NJ Tax Stop: Indirect Sales Tax Assessment Methods

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New Jersey’s sales tax rate is one of the highest state-levied sales tax rates in the country and generates a significant portion of the state’s revenue each year. Since Jan. 1, 2018, the sales tax rate has been 6.625%.[1] Sales tax brought New Jersey more than $9.6 billion in fiscal year 2018[2] and New Jersey Gov. Phil Murphy’s proposed budget estimates that it will grow to $11.2 billion in fiscal year 2020.[3] According to his proposed budget, sales tax represents the second largest source of revenue in the state at 28% (after income tax at approximately 40%).[4]

It is no wonder that New Jersey spares no resources in auditing sellers to verify that all taxable sales are reported correctly. On June 1, 2019, the New Jersey Division of Taxation updated its New Jersey Manual of Audit Procedures, or NJMAP, which in chapter 12 discusses audits of cash businesses through the use of indirect methods. In an audit, if the seller’s records are lacking, the Division of Taxation will rely on an indirect method to determine the actual amount of the sales in the audit period.[5]

In light of the continued centrality of sales tax audits to the New Jersey budget, and 12 years since the landmark decision was issued by the New Jersey Appellate Division in Yilmaz Inc. v. Director of the Division of Taxation,[6] this article analyzes the Yilmaz holding and subsequent precedents regarding the proper use of indirect methods. We focus on the presumption in favor of the division regarding the reasonableness of its methods and highlight how a taxpayer can successfully rebut the presumption or even argue that an indirect method should not have been used in the first place.

Mark-On Audits and Yilmaz

The most common indirect method is the “mark-on.” This method, which is typically used for restaurant audits, examines a sample period to determine the ingredients that the seller had purchased. Based on the meals that are available for purchase, the method then calculates how much of each ingredient is allocated to each menu item.

Based on this information, a mark-on is determined, which is the factor by which the ingredient purchase is multiplied to determine sales. Once a mark-on percentage is determined, it is applied to all the periods within the audit period based on the taxpayer’s reported cost of goods sold (at beginning and end of the tax year), reconstructed purchases, or industry standards for purchases typical for the type of retail establishment.[7]

In Yilmaz, the Appellate Division affirmed the Tax Court’s decision[8] that it is incorrect to place the onus on the division to establish that it had used the best possible method to estimate the taxpayer’s receipts. Rather, the division is given broad authority to determine the tax from any available information.[9] The taxpayer has the burden of overcoming the presumption with “cogent evidence that is definite, positive, and certain in quality and quantity to overcome the presumption.”[10]

The taxpayer showing that an “aberrant” methodology was used by the division will overcome the presumption of correctness, but showing simply that an imperfect methodology was used will not.[11] A taxpayer may produce competent independent evidence, expert or otherwise, or may produce evidence through cross-examination of the auditor that could be sufficient to overcome the presumed correctness of the assessment.[12] But a taxpayer cannot second-guess an auditor’s reasonable estimate or make vague allegations without evidence. A taxpayer also cannot offer a different indirect method than the one that the division decided to use.

Since Yilmaz was affirmed, this case has set the standard that a taxpayer needs to meet to rebut the division’s determination of unreported sales. Yilmaz has been cited in most, if not all, sales tax cases that have reached the New Jersey Tax Court. The following two recent cases since Yilmaz highlight the limits of the division’s broad discretion even under Yilmaz, while underscoring the high burden that a taxpayer needs to meet to rebut the division’s final determination.[13]

Saulwil and Practice Points

In Saulwil Inc. v. Director of the Division of Taxation and Samuel and Louise Hammer v. Director of the Division of Taxation,[14] the director moved to dismiss the plaintiffs’ case on the basis that they had failed to meet their burden of proof and failed to overcome the division’s presumptively correct final determinations.

Saulwil’s evidence consisted of records that it had maintained, as well as testimony of a representative of the point-of-sale software used to produce sale summaries. On this basis, Judge Mala Sundar found that Saulwil’s evidence was enough to rebut the presumptive correctness of the division’s determination.

There are several important practice points that the Saulwil decision raises.

First, records of sales must be kept for examination and inspection for four years or for a different duration with the division’s consent.[15] But for taxable nonexempt sales, the regulations also permit disposing of the individual sale records after 90 days and instead maintaining a summary of records four years.[16] When the summaries accurately represent the taxable sales and the summaries cannot be altered by the taxpayer, then these summaries are adequate and the use of an indirect method is not permitted.

Unfortunately, many times a mark-on will be commenced because the taxpayer does not maintain cash register tape for the entire audit period even though other documents of equal weight are maintained. It is important to question the propriety of the use of an indirect method at all stages of an audit if any of the sanctioned records were maintained.

Second, Saulwil was successful in rebutting the division’s position by showing that the initial discrepancy in bank deposits that led the division to commence the mark-on was easily explained. The division took the position that its use of the mark-on had been warranted because the bank records had not been provided to the auditor — yet, it did not object to Saulwil’s introducing these same bank records as evidence at trial.

Therefore, when key records that would substantiate the taxpayer’s return position were not provided at audit for whatever reason, it is still important to introduce these documents at trial. If the division cannot prove that the records are unreliable, these documents will go far to proving that the use of an indirect method was not permitted.

“Gatta” Turn Square Corners

The other recent decision that analyzes Yilmaz is Ciriaco Gatta, Marie Gatta & Maria Gatta LLC v. Director of the Division of Taxation,[17] which was decided on Dec. 14, 2018. On a motion for summary judgment, Judge Mark Cimino determined that the law and regulations as explained by Yilmaz give the division wide latitude to determine tax from any available information when the taxpayer’s records are deemed insufficient.

Therefore, the taxpayer’s “naked assertions” are not sufficient to rebut the presumption of correctness that attaches to the determined deficiency. Yet, despite the division’s broad authority, “the government[,] in dealing with the taxpaying public, must turn square corners.”[18]

Invoking the square corners doctrine in the context of sales tax examinations serves to remind the division that ultimately the goal of the indirect method is to determine the correct amount of tax — not to punish the taxpayer for not maintaining the required records. Citing the principles in the New Jersey Supreme Court decision in FMC Stores Co. v. Borough of Morris Plains,[19] Judge Cimino explains:

While the court recognizes the possible frustration of the [d]irector and its auditors in attempting to ensure that everyone pays their fair share, it is important to realize that the fair share is a requirement for everyone regardless of the condition of their books and records, or, their attempts to evade taxes. A wildly incorrect assessment could become a de facto penalty on the taxpayer.[20]

In sum, the presumption of correctness is premised on the division acting in good faith. The goal of the indirect method is to determine the correct amount of tax. It should not be used to penalize the taxpayer with a determination that is out of proportion to the size of the retail establishment, blatantly inconsistent with the taxpayer’s records that have been maintained, or one that is intended only as an initial negotiating position that will be further whittled away at a conference with the Conference and Appeals Branch and then litigation. The indirect method should not replace penalties, which, as Judge Cimino notes, are appropriately enacted only by the Legislature, not the taxing authorities.

While the taxpayer cannot dictate which method to use to determine the correct amount of sales, in Gatta, the court found that the plaintiffs did raise sufficient concerns with the mark-on to undermine the division’s results. The auditor left out key ingredients from many of the dishes from the mark-on analysis. This omission causes the mark-on to increase from 4.4 to 4.9. The auditor widely understated the cost for a fish entrée and also understated the price for the same dish.

The court noted that seemingly small errors, when propagated from a sample period to the entire audit period, can lead to a large enough error that will prevent the division from prevailing on summary judgment. A key takeaway is that in the context of a mark-on, even small errors should be challenged because they can lead to a large error in the overall amount of tax due.[21]

Another example of an aberrant mark-on method is found in Charley O’s Inc., t/a Scotty’s Steakhouse v. Director, Division of Taxation.[22] This decision was cited by the Appellate Court in Yilmaz, holding the audit findings to be aberrant because the division used the gross receipts reported on the taxpayer’s corporate business tax returns, and not the sales tax returns, out of convenience and not because the amount reported was more accurate.

Despite the taxpayer’s victories in Saulwil and Gatta, these were not the final dispositive decisions in their respective cases, which are both still pending in Tax Court. Defeating summary judgment where all reasonable inferences are made in the taxpayer’s favor is very different from presenting proofs that show the correct amount of sales. As long as the taxpayer can harness competent independent evidence, it can prevail at putting material facts in dispute to defeat summary judgment.


Twelve years since Yilmaz, Saulwil and Gatta have been instructive for practitioners to defend clients in sales tax-related litigation. An indirect method is only allowed when the taxpayer has not maintained records that the law requires. If the division persists in employing an indirect method, which is invoked habitually by the auditors in cash business audits, the indirect method’s conclusions can be challenged.

Once an indirect method is challenged in Tax Court, the key to prevailing is to become fully familiar with every component of the indirect method’s extrapolation to show why errors, though insignificant at first glance, are in fact fatal to the indirect method’s conclusions. The taxpayer should remind the division in court that the goal is to determine whether the taxpayer “paid the correct amount of tax due”[23] and the division should “turn square corners” in doing so.

This article was originally published in Law360.

As the law continues to evolve on these matters, please note that this article is current as of date and time of publication and may not reflect subsequent developments. The content and interpretation of the issues addressed herein is subject to change. Cole Schotz P.C. disclaims any and all liability with respect to actions taken or not taken based on any or all of the contents of this publication to the fullest extent permitted by law. This is for general informational purposes and does not constitute legal advice or create an attorney-client relationship. Do not act or refrain from acting upon the information contained in this publication without obtaining legal, financial and tax advice. For further information, please do not hesitate to reach out to your firm contact or to any of the attorneys listed in this publication.

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