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Restaurant owners angry over state audit methods

David "Doc" Panaro and Dennis Nettina, owners of the Buffalo Tap Room & Grill in Tonawanda, have always prided themselves on their integrity. They run a clean business, keep meticulous records and treat their employees, customers and vendors with respect.

So when the state accused them of dodging roughly $330,000 in sales tax over three years, they were first scared and then angry. Now they're determined to fight.

Within the last decade, the New York State Department of Taxation and Finance has ramped up efforts to enforce sales tax compliance. Audits have become even more frequent since Gov. David A. Paterson and state legislators identified increased sales tax audits as a way to close the budget gap without raising taxes or cutting services. Paterson hired 330 more auditors with the goal of raising an extra $220 million per year.

But local small business owners are saying newly accepted auditing practices have them over a barrel. They say the audits, instead of identifying legitimate tax evaders, are being misused to hang imaginary debts on business owners and force them to pay up.

The state also recently started using desk audits, in which they use third-party information to scrutinize whether businesses may be making more money than they're reporting. For example, the state can look at how many pizza boxes a vendor has sold to a pizzeria and if the number of boxes is more than the number of pizzas the company said it sold, the state can look closer to find whether tax evasion is the source of the discrepancy.

"If the state went through a normal audit process and determined that we owed money, we wouldn't fight it. We're not opposed to paying taxes," said Panaro.

Instead, he said he was told all of his paperwork checked out, but he didn't meet the state's standards for keeping "adequate records." The restaurant had failed to keep every paper copy of each guest's order receipt for the entire three-year period. That opened the door for the auditor to use "indirect audit methods" to estimate what he thought the restaurant owed.

The method of estimation the state used was to observe the restaurant's sales for a day, then compare it with the same date on a previous year. The previous year's reported sales were 25 percent lower, so the auditor took that percentage and multiplied it over each day's sales of the three-year period, deciding the restaurant did enough unreported business to owe an additional $330,000 in sales tax.

"They almost did me a favor by coming up with such a ridiculous number, because it's so obviously wrong," said Panaro.

Such methodology may sound outrageous, but it is used and upheld in tax court. The National Federation of Independent Business lobby, made up of 10,000 small business owners, recently requested New York State Comptroller Thomas DiNapoli probe the state's auditing practices, calling them overly aggressive and unfair.

Joe Giafaglione, owner of Bar Bill Tavern in East Aurora, has been audited twice in the past four years. His purchase of ground hamburger raised suspicion when it was found there were no hamburgers on the menu (it was being used as an ingredient in chili).

"It's totally ridiculous the way they come up with figures without any evidence," said Giafaglione. "They say they need 20 [documents], so you give them 19 and they say, 'Ah, you don't have that? Well, now we'll have to estimate.' "

Giafaglione's "inadequate records" once again opened the door for the auditor's estimation. He took Giafaglione's invoices, multiplied his food costs against a national markup average and estimated he owed $125,000 in additional, unpaid taxes, plus interest and penalties. He has spent $100,000 so far fighting the state's claims.

As a basis for their estimates, auditors often use the Restaurant Industry Operations Report by the National Restaurant Association and Deloitte & Touche, which looks at voluntarily reported financial income and expenditure averages from various restaurants around the country. However, the report itself says it is not to be used as an industry standard, only a comparative management tool.

The state used the same report in an audit of Mark Supples' iconic Allentown eatery Mother's, estimating that he owed the state a total of $536,589.45 in additional sales tax, penalties and interest.

He paid $149,000 in attorneys fees, plus the cost of forensic accountants, consultants and tax specialists, and won his case on the basis that the audit's estimation methods were "arbitrary and patently unreasonable."

"I've paid, I don't even want to think of how much, money in taxes over the past 30 years. I've employed a lot of people. But, I'm treated like I'm a thief and a criminal," said Supples.

Supples is one of the rare restaurateurs to win his case. Many owners, just scraping by and unable to afford forensic accountants, tax specialists and attorney fees, cut their losses and settle on a payment out of financial necessity, industry experts said.

"The issue is not that people are collecting tax money and not remitting it -- that would be fraud and the state would prosecute it. The issue is deeming that people do not have adequate records and are being penalized on the basis of that," said David E. Gross, owner of Sales Tax Solutions and Consulting, which audited Mother's and helped Supples prove his case.

Auditors are using the "inadequate records" as an enforcement loophole, he said, stretching the latitude of the law and, in turn, bilking money and putting families out of business. The records owners are required to keep are extremely stringent, but those requirements are little known and not routinely highlighted by the state.

"Probably 95 percent of small businesses don't have what New York State considers adequate records and if you don't have it, it's open season," said Robert Bielecki, a partner at Schunk, Wilson and Co. Certified Public Accountants.

Mark Klein, a tax attorney and partner at Hodgson Russ LLP, said clients have had auditors use several different criteria for estimating purposes, then picked whichever one generated the largest tax bill.

"Whenever the tax department issues a bill, it's presumed correct. The burden of proof is on the taxpayer," said Klein.

The state has said it is ramping up efforts to make sure business owners know what they need to do to be considered in full compliance.

"The solution is to have accurate books and records, and then we wouldn't be in the business of estimating," said William Comiskey, Deputy Commissioner of Tax Enforcement for the New York State Department of Taxation and finance.

He said he has heard the widespread concerns about auditors using intimidation and unfair tactics, but while there may be one or two rogue auditors in existence, he doesn't believe bullying behavior or capricious estimating is at all common.

"If that's the way audits are being conducted, I'm really concerned. It's not the way they're trained, they are not to approach with an adversarial mindset," he said. "We're doing everything we can to train staff, to monitor staff, to ensure our processes are fair."

He fiercely defends the state's estimation methodology, qualifying that it is used as only as one piece of the puzzle, in conjunction with the rest of a business's records.

As part of the desk audit process, when the state initially finds information prompting them to target a business, it sends a letter asking for additional records to review. At the same time, the taxpayer is given the option of admitting without penalty that they have underreported sales tax. According to the state, five percent of respondents take advantage of that option. For another 25 percent, the additional records clear up the state's questions, ending the process and avoiding audit.

"We're not trying to hurt business. We're trying to educate them on the requirements and make sure everybody gets a level playing field by making sure everyone is abiding by the rules," said Comiskey. "It's not a gotcha."

e-mail: schristmann@buffnews.com

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