For several years, businesses with significant cash transactions were incredibly difficult for a state to do a sales tax audit. There has always been a looming undertone that businesses such as restaurants, convenience stores, and liquor stores were often not faithfully reporting the proper amount of state sales tax. Conversely, the big chain store owners with multiple stores in the best locations were complaining about the small, single store owner. Over the years, the revenue agency in a state has been able to get higher standard third-party reporting.
The state strategically planned and calculated its attack. The attack was launched from several fronts. The state was able to obtain reports from the beer and cigarette vendors as to what has been sold to each retailer. Simultaneously, the state was able to obtain from the industry, such as the National Association of Convenience Stores (NACS), how much those beer and tobacco products are marked up and the proportion of those sales in relation to total sales. With the number of purchases, the estimated markup of the purchases, and the proportion of sales of alcohol and tobacco products, the state could reasonably estimate the number of sales made by each and every business that sold alcohol and/or tobacco.
Armed with critical third-party reporting data, states started auditing these enterprises by the hundreds. Not only did they have the data, but also had a systemized approach allowed the state to do more audits with less manpower. Whether records are provided or not, a state will often utilize its own approach and go after the small business owner using the model that estimates the maximum amount of state sales tax. If the business is not adequately represented and records aren’t provided and the ultimate assessment isn’t timely challenged, the state will begin collections by freezing bank accounts and eventually strangling the business until it goes out of business. And, if that doesn’t work, the state will move on to the owner of the business by penalizing and prosecuting them for the sales taxes not paid. Notice that this final result is an all-out attack on the small, one owner convenience store industry, which is exactly what the mega-chain gas stations covertly asked the state to do in the first place Below we will discuss how each of these tactics, when combined, results in complete devastation of the small community of convenience store owners and their families.
Unreliable Third-Party Data
As discussed above, the entire premise of the audit is based on third-party data. In this particular situation, the underlying data are date-provided by the vendors of sales made to the retailers. While it is logical that the majority of the purchases made by each convenience store, gas station, restaurant, liquor store, or smoke shop, are ultimately sold higher than the cost and are predominantly taxable sales, the underlying data is often unverified and inaccurate.
The wholesale data, which is often broken down by type of product, by month, and by the retailer, gave the state an abundance of information about the beer, cigarettes, and other alcohol/tobacco products these small business owners were buying. Large chains, such as Sam’s Club would often duplicate purchase data, misapply the data to the wrong account, and/or submit data on all purchases, not just alcoholic beverages and tobacco purchases.
Therefore, it is critical to obtain the purchase data yourself and compare it to your actual records. If you know what the state’s Department of Revenue (DOR) has, you can take the initiative to show why their assumptions are wrong. Armed with the shiny, new third-party purchase data, the state extorting millions of dollars from these poor, small, community business owners is based on false information.
Industry Averages Based on Magazine Surveys
Having the purchase data (costs) for alcoholic beverages and tobacco sales were Step 1. Next, the state had to create a way to estimate sales if they received untrustworthy records from the business. Naturally, the state devised a way to estimate the markup by using industry averages from magazine surveys.
As an aside, this approach seems to be suspect for a number of reasons. First and foremost, it seems as though the owner of multiple gas stations or convenience stores might have an incentive to overstate their profit margins for a magazine survey. If they report higher profits, it may incentivize others to report higher profits as well. Simple competitive market concepts dictate that if everyone raises their prices, the profits will go up for all.
There is also a strong likelihood that large brand names and chains may actually have higher prices than the mom and pop convenience store or gas station. Maybe the chains have the most desirable locations that lend themselves to higher pricing. Perhaps, brand loyalty and a number of other factors will allow large companies to get higher prices.
Combining the incentive to report higher prices in a survey along with the probability that the biggest and best stores often get the maximum price, it is likely the magazine survey overstated the prices of the purchases made by the individual convenience stores and gas stations. Worse yet – how reliable is the data coming from a magazine survey, almost entirely derived from the largest chain gas stations in the best locations across the country? Even if the survey statistics were reliable for the big stores, just how applicable are these statistics for tiny, community-based convenience stores with no gas, in poor areas of town, with several other small convenience stores and gas stations within a quarter-mile of each other? These little community convenience stores are barely surviving, with sometimes as little as 5% markup on beer or cigarettes just to compete against other stores.
Not only are these statistics unverified and questionable to begin with, but also the survey provided by the NACS and used by the state to develop the campaign model was derived from responses that comprised less than 1% of single store owner responders. Obviously, it makes sense that almost every convenience store being attacked by the state is a small, single store owner, but the “industry averages” that came up with the campaign model against these single store owners are 99% from the mega-chain stores in the best locations, with the best markups. The industry averages used by the state do not even come close to reality. Now combine inflated, estimated markups with completely false purchase information – and we have an exponentially growing problem with the state’s Revenue Agency estimated assessments.
To add insult to injury, the NACS has a completely separate survey that they give to single-store owners. The state, motivated by the big chain stores, conveniently ignored the “best available information” about the taxpayers they are auditing because it doesn’t produce as high an assessment. If the purpose of the audits were to find out what the industry really owed, logic would dictate that the state uses statistics from the market segment being audited, not the biggest, best, and most profitable businesses in the industry to estimate the sales of the small guy just trying to survive. There might have been one flagrant cheater that slips through the cracks if their estimates were not inflated through the roof. Instead, hundreds and hundreds of honest, hardworking small business owners get slapped with outrageous estimates and are forced to hire someone to fight back. I also find it appalling that most of the employees of the state using these industry averages do not even realize the statistics are from magazine surveys.
But wait, this is not the end of their tyrannical practices. It gets much worse.
State Over Estimates Taxable Sales
For those keeping score at home, the state’s Revenue Agency has the amount of alcohol and tobacco purchased by the retailer along with the profit margin or markup on those items. In order to estimate total sales, the state would need a way to determine the amount of non-alcohol and non-tobacco sales relative to a specific business. You guessed it! – Why not use the magazine survey data for this variable as well.
Using the NACS survey data of the biggest, best, and most profitable convenience stores, the state has the tools to estimate total sales. Although the exact amount varies year to year, according to the survey, about half of a convenience store or gas station sales are alcohol or tobacco products. In effect, this means that roughly, the other half of sales are non-tobacco and non-alcohol related sales.
Assume that a state has data showing that a retailer buys $40,000/month of alcohol and tobacco products. Based on a 25% markup, provided by the survey from the NACS magazine, the retailer would have estimated beer and cigarette sales of about $50,000/month. Given that, about 50% of its sales are beer and cigarettes, per the NACS survey, its total estimated sales are about $100,000/month. The survey also indicates that about 85% of a store’s sales are taxable, on average, which would show taxable sales of about $85,000/month. Using that figure times the tax rate x the number of months in the audit period and giving credit for the tax paid, a state has just completed its assessment without ever reviewing the taxpayer’s records. As you can see, without difficulty, the state can easily estimate a $100,000+ tax assessment that this struggling business owner must defend against or pay.
At this point, I will point out that we have defended well over 1,000 convenience stores with sales tax assessments across the country. Without the slightest shadow of a doubt, the estimates are all overestimated. The most consistent thing I hear from prospective clients in my office is:
“I wish I made those kinds of markups. If I did, we wouldn’t be here in the first place!”
A much more accurate method of determining a convenience store’s sales is to review the actual records from the store’s point of sale system. Many, if not most, convenience stores have monthly reports that depict exactly what their sales are. Alternatively, the state might use common sense to realize that almost every convenience store that uses competent counsel to challenge the grossly overestimated assessment received dramatic reductions in the tax assessment. One might consider that a reasonable taxing authority would adjust their estimating model to match the results they have found from reviewing the actual business in the industry. From our experience, the typical small, community, convenience store has at least 15% exempt sales, at least 55% alcohol and tobacco sales, and dramatically smaller markups on products.
The slight differences between these two methods reflect that the DOR’s estimating model results in anywhere from 100% to over 500% exaggerated assessments, completely victimizing the industry. The state’s DOR has been bragging about the results.
Structure the Audit to Ignore Taxpayer Information
To understand just how sneaky the state’s DOR is when attacking the convenience store and gas station industry, you need to understand a little bit about the state’s laws. Specifically, the state has a built-in provision that if the taxpayer does not provide sufficient or reliable records, the state believes it can use the “best available information.” It almost goes without saying that it is much less work for the auditor to fall back on a formula-driven “best available information” audit in lieu of actually auditing and reviewing the taxpayer’s records. Often times, whether providing records or not, results in a guilty until proven innocent assessment that the business is stuck defending.
The auditor will often include a questionnaire and ask questions relating to the business’ average sales that are assumed to be by type of product as a percentage of total sales (aka “sales mix”) and what the average markup is on each of these types of products (aka “markup”). They ask for a total purchase amount for alcohol and tobacco for one year during the audit (a year that matches the wholesale ABT data) but do not ask for the details or for actual purchase records. Then they curiously ask for the “most recent month’s z-tapes and purchase records.” This is the sneaky part because, by the time, the audit notice arrives, the “most recent month” of z-tapes and purchase records will almost always fall just outside the audit period. In other words, the audit questionnaire, by design, very specifically avoids asking for sales records and purchase records during the audit period. Even if the taxpayer complies with every question on the questionnaire, the state’s DOR still would not have any direct purchase or sales records during the audit period from the taxpayer. Then, the state’s DOR has the audacity to tell the taxpayer that they refused to give records, which resulted in the estimates.
I’m sure the DOR’s response is uniformly the same. It goes something like this: “We give the taxpayer every opportunity during the audit and during the administrative process to prove that the estimate is wrong.” The problem is that when the taxpayer sends actual records from the audit period and the numbers do not match the Department’s infamous industry averages, the auditors decide the records must be unreliable and just ignore the actual records. The auditors and conferees have not been told that the estimates are from a magazine survey. The auditors are not told that most protests that are fought with competent counsel (and good records) reveal how grossly overestimated the “industry averages” are. I, personally, have received so many phone calls from convenience store owners or their accountants telling me the same fact scenario. “We provided everything they asked for but they completely ignored all the records.” “Our store is nowhere near large enough to handle that kind of volume of sales.” “The SAM’s data are completely wrong.” The variations are numerous, but the theme is the same – there is no way that our sales were anywhere close to what the state is estimating. There are probably over a thousand small, family-owned convenience stores that have been completely victimized by the DOR’s campaign in this industry.
HELP! – The State Just Froze My Bank Account
Once the audit is finished and the state has chosen to ignore the actual records provided by the taxpayer, the state’s DOR turns the matter over to a local collection agent. The DOR thinks of these grossly overestimated tax assessments as nothing more than an “accounts receivable” and the collection agent is tasked with collecting the money from the helpless business owner. This collector’s job is simple – collect the money. If the assessment is final, the collector does not care that the assessment is an overestimate or a result of government abuse that occurred up to this point. Their job is to talk the taxpayer into paying the money. If the taxpayer does not comply within a very short amount of time, then the collector will issue a Tax Lien against the business. The taxpayer only has a short period of time to legally challenge the lien, or the collection agent will start freezing the business’ bank accounts and, occasionally, the merchant accounts as well. No matter your relationship with the bank, the bank has no choice but to comply. You can imagine how quickly a high volume, very low-profit margin business doesn’t survive when they cannot access their cash.
Another trend that we see all too often is that the DOR fails to send the taxpayer notices about the final assessment or the outcome of a protest. The notice will go to a bad address or sometimes, only to someone that represented the taxpayer, but the taxpayer never actually gets the notice. What happens all too often is that the first notice the business gets letting them know that their challenge to the audit assessment is over is when the business’ bank accounts are frozen. From a legal standpoint, the taxpayer has lost all guaranteed appeal rights by the time the DOR has the power to freeze the account. While it can be very difficult to get an audit re-opened, there are some procedural arguments that can be made and some back channels that can be explored.
If the assessment is not paid at this point, the state often will try other collection tactics. Most commonly, the DOR will attempt to penalize or pursue the tax from the business owner. To recap, the state overestimated your liability, structured the audit to use third party data in lieu of actual documentation, and attempted to go after the business owner. All the while, the business is guilty of trying to prove its innocence.