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Noonan’s Notes Blog is written by a team of Hodgson Russ tax attorneys led by the blog’s namesake, Tim Noonan. Noonan’s Notes Blog regularly provides analysis of and commentary on developments in the world of New York and multistate tax law. Noonan's Notes Blog is a winner of CreditDonkey's Best Tax Blogs Award 2017.

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Hard Hats Required: Sales Taxes & Capital Improvements - Some Practical Pointers

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Businessman holding hard hatWe recently authored an article in State Tax Notes analyzing New York’s complicated rules affecting sales taxation of contractor services and capital improvements. In this follow-up post, we want to highlight a few practical problems and issues that taxpayers frequently confront by taking a look at several recently litigated cases involving capital improvements.

Businesses become entangled in these rules quite often. The rules themselves are complicated, and the answer to the question “Is this subject to tax?” nearly always depends upon the specific facts. For anyone who is sitting down to perform a client’s or company’s weekly bookkeeping or, worse, for those who are facing an audit, we can draw a few useful lessons by looking at the recent misfortune of others.  A quick survey reveals that, so far this year, at least four different cases involving claims of capital improvements went all the way to trial and were litigated in New York.  In each case the auditor – not the taxpayer – won.  Let’s take a quick peek at these cases to see why.

The first case, In re Adirondack Bank, was decided by the Tax Appeals Tribunal in May. The case focused on whether the taxpayer—a bank—should have paid sales taxes on certain construction services it had purchased from various vendors. Among those services, the bank hired a security company to install and update its security systems at various branches. The bank also hired a paving company to remove and replace driveway blacktop at another branch. The bank claimed each project was a capital improvement and argued that no sales tax was due. But, the bank lost twice, and reading the case, it’s not hard to see why.

Remember, a capital improvement must be three things simultaneously: 1) it must add substantial value; 2) it must be permanently affixed; and 3) it must be intended to be permanent. The ALJ concluded, and the Tribunal agreed, that the bank simply failed to present sufficient evidence at trial that these projects met each prong of the test. The bank apparently submitted various invoices, but little else, and that proved fatal. At trial, the ALJ speculated that the installation of the security system might have added substantial value (prong one), but no evidence was submitted to explain whether the security equipment was permanently affixed (prong two). For example, the bank could have, but did not, submit evidence showing how the equipment was wired into the building or what damage, if any, would result from its removal. Similarly, the ALJ also speculated that the installation of the blacktop could have been permanently affixed (prong two), but there was no evidence addressing the size and scope of the work in order to determine whether it was merely the repair of a certain section or whether it was a complete repaving of the driveway (prong one). The taxpayer failed to submit affidavits, photographs, the underlying contracts, and/or testimony of witnesses to explain how and why the work qualified as tax free. When litigating, proof of each and every aspect of your case is essential.

The second case, In re Blackhat Chimney & Fireplace, was also recently decided by the Tax Appeals Tribunal. In this case, the taxpayer was a fireplace retailer that made both taxable and non-taxable sales. It seems that its sales of fireplaces and fireplace equipment without installation were taxable, but its sales of fireplace installations otherwise qualified as capital improvements. The problem for this taxpayer was that its books and records were simply inadequate for the auditor to reconcile all of its sales and all of its expenses. The business, apparently, did not and could not track individual transactions. Further, the taxpayer’s records failed to identify which of its purchases were used in connection with its services (for installations and repairs) and which were sold at retail.

At trial, the business challenged the auditor’s use of a test period audit methodology (a common alternative method) to estimate its liability. Understandably though, the taxpayer lost at trial and then lost again on appeal. A company’s failure to maintain adequate business records authorizes an auditor to come up with some other method to estimate the tax liability. The burden, then, falls on the taxpayer to prove that the auditor’s method was erroneous or unreasonable. While not impossible, that’s hard to do when you don’t have your own records to rely on. It’s worth noting that the Tribunal upheld the imposition of penalties against the taxpayer. As they say, the best defense is a strong offense, and proper bookkeeping goes a long way.

The final two cases were each decided by the Division of Tax Appeals this year. In re Sweet Construction was decided in June and In re NW Sign Industries was decided in January. Both cases help us to understand the importance of timely collecting and completing exemption certificates. Under the sales tax, as a general rule, all sales are presumed to be taxable. However, when a vendor timely accepts, in good faith, a properly completed capital improvement certificate from his customer, then he is generally relieved of his collection liability. As such, Form ST-124, Certificate of Capital Improvement can be powerful evidence in convincing an auditor that no tax is due.

In the Sweet Construction case, the taxpayer was a contractor that performed both taxable repair services and tax-free capital improvement projects. On audit, the taxpayer was unable to provide proper documentation substantiating the capital improvement jobs. For example, in one instance, the taxpayer provided an unsigned, undated certificate. In another instance, a signed certificate was produced, but it otherwise was improperly completed and lacked sufficient details. Copies of the underlying contracts for the work performed were not produced. At trial, the taxpayer offered its CFO and comptroller as witnesses. However, the ALJ determined that neither witness was able to provide “specificity concerning the exact capital improvements” at issue. Unsurprisingly, on this record, the taxpayer lost. Further, penalties were upheld.

The NW Sign Industries case is similar. The taxpayer operated a manufacturing and installation business. The auditor agreed that the business had adequate books and records, but he questioned certain transactions claimed as capital improvements. The certificates on file contained missing information and had been untimely received. The taxpayer provided invoices, but otherwise failed to provide the underlying contracts or other documentation explaining the nature and scope of the work performed. Again, given the lack of proper evidence, it is not terribly surprising that the taxpayer failed to meet its burden and lost its court battle.

What can we learn from these, and similar, cases? While each case is unique, and while we are only privy to the published decisions, we can, in fact, tease out some very helpful lessons. Here are a couple, generalized rules of thumb to keep in mind for your company or clients.

  1. In New York, all sales are presumed taxable.
  2. The burden to prove otherwise rests on the taxpayer.
  3. Businesses in New York have a statutory obligation to keep and maintain adequate business records.
  4. If your books and records are inadequate, auditors can and will find other, indirect ways to project your sales and compute an estimated (some might say, fictitious) tax liability. 
  5. Auditors routinely impose penalties, which courts often uphold. 
  6. If you can’t reach a sensible resolution with an auditor and, as a consequence, you plan to litigate, then keep in mind you are going to need documentation and evidence supporting your claims if you hope to persuade a judge. 
  7. While not mentioned as an issue in the cases above, sales taxes are “trust fund” taxes; consequently key officers and employees could be held personally liable to repay these liabilities. 

These reminders may, at first, sound pretty basic, but time and time again they bear repeating. If you have questions, contact your friendly tax professional.

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