The New York State Division of Tax Appeals (DTA) recently ruled that the New York State Department of Taxation and Finance (the “DTF”) can use the results of a prior sales tax audit to assess corporate income (franchise) tax. Since unreported additional corporate income is generally treated as having been distributed to the shareholders, the ruling means that the individual shareholders can also be assessed additional income tax based on the amount of additional sales determined in the underlying sales tax audit.

In the Matter of Mediabuss Systems, Inc.,(1) which was decided on November 29, 2012, the DTF conducted a corporate franchise tax audit of the taxpayer, and requested, among other things, the taxpayer’s books and records. When the taxpayer failed to produce the requested records, the DTF used the results of a prior sales audit to determine that the Corporation was liable for additional corporate franchise tax. In particular, the franchise tax auditor used the adjusted gross income, net income and cost of goods sold ratios from the sales tax audit to determine the additional franchise tax due. The issue before the DTA was whether the DTF’s reliance on the sales tax audit for determination of additional corporate tax was proper.

In response, the DTA confirmed that the DTF’s reliance on the audit work and conclusions of a prior sales tax audit was permissible to determine the additional corporate tax due. The DTA pointed to NY Tax Law § 1081(a) which provides that if a taxpayer required to file a franchise tax return fails to do so, “the [Division] is authorized to estimate the taxpayer’s New York tax liability from any information in its possession” (emphasis added).(2) Based on this interpretation of the statute, and the taxpayer’s failure to produce any evidence proving that the methodology utilized by the DTF was erroneous, the DTA upheld the DTF’s use of the sales tax audit findings to determine the additional corporate tax due.

The decision in Mediabuss illustrates the far reaching implications that arise any time a sales tax assessment becomes final, whether through litigation or by consent. An individual taxpayer’s consent to a sales tax assessment renders the tax liability fixed and final and generates an income tax bill for the additional sales to which the taxpayer agreed, with the taxpayer “collaterally estopped” from denying the additional income, since the taxpayer has already agreed to it in the sales tax audit.(3) In addition, if a Corporation consents to additional sales in a sales tax audit, those additional sales will be treated as additional corporate income. If the Corporation is a C-Corporation it will then have to pay additional corporate franchise tax. However, it doesn’t stop there. The Corporate income can then be taxed to the shareholders as “constructive dividends” to which they will be barred from contesting the amount of additional income because of the prior determination or consent.(4) Even if the Corporation is an S-Corporation and pays no tax of its own, the income will flow through to the shareholders without any defense to the prior determination of additional income. Finally, a relatively recent 2nd Circuit Federal case makes a final New York income tax determination binding on the taxpayer for the corresponding and significantly higher, federal tax liability.(5)

In making the determination to consent to, or abandon a defense against, a proposed New York State sales tax assessment, one must consider the additional state, local and federal personal and corporate income taxes that will subsequently be assessed. In many cases, these additional taxes make it appropriate to mount a vigorous defense to sales tax assessments which on their own would not warrant the trouble or cost.

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(1) DTA NO. 824207
(2) See, In Matter of Dujak Trucking Corp., (Tax Appeals Tribunal, April 1, 1993).
(3) See, Matter of Brewsky’s Goodtimes Corporation, N.Y.S. Tax App. Trib., DTA No. 817439, 2/22/01; Matter of House of Lloyd, Tax Appeals Tribunal, November 13, 1998; Matter of SICA Elec. & Maintenance Corp., Tax Appeals Tribunal, February 26, 1998).
(4) Matter of Anna O’Hagan, 1987 N.Y. Tax LEXIS 884 (N.Y. Tax 1987); Matter of Pavlou, 1986 N.Y. Tax LEXIS 167 (N.Y. Tax 1986); Matter of Weber, 1986 N.Y. Tax LEXIS 237 (N.Y. Tax 1986)
(5) Sunik v. Commissioner of Internal Revenue, 321 F.3d 335, 337 (2d Cir. 2003).