The Vermont Supreme Court upheld a meals and rooms tax, alcohol tax, and personal and corporate income tax deficiency assessed against an S corporation and its two shareholders that was based on an auditor's estimation of the taxpayers' income because the court determined that the auditor used proper methodologies to estimate the taxpayers' income after finding that the records they maintained were inadequate and unreliable.
The taxpayers operated a restaurant and bar and used a cash register that produced two types of paper tapes, a running tape that recorded each sale as it was rung in and a "Z tape" that was produced at the end of each day and showed a summary of that day's sales. The Z tapes were put into an envelope at the end of each day, and the daily totals of food and alcohol sales were noted on the envelope. The amounts written on the envelope were then transferred to a weekly summary of sales, which were used to complete the various tax returns.
Upon reviewing the taxpayers' returns, the auditor found that the cost of goods (COG) to gross receipts ratio calculated from the taxpayers' returns was more than double the industry average for a restaurant and bar and that the $500 inventory reported each year during the three-year audit period indicated that the taxpayers had no inventory control procedures in place. During an on-site investigation the auditor found that the running tapes were in large rolls, not dated or labeled, and the ink was too faded to read on the three he examined. He also found that the totals on the Z tapes did not always match the totals recorded on the envelopes. There were handwritten adjustments on the Z tapes where some numbers were crossed out and others written in. The taxpayers claimed that the cash register had problems throughout the three-year audit period and did not produce accurate Z tapes, so the shareholder/owner would put down his recollection of the day's total rather than what was reported on the tapes. He further testified that he ignored the Z tapes and instead wrote the running tape totals on the envelopes. However, of the running tapes for the 14 dates examined by the auditor, only four matched what was written on the envelope.
The auditor determined that the records were too unreliable to recreate the restaurant's income and, therefore, estimated the income using industry averages of goods sold and drink sizes. He calculated what the restaurant's COG ratio would be based on the income recalculated for the restaurant's alcohol purchase records obtained from the restaurant's beverage vendors and reconstructed the income using a routine audit procedure. He considered the average price of the restaurant's drinks as stated and the average costs of alcoholic drinks based on a review of vendor invoices, and calculated a COG ratio for beer, for wine, and for liquor. The auditor rejected the taxpayers' claim that the bar averaged a four-ounce pour as being unrealistic given that the industry standard was a one-and-one-half-ounce pour. The auditor then applied a food ratio of 50%, based on industry ranges and taking into account the fact that the taxpayers purchased all the food at retail. The tax assessed was based on the combined COG ratios recalculated by the auditor.
The court found that the auditor properly estimated the taxpayers' income using accepted methodologies after the taxpayers failed to maintain and provide adequate books and records. The taxpayers failed to prove by clear and convincing evidence that the auditor's estimation was improper, and, thus, the assessment was sustained.
Travia's Inc. et al. v. Department of Taxes, Vermont Supreme Court, No. 2012-422, August 9, 2013, ¶200-802
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