New York State is looking for additional sources of revenue to close its substantial budget gaps. Increased rates and stepped up enforcement have had their effects on our clients. Sales tax enforcement is one area that has been particularly active in the past few years and the costs of non-compliance can result in substantial taxes and penalties paid to our friends in Albany.

Generally speaking sales of tangible personal property are subject to New York sales tax unless they are specifically exempted. Sales of services are generally exempt from New York sales tax unless specifically taxable. Examples of exempt purchases are mostly food, medicine, machinery, equipment and parts used in manufacturing along with items intended for resale to another purchaser. Taxable services are repair services (as opposed to services for capital improvements), landscaping and trash removal to name just a few of many.

The rules regarding what is taxable can be arcane and turn on very narrow definitions. For example, a single Twix candy bar purchased at the check-out counter is subject to sales tax but if you picked up a box of them in the aisle these are tax free as they are considered cookies under New York rules. The slicing of a bagel and loading it with cream cheese moves it from a non-taxable food item to a taxable prepared food. These seemingly minor nuances create land mines for taxpayers in New York.

If you are a New York business required to collect sales tax on sales, you are required to pay this over to New York State. This is considered a trust fund tax in that it really belongs to New York State and you are holding in trust for the state until it is paid over. To the extent that these amounts do not get paid over, New York State takes a rather dim view of this especially when it is an intentional act.

If you get the dreaded notification of a sales tax audit you will receive information as to your rights as a taxpayer indicating that audits will be conducted using professional standards. This may be true to the extent that you have auditable business records and adequate internal controls. If New York makes the determination that you have inadequate business records, then they have been allowed by previous judicial precedent, great leeway to use any reasonable method to determine one’s tax liability. 

In order for a New York business to meet the adequate records requirement the emphasis is on having records in electronic format to ease the burden on the auditors. If you have electronic records but do not maintain them or fail to provide them, the penalties can be quite severe. Starting in June of 2009 the first quarter failure will result in a $1,000 penalty and subsequent quarters will result in a $5,000 penalty. For a typical three year audit period you are looking at $56,000 in penalties before the audit even begins. This is certainly worth investing in adequate IT resources and making sure they work properly.

You are not required to have electronic records but you then must maintain documentation on every sale and purchase and they must be auditable. For a small restaurant this means keeping every guest check ever used and they need to be in numerical sequence so they can be tied back to original cash register tapes. These are nearly impossible standards for any business which gives auditors tremendous leeway in assessing tax because of “inadequate records”. New York can and will extrapolate sales based on industry indices to arrive at what they think sales should be. For example, using our restaurant, New York can use IRS data for restaurants of similar size and recompute sales based on a sales-to-labor ratio. The taxpayer is in a tough spot because of the lack of records, unless it can be proven that this is not a rational method.

The assessment of additional sales tax as a result of an audit will mean payment of the tax, interest and most likely a penalty and a penalty rate of interest which is double the normal rate. That may be only the beginning of the trouble as the sales tax auditors share information with income tax auditors who in turn share information with the IRS. A $25,000 sales tax assessment could turn into a $21,000 state income tax assessment and a $90,000 federal income tax assessment - all before penalty and interest. From a business standpoint, having good accounting systems and internal controls is just good business practice. With the power auditors have and the ability to impose tax, penalty and interest it just makes financial sense as well.

If a business in New York is assessed a trust fund tax, New York has the ability to go after responsible parties. These are generally people that control the check book and make the decisions to either pay or not pay. A corporate officer is a likely target for this and the corporate shield will not protect him or her. Generally shareholders are not responsible parties if they are merely investors and not officers or directors. Limited Liability Company members are not afforded this corporate protection. Through a quirk in the law, LLC and LLP members, even if they are merely investors have joint and several liability, as if they were a general partner in a partnership.

An ounce of protection is worth a pound of cure. Take a good look at your accounting records and your system of internal control - or have Dermody, Burke & Brown perform an assessment. If you receive an audit notice be very careful and please contact our firm for assistance through the process. If you have to collect or pay sales tax please don’t try to play games because the audit activity is at an all time high and the consequences of non-compliance can be quite severe.

The information reflected in this article was current at the time of publication. This information will not be modified or updated for any subsequent tax law changes, if any.