My business didn't keep adequate sales records, so the auditor reconstructed our sales from bank deposits and then added a 25% markup on top for undocumented cash sales -- can they do that, and do I still owe the first-time penalty?

Plain-English summary

This ruling shows both sides of a sales tax audit built on bank statements instead of proper sales records -- what the Department is allowed to do when your own records are inadequate, and where that authority runs out.

A Virginia retailer selling remote-control planes, cars, drones, and toys was audited for three years and couldn't produce adequate sales records -- only daily activity summaries with no underlying sales data behind them. Because the records were inadequate, the Department was authorized to reconstruct the retailer's actual sales using the "best information available," which here meant averaging the retailer's own monthly bank deposit statements (after subtracting reported taxable sales and credit-line transfers) to estimate monthly sales. The retailer also couldn't prove any of its deposits represented exempt sales, since it had no invoices or exemption certificates to back that up, and unsupported claims about personal deposits and rent payments from the owner were rejected for the same lack-of-documentation reason.

The auditor then went a step further, adding a 25% markup on top of the bank-statement-derived sales figures specifically to account for cash sales the auditor assumed were still going undocumented. The Department had previously approved this kind of markup technique in a 2016 ruling -- but only because that case involved a grocery store, where the auditor could compare the taxpayer's sales patterns against OTHER grocery businesses to justify the specific percentage used. Here, there was no comparable-business data for a hobby/toy retailer, so the 25% markup had no factual foundation and was removed from the assessment. Separately, because this was the retailer's first-ever sales tax audit ("first-generation audit"), Virginia's penalty regulation exempts first-generation audits from penalty altogether, so both the compliance penalty and the amnesty penalty were also removed.

What this means for you

Any business whose sales records don't hold up under audit

If you can't produce adequate invoices, exemption certificates, and sales records, the Department can and will reconstruct your sales from whatever reliable information IS available -- most commonly your own bank deposit records. Daily summaries without supporting sales data are not enough to avoid this.

Businesses facing an ADDITIONAL percentage markup on top of reconstructed sales

An auditor's markup for "undocumented cash sales" isn't automatic -- it needs some factual basis, like verified comparable-sales data from similar businesses in the same industry. If your business doesn't have comparable data available (as here, for a niche hobby/toy retailer), challenge the markup specifically, separate from the underlying reconstruction methodology.

Businesses being audited for the very first time

Ask whether this is your first-generation sales tax audit. Virginia's regulations generally waive penalty (though not the underlying tax) for a taxpayer's first audit, regardless of how the tax liability itself comes out.

Common questions

Q: The auditor used my bank statements instead of my sales records -- is that allowed?
A: Yes, when a dealer's own records are inadequate to determine actual taxable sales, Virginia law authorizes the Department to use the "best information available" to reconstruct sales, and bank deposit records are a standard source for that reconstruction.

Q: Can an auditor add an extra percentage on top of my reconstructed sales for "unreported cash sales"?
A: Only if there's a factual basis for it, such as comparable-sales data from similar businesses in your industry. Without that kind of support, an added markup can be successfully challenged, as it was here.

Q: Do I owe a penalty if this is my first sales tax audit?
A: Generally not. Virginia's regulations exempt first-generation audits from penalty, separate from whatever underlying tax is ultimately assessed.

Citations and references

• Va. Code § 58.1-603 (tax imposed on retail sellers of tangible personal property in Virginia)
• Va. Code § 58.1-633 (dealer must keep and preserve suitable sales records); Title 23 VAC 10-210-470 (recordkeeping requirements)
• Va. Code § 58.1-618 (Department may use best information available to reconstruct sales when records are inadequate)
• Va. Code § 58.1-623 (dealer bears the burden of proving a sale is exempt absent a valid certificate)
• Va. Code § 58.1-635 (mandatory penalty on tax deficiencies); Title 23 VAC 10-210-2032 B 3 (no penalty generally assessed on first-generation audits)
• P.D. 16-95 (5/20/2016) (25% markup on undocumented sales approved only where comparable-business sales data supported the percentage)

Subject

Administration : Record Requirements - Dealers Failure to Collect & Report, Audit Report - Underreported Sales Markup; Exemptions : Services, Exemption Certificates; Penalty - First Generation Audit

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 22-37

Original ruling text

March 8, 2022

Re: § 58.1-1821 Application: Retail Sales and Use Tax

Dear *:

This will reply to your letter in which you protest the sales and use tax assessments issued to * (the “Taxpayer”) as a result of an audit for the period October 2012 through September 2015. I apologize for the delay in responding to your appeal.

FACTS

The Taxpayer, located in Virginia, provides sales, training, and service for remote or radio controlled airplanes, cars, and unmanned aerial vehicles, commonly known as drones. Additionally, the Taxpayer sells a large variety of toys and accessories.

Under audit, the Department discovered the Taxpayer failed to maintain and provide adequate sales and use tax records to determine taxable sales. The auditor compared the gross sales reported on the Taxpayer’s federal tax returns to the Taxpayer’s Virginia sales tax returns and the Taxpayer’s bank deposit statements for the period to determine the Taxpayer’s underreported sales. In order to compute the tax liability, the auditor used the average of the Taxpayer’s monthly bank statements to calculate monthly sales and also applied a 25% markup to each monthly sales amount reflected in the bank statements to capture underreported cash sales.

The Taxpayer contests (1) the auditor’s methodology used to calculate underreported sales, (2) the taxation of exempt sales, (3) the auditor’s 25% markup of underreported monthly cash sales, and (4) the penalty for nonpayment.

DETERMINATION

Underreported Sales Methodology

Virginia Code § 58.1-603 imposes a tax upon every person who engages in the business of selling at retail or distributing tangible personal property in Virginia. Virginia Code § 58.1-633 states that every dealer required to make a return and collect sales tax “shall keep and preserve suitable records of the sales, leases, or purchases, as the case may be, taxable under this chapter, and such other books of account as may be necessary to determine the amount of tax due hereunder, and such other pertinent information as may be required by the Tax Commissioner.” The record keeping requirements for taxpayers subject to the Virginia retail sales and use tax are further explained in Title 23 of the Virginia Administrative Code (VAC) 10-210-470. When a dealer fails to maintain adequate records, the Department is authorized by Virginia Code § 58.1-618 to use the best information available to reconstruct a dealer’s sales and purchases to determine whether any tax liability exists.

To calculate the Taxpayer’s underreported sales and corresponding tax assessment, the auditor used the Taxpayer’s monthly bank statements to extrapolate the Taxpayer’s monthly sales. The Taxpayer provided all of the statements except for December 2012. Averages from the Taxpayer’s December 2013 and December 2014 bank statements were used to estimate December 2012. The auditor then subtracted the reported taxable sales and line of credit transfers from the monthly bank statements to arrive at the estimated monthly sales based on supporting records.

The Taxpayer asserts it provided daily summaries that showed its monthly activity, but was unable to provide individual sales records. However, daily summaries are not adequate records without supporting sales data. Because the Taxpayer failed to maintain or provide adequate records for the auditor to determine the Taxpayer’s actual sales during the audit period, the auditor used the best information available ( i.e ., monthly bank statements) to reconstruct the Taxpayer’s retail sales and calculate any tax liability.

Exempt Sales

Virginia Code § 58.1-623 states “all sales…are subject to the tax until the contrary is established…the burden of proving that a sale, distribution, lease, or storage of tangible personal property is not taxable is upon the dealer unless he takes from the taxpayer a certificate to the effect that the property is exempt under this chapter.” The Taxpayer’s lack of sales invoice records and sales tax exemption certificates made it impossible to verify exempt sales listed on the bank statements.

Further, the auditor did not subtract deposits for what the Taxpayer claims were personal sales and rent paid to the Taxpayer’s owner. Again, the Taxpayer did not provide documents supporting its assertion.

Application of the Percentage Markup to Underreported Sales

After the auditor arrived at the estimated monthly sales using the Taxpayer’s average monthly bank statements, the auditor applied a 25% markup to the calculated monthly amounts to account for undocumented cash sales.

The Department addressed a similar situation in Public Document (P.D.) 16-95 (5/20/2016). In P.D. 16-95, the Tax Commissioner determined the auditor’s use of a 25% markup to account for undocumented sales an acceptable use of a markup percentage for a taxpayer engaged in the grocery business due to the auditor’s use of comparable sales information from other grocery businesses to calculate the percentage. In this instance, the Taxpayer is engaged in a hobby and toy business that lacks comparable businesses upon which the auditor may compare sales information.

Penalty

Virginia Code § 58.1-635 mandates the application of penalty to tax deficiencies. Title 23 VAC 10-210-2032 B 3 generally provides that a penalty will not be assessed in first generation audits. Because this is a first generation audit of the Taxpayer, the compliance penalty and the amnesty penalty will be removed in accordance with the Department’s penalty regulation.

CONCLUSION

Based on the information provided and available, I find the auditor’s use of the Taxpayer’s monthly bank statements to reconstruct monthly sales and determine underreported sales was appropriate as the best available information under Virginia Code § 58.1-618. The auditor also correctly determined the Taxpayer lacked records supporting the subtraction of exempt sales in accordance with Virginia Code § 58.1-623. However, the auditor’s use of the 25% markup applied in P.D. 16-95 was not appropriate.

The audit will be returned to the appropriate field audit staff to make the adjustments consistent with this determination. The audit staff will adjust the assessment to remove the 25% mark-up and eliminate the penalties from the audit report. After the revisions are complete and adjustments have been made to the audit assessments, revised bills will be mailed to the Taxpayer. No additional interest will accrue provided the assessments are paid within 30 days of the dates of the bills.

The Code of Virginia sections, regulations, and public document cited are available online at www.tax.virginia.gov in the Laws, Rules, and Decisions section of the Department’s website. If you have any questions regarding this determination, please contact * in the Office of Tax Policy, Appeals, and Rulings at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/1559.C

Related Documents

16-95