Tax Appeals Tribunal Rejects Division’s Methodology as Lacking Rational Basis

Finding that the Division’s estimated methodology for determining taxable sales lacked a rational basis, the Tax Appeals Tribunal in two recent cases cancelled sales tax assessments. This office handled the appeal in the most recently decided case, In the Matter of Gulzar A. Khan and Ishtiaq Khan, DTA Nos. 820701 and 820702 (Sept. 4, 2008).

[Petitioners’ corporation operated a service station in Harlem. In estimating repair sales, the Division’s auditor relied on an investigator who reported that the corporation’s premises included two repair bays and that there were sufficient employees present to operate both bays on a full time basis. Based on “prior audit experience,” the auditor estimated that each bay generated sales of $130 per hour, and multiplied that figure by two bays used eight hours per day, six days per week, resulting in total estimated repair sales of $648,960 for the audit period. The ALJ found that Petitioners’ failure to produce books and records justified resort to estimated methods employed by the Division. Finding unsubstantiated the Petitioners’ assertion that the Division’s estimated repair sales were too high, the Division of Tax Appeals issued a Determination upholding the assessments for both fuel sales and repair sales. Exceptions were filed and the instant appeal ensued.]

In its decision, the Tax Appeals Tribunal made the following additional finding of fact: “When the auditor met with Mr. Khan for 3.5 hours on May 30, 2003, he was not asked any questions about his gas station’s hours of operation, the number of employees, the number of mechanics, or whether they were full or part time. . . The [investigator’s] report indicates that, as of the date of the report (8/8/02), the business had four employees, but does not specify that they are mechanics. The report states that there were nine customers during the time of the visit, but fails to show how long each visit lasted or what type of customers are referred to.”

On appeal, Petitioners took issue with the sales tax imposed on repairs, arguing that the method employed by the Division in calculating estimated tax on repair sales lacked a rational basis. Petitioners also argued that the Division’s estimate of the scope and extent of Petitioners’ repair work and the amount of time the repair bays were operated was excessive. The Division argued that the Determination should be sustained, citing three cases involving one-day observation tests and prior audit experience.

In its opinion, the Tribunal first cited Matter of Grecian Square v. Tax Appeals Tribunal, 119 AD2d 948 (1986) for the proposition that “a determination of tax must have a rational basis in order to be sustained.” The Tribunal noted that “[w]hile considerable latitude is given to an auditor’s method of estimating sales under such circumstances as may exist in a given case, it is necessary that the record contain sufficient evidence to allow the trier of fact to determine whether the audit has a rational basis.” In Grecian Square, the record lacked testimony concerning the applicability of the audit experience to the tavern in question. The Tribunal remarked that such information “is necessary to provide the taxpayer with an opportunity to meet their burden of proving such methodology is unreasonable.”

The Tribunal observed that the Division’s investigator noted in his report: “A busy service station with a two bay repair shop. No convenient (sic) store. Few Tires.” However, the Tribunal reasoned that the fact that the taxpayer had “sufficient employees” to operate two repair bays “does not mean that both repair bays were busy when he was there.” The Tribunal also noted that report failed to quantify how many employees were “sufficient”. The Tribunal found the “lack of curiosity” of the auditor in inquiring as to the type of repair sales “troubling,” and remarked somewhat caustically that the auditor’s assertion that the “taxpayer[’s station] was ‘busy’ does not tell us anything; it is just another conclusory statement.” The Tribunal also noted that the investigator took no pictures of the actual business activity on the date of the investigation.

The Tribunal distinguished earlier cases which had sustained the use of “prior audit experience,” explaining that “this case does not reflect a change in that regard, but some evidence must be offered to show how that prior audit experience relates to the specific taxpayer.” (Emphasis added). In the cases cited by the Division, the auditor or investigator “had interaction with the owners or employees and made inquiries as to how the particular business was operated.” The Tribunal noted that “[t]he Oak Beach Inn case was also distinguishable. Although the auditor relied, in part, on prior audit experience in that case, it involved a much more detailed record surrounding the test period and markup audit of that taxpayer.” The audit record was sparse, and was based on the “very brief, conclusory statements of an investigator who did not testify and who could not be cross examined as to the manner of his ‘investigation’.”

Citing Matter of Chartair, 65 AD2d 44 (1978), and Matter of Grecian Squire, the Tribunal stated that unless the “audit experience” has “some relevance” to the taxpayer’s business, “we have no way of knowing whether the audit experience relied on is valid or not. Thus, we conclude that the Division has failed to show a rational basis for its audit of petitioner’s repairs, and that portion of the audit results must be cancelled.”

This case demonstrates that although estimated methodologies need not result in “mathematical precision,” and the burden remains on the taxpayer to show the lack of a rational basis, there is a limit to how far the Division can go when estimating sales. Here, the Division veered substantially over the line in estimating taxable repair sales. The demeanor of the Tax Appeals Tribunal panel and the tenor of their questions directed at the Division’s counsel at oral argument left no doubt that the panel was clearly disturbed by the manner in which Petitioner’s repair sales had been estimated. The decision, which has precedential value, sets a significantly higher standard for the Division when utilizing estimated methodologies.

[Although “Determinations” made by an ALJ following a hearing in the Division of Tax Appeals cannot be cited or relied upon in future administrative proceedings, “Decisions” of the the Tax Appeals Tribunal, in contrast, become part of the common law and, although they not as authoritative as cases decided by the Appellate Division, are staré decisis (lat.: to stand by that which was decided) and must be followed in later cases unless overturned.]

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In another case decided this summer, the Tax Appeals Tribunal, finding the Division’s estimated methodology for determining jewelry sales at a mall kiosk lacked a rational basis, also reversed the Determination of the ALJ, and cancelled the Notice of Determination. Matter of the Petition of Muhammad S. Abbasi, DTA No. 820239 (6/12/08).

[The taxpayer sold jewelry from a rented kiosk in the Broadway Mall in Hicksville. The Division commenced a sales tax audit based upon a complaint by a customer that the taxpayer had offered to charge no sales tax if the customer paid cash. Finding that the taxpayer had failed to produce requested books and records, the Divison’s auditor resorted to an estimated methodology which computed sales tax liability by multiplying the rent by a factor of ten. On appeal, the Division asserted that rent factor employed was valid based upon the auditor’s experience. The taxpayer argued that the audit methodology lacked a rational basis since the kiosk was not comparable to a jewelry store. The ALJ determined that the neither a bank deposit analysis nor an observation test was required even though those alternative methods might have produced a more accurate result. The instant appeal followed.]

The Tribunal found that resort to external indices was appropriate since the taxpayer had produced sufficient records. However, the Division’s presentation of “an estimated dollar amount of sales . . . based on the Division’s ‘experience’,” in which the “individual citizen has no opportunity to challenge or even examine” the audit methodology “strongly suggests the absence of fairness.” The Tribunal held that the record “must contain sufficient evidence to enable the trier of fact to determine whether the audit has a rational basis.” The ALJ justified its use of rent as a basis for projecting sales based upon Tax Law §1138(a)(1), which provides that “external indices” include items “such as . . . rental paid.” However, the Tribunal found that the language “such as” followed by various specific examples “are clearly intended to be nonexclusive examples.” The Tribunal “infer[red]” that “the estimate should be logically and empirically related to the subject of the tax.”

The Tribunal then cited various cases where use of a rent factor was permitted. In those cases the “statistical report . . . was publicly available and the taxpayer would thus be able to challenge[] the soundness or applicability of the report.” However, in Matter of Basileo, the Tribunal rejected an estimate of a restaurant’s sales made by “obtaining figures for two other restaurants each deemed to be comparable . . . and averaging them.” The Tribunal expressed skepticism with the Division’s decision to use a rent factor of 10, based upon its claim that two recent “no change” audits for two other jewelry stores in Nassau County found gross sales in one to be 40 times the annual rent, while that in another audit, was 8 times the annual rent.

The Tribunal concluded:

“In each of the cases . . . in which rent-to-sales ratios have been found to provide a rational basis . . . the Division has begun with a broad sampling . . . and then tailored that information to make it comparable to the matter at hand. Although the logical and empirical connection between rental expense seems weak, in each case meaningful information was provided as to how the data underlying the rent factor was selected . . . and the petitioner was given a full opportunity to challenge [its] validity. Here, the auditor began and ended his analysis with ‘a benchmark kind of thing’ of ten times rent, which was apparently drawn from flea market audits and ‘regularly used’ in his office. The habits of mind so described do not in our view provide the required rational basis for estimating tax liability. Accordingly. . . the Notice of Determination is cancelled.”

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