 100 N.J. at 413, 495 A.2d 1308 (quoting Aetna Life Ins. Co. v. City of Newark, 10 N.J. 99, 105, 89 A.2d 385 (1952)).

6. Id. at 414-15, 495 A.2d 1308.

7. Yilmaz, supra, 22 N.J

8. Cash register tapes are source documents that enable the Division to spot check the accuracy of the summary records. In other words, although not absolutely required by the regulations if summary records are available, cash register tapes are helpful, and if an auditor has reason to believe that a taxpayer's summary records are inaccurate, and no cash register tapes are available, the use of a markup analysis is appropriate. N.J.S.A. 54:32B-19.

9. The court mused that the negotiating of gross sales on the corporate income tax return may have to be done to facilitate a loan.

10. http://www.irs.gov/businesses/small/article/0,,id=210627,00.html#SoP