Court Opinion

ID: 4692714
Source: CourtListenerOpinion
Date Created: 2021-06-03 19:20:39.616591+00
Date Added: 2024-06-11T08:05:17.603363
License: Public Domain

FILED
                                                                                        June 3, 2021
                                                                                         released at 3:00 p.m.
                                                                                     EDYTHE NASH GAISER, CLERK
                             STATE OF WEST VIRGINIA                                  SUPREME COURT OF APPEALS

                           SUPREME COURT OF APPEALS                                       OF WEST VIRGINIA

Matt Irby, Acting State Tax Commissioner of West Virginia,
Petitioner, Respondent below

vs.) No. 20-0226 (Kanawha County 14-AA-1)

Kang M. Zheng, Mei Zheng, and Asian Grill,
Respondents, Petitioners below

                               MEMORANDUM DECISION

        The petitioner herein, Matt Irby, Acting West Virginia State Tax Commissioner, 1 appeals
the February 14, 2020 “Final Order” of the Circuit Court of Kanawha County that reversed the
December 4, 2013 “Final Decision” of the West Virginia Office of Tax Appeals (“OTA”). At issue
are the Tax Commissioner’s assessments of sales tax, business franchise tax, and personal income
tax against the respondents herein, Asian Grill, Kang M. Zheng, and Mei D. Zheng. 2

       The Court has considered the parties’ written and oral arguments, as well as the record on
appeal and the applicable law. This case satisfies the “limited circumstances” requirement of Rule
21(d) of the West Virginia Rules of Appellate Procedure and is appropriate for a memorandum
decision rather than an opinion. For the reasons set forth below, the decision of the circuit court is
reversed and this case is remanded to the circuit court for entry of an order reinstating the OTA
decision.

                                I. Factual and Procedural History

        Spouses Kang and Mei Zheng own Asian Grill, a restaurant in Charleston that has a few
seats for customer dining but primarily serves take-out and delivery food. After eating meals at
Asian Grill in September and December 2010, auditors Shannon Hockensmith and Cathy Mills,
of the State Tax Department, observed that Asian Grill employees were not entering all sales into
the restaurant’s digital point of sale cash register. Ms. Hockensmith testified that on one occasion,
Ms. Mills paid with a credit card; although the transaction was processed through the restaurant’s
credit card machine, it was not entered into the cash register. Ms. Hockensmith testified that she

       1
          This appeal was initially filed by Dale W. Steager, the then-Tax Commissioner, in his
official capacity. Because Matt Irby is now the Acting Tax Commissioner, his name has
automatically been substituted as the petitioner pursuant to Rule 41(c) of the Rules of Appellate
Procedure. The Commissioner is represented on appeal by Assistant Attorney General L. Wayne
Williams, Esq.
       2
           The respondents are represented by C. Page Hamrick, Esq.

                                                  1
paid with cash, and the sale was written on a piece of paper but was not entered into the cash
register. This caused the auditors to become suspicious of whether Asian Grill was failing to
accurately record its sales and was failing to properly remit to the State all sales tax money that it
collected from customers.

         These auditors, joined by a third auditor Jean Warner, conducted surveillance on Asian
Grill over two partial days and one full day in January of 2011 to obtain a count of customer
transactions. Much of the surveillance was performed from the restaurant’s parking lot, although
the auditors also entered the restaurant at times. The auditors counted the number of customers
who ate in the restaurant and counted the number of food orders that were taken out of the
restaurant. When counting delivery orders, if they could not see inside the bag or box, they
assumed that each bag contained an order for one customer and that each box contained an order
for two customers. On January 20, 2011, they surveilled for just part of the day and counted forty-
four transactions. During a partial day of surveillance on January 27, 2011, they counted thirty-
four transactions. During a full day of surveillance on January 28, 2011, the auditors counted
eighty-seven transactions.

        Next, the Tax Department requested business records from the respondents including sales
reports, tax returns, receipts for credit card sales, receipts for cash sales, and cash register tapes.
The records produced by the respondents reflected far fewer customer transactions than the
auditors had observed during the surveillance. For the entire day of January 20, the respondents
claimed that Asian Grill had only thirty-two customer transactions (as compared to the forty-four
transactions counted by the auditors during just part of this day). For the entire day of January 27,
Asian Grill reported twenty-eight transactions (the auditors counted thirty-four during part of this
day). For the entire day of January 28, Asian Grill reported thirty transactions (the auditors counted
eighty-seven). Thus, the auditors observed more sales in the two partial days of surveillance than
the respondents reported for those entire days. Moreover, on the full day of surveillance, the
auditors observed almost three times more sales than the respondents claimed.

        During the January 20 surveillance, Ms. Mills had entered the restaurant, purchased food
for $9.86, and witnessed six orders being taken over the telephone. Asian Grill’s records did not
include Ms. Mills’s purchase or three of the six orders that she overheard. On January 28, 2011,
Ms. Hockensmith and Ms. Mills both entered the restaurant and observed four transactions, at least
three of which were not listed in Asian Grill’s sales records. In addition, the auditors determined
that the records the respondents were claiming to be cash register tapes were actually adding
machine tapes. 3 As a result of this review, the Tax Commissioner concluded that the respondents’
records were insufficient to accurately reflect Asian Grill’s sales. Critically, Asian Grill was
collecting sales tax from its customers for all the transactions but was not remitting the collected
taxes to the State for the non-recorded sales. During the investigation, the Tax Department staff
also discovered that the respondents had not paid any West Virginia business franchise taxes for

       3
          A Tax Department auditor testified that if Asian Grill employees had entered every
transaction into the restaurant’s point of sale cash register, the register could have produced a
record, referred to as a “z tape,” listing all daily transactions, what time each transaction occurred,
the amount of each transaction, and the amount of sales tax collected from the customer for each
transaction.

                                                  2
2005 through 2009, and had only paid the minimum fifty dollars in business franchise tax for 2010
and 2011.

        Because the respondents’ records were incomplete and inaccurate, a Tax Department
auditor used a ratio analysis to calculate the number of transactions that should have been reported
and the amount of taxes that should have been paid. She took the number of transactions that Asian
Grill reported during the one full day of surveillance, 30, and divided it by the number of
transactions that were calculated pursuant to the surveillance, 87, which equals 34.5 percent. 4 She
then subtracted 34 percent from 100 percent to conclude that Asian Grill had underreported its
sales by 66 percent. 5 The auditor then took the amount of monthly sales that Asian Grill had
reported between January 2009 and June 2012, both cash and credit card sales, and multiplied
these amounts by the number 1.66 for the purpose of estimating Asian Grill’s actual sales. 6

        Using the estimated sales amounts that the auditor calculated, and after giving credit for
the taxes that Asian Grill and the Zhengs had paid, the Tax Commissioner issued three
assessments. First, the Tax Commissioner issued a sales and use tax assessment to Asian Grill for
the period of January 1, 2009 through June 30, 2012 in the amount of $17,413.11 in unpaid tax,
plus $2,953.55 in interest, plus $4,284.29 in additions to tax, for a total sales and use tax assessment
of $24,650.95. Second, the Tax Commissioner issued a business franchise tax assessment based
upon the Zhengs operating the business as a partnership or a pass-through entity. The business
franchise tax assessment covered the period October 26, 2005 through December 31, 2011 and
was in the amount of $5,424.00 in unpaid tax, plus $1,176.28 in interest, plus additions to tax of
$1,356.00, for a total business franchise tax assessment of $7,956.28. 7 Third, the Tax
Commissioner concluded that the Zhengs, as owners of Asian Grill, owed additional West Virginia
personal income tax for the unreported sales for the period of January 1, 2009 through December
31, 2011 in the amount of $12,398.00, plus $1,641.71 in interest, plus $3,099.50 in additions to
tax, for a total personal income tax assessment of $17,139.21.

        The respondents challenged these assessments and a two-day evidentiary hearing was held
before an OTA administrative law judge. After considering the evidence, the OTA entered an order

       4
          The Tax Department used only the full-day count for this analysis because without z
tapes, it was impossible to match Asian Grill’s sales records to the same time of day when the
auditors had performed their partial days of surveillance.
       5
         The Tax Department auditor also performed an alternate calculation using the number of
customers counted during the full day of surveillance, the average size of a household in Kanawha
County, and the average menu price at Asian Grill. Using these figures, she calculated a sales total
of $1,219.66 for January 28, 2011, which, given reported sales of $463.78, showed that Asian Grill
was not reporting approximately sixty-two percent of sales.
       6
          As will be discussed infra, multiplying the reported sales by 1.66 did not reach the result
that the Tax Department was intending.
       7
         The Tax Commissioner determined that the respondents had not filed any West Virginia
business franchise tax returns for tax years 2005 through 2009.

                                                   3
on December 4, 2013 affirming the assessments in full. In particular, the OTA found that Asian
Grill’s records were incomplete and inaccurate, and the Tax Department did not abuse its
discretion by basing the assessments on a comparison of the surveillance data to the respondents’
reported sales. The OTA rejected the respondents’ arguments that the Tax Commissioner’s
methodology constituted a “sample and projection audit” and that it must be done with a statistical
validity of ninety-five percent. 8 The OTA concluded that the Tax Commissioner had used the best
information available to perform a ratio analysis, and that the respondents had not met their burden
of showing that the assessments were clearly wrong, arbitrary and capricious, or contrary to law.

        The respondents appealed the OTA’s decision to the circuit court. After a lengthy delay,
the circuit court entered its final order on February 14, 2020. The court affirmed the OTA’s finding
that the respondents’ records were inadequate and incomplete. The court stated that the OTA’s
finding regarding the inaccuracy of the records was “credible and undisputed.”

        However, the circuit court found that the Tax Department’s methodology in determining
the amount of taxes to assess was arbitrary and capricious. The court was critical of the use of one
day of surveillance data to increase three years’ worth of sales by sixty-six percent. In addition,
although Ms. Hockensmith testified that Tax Department auditors receive on-the-job training on
how to perform surveillance audits, the court was critical of a lack of classroom education and a
lack of any manual specifying audit policies and procedures. Next, the court found that it was error
for the Tax Department to have “grossed up” both the credit card and cash sales that Asian Grill
reported. Finally, the court concluded in summary fashion that the assessment of business franchise
taxes was not sufficiently developed at the OTA hearing. Accordingly, the circuit court reversed
the OTA’s decision and remanded the case for the issuance of new assessments that “are to be
computed in a manner consistent with this Order as well as further fact finding in regard to the
Business Franchise Tax issue.” 9

                                      II. Standard of Review

        The Tax Commissioner appeals the circuit court’s February 14, 2020 order to this Court.
In administrative appeals, we apply a de novo standard of review to legal questions. “Interpreting
a statute or an administrative rule or regulation presents a purely legal question subject to de novo
review.” Syl. Pt. 1, Appalachian Power Co. v. State Tax Dep’t of W. Va., 195 W. Va. 573, 466
S.E.2d 424 (1995). However, factual findings by the OTA are given deference. “Once a full record
is developed, both the circuit court and this Court will review the findings and conclusions of the
Tax Commissioner under a clearly erroneous and abuse of discretion standard unless the incorrect

       8
         The respondents argued that to be statistically valid, the auditors needed to perform thirty-
six full days of surveillance. Both the OTA and the circuit court found this demand to be
unreasonable.
       9
         It is unclear exactly what the circuit court wanted the OTA and Tax Commissioner to do
when recalculating the assessments on remand because the court did not specify how many days
of surveillance data must be used, did not address how meaningful surveillance data could be
obtained almost eleven years after the relevant tax years, and did not specify what facts or issues
needed to be developed for purposes of reviewing the business franchise tax assessment.

                                                  4
legal standard was applied.” Syl. Pt. 5, Frymier-Halloran v. Paige, 193 W. Va. 687, 458 S.E.2d
780 (1995).

        We are also mindful that when a taxpayer petitions the OTA for a review of an assessment
issued by the Tax Commissioner, it is the taxpayer’s burden to prove that the assessment is
incorrect. “Except as otherwise provided by this code or legislative rules, the taxpayer or petitioner
has the burden of proof.” W. Va. Code § 11-10A-10(e) (2002); accord W. Va. Code R. § 121-1-
63.1 (2003) (“The burden of proof shall be upon the petitioner except as otherwise provided by
statute or legislative rule.”); W. Va. Code R. § 121-1-69.2, in part ( “Failure to produce evidence
[at OTA hearing], in support of an issue of fact as to which a party has the burden of proof and
which has not been conceded by such party’s adversary, may be ground [sic] for dismissal or
determination of the affected issue against that party.”).

       With these standards in mind, we consider the issues on appeal.

                                          III. Discussion

        West Virginia law imposes a consumer sales tax on the sale of tangible personal property
and services, including restaurant meals. See W. Va. Code §§ 11-15-1 to 11-15-34. The vendor
that sells these goods and services is responsible for collecting the sales tax from each customer
and remitting the entire amount of collected taxes to the State. See e.g., W. Va. Code §§ 11-15-3
(2003), 11-15-5 (2003). Persons must also pay personal income tax on their taxable earnings,
including cash and “under the table” earnings. See e.g., W. Va. Code § 11-21-12 (2019). Moreover,
partnerships are required to pay business franchise taxes on capital. See W. Va. §§ 11-23-1 (1985),
11-23-4 (1985).

        The Tax Commissioner has “the duty to . . . see that the laws concerning the assessment
and collection of all taxes . . . are faithfully enforced.” W. Va. Code § 11-1-2 (1933). To carry out
this duty, the Commissioner may examine any books, papers, and records of a taxpayer. See W.
Va. Code § 11-10-5a (1986). If the Commissioner believes that a tax return is deficient, he may
determine or estimate the tax liability and issue a tax assessment:

               If the Tax Commissioner believes that any tax administered under
               this article has been insufficiently returned by a taxpayer, either
               because the taxpayer has failed to properly remit the tax or fee, or
               has failed to make a return, or has made a return which is
               incomplete, deficient, or otherwise erroneous, he or she may
               proceed to investigate and determine or estimate the tax liability and
               make an assessment therefor.

W. Va. Code § 11-10-7(a) (2019); accord W. Va. Code § 11-21-12g(d) (2005) (providing that
when Commissioner audits for compliance, Commissioner may change taxpayer’s computation of
taxable income to comply with law).

        We begin our analysis by recognizing an important point upon which both the OTA and
the circuit court agreed: the respondents’ business and tax records were not accurate. The records

                                                  5
failed to include all the restaurant’s sales and failed to account for all the sales tax collected from
customers. State law requires vendors to maintain complete and accurate records for purposes of
sales taxes including “gross proceeds from sales of personal property and services . . . [and] [t]he
amount of taxes collected under this article, which taxes shall be held in trust for the state of West
Virginia until paid over to the tax commissioner[.]” W. Va. Code § 11-15-4(b) (2003), in part. 10
Likewise, “[e]ach taxpayer shall keep complete and accurate records of taxable sales and of
charges, together with a record of the tax collected thereon, and shall keep all invoices, bills of
lading and such other pertinent documents in such form as the tax commissioner may by regulation
require.” W. Va. Code § 11-15-23 (1978), in part; accord W. Va. Code R. § 110-15-14.1.1 (1993)
(same language as statute).

        Legislative rules promulgated pursuant to the statute require that “[e]very person doing
business in the State of West Virginia . . . shall keep complete and accurate records as are necessary
for the Tax Commissioner to determine the liability of each vendor or vendee for consumer sales
and use tax purposes.” Id. at 110-15-14a.1. More specifically, a vendor must maintain, inter alia,
“[r]eceipts from sales” and the “[t]otal purchase price of all tangible personal property purchased
for sale, consumption or lease[.]” Id. at 110-15-14a.1.1, 110-15-14a.1.3. The records

                shall consist of the normal books of account ordinarily maintained
                by the average prudent person engaged in the activity in question,
                including bills, receipts, invoices, cash register tapes, or other
                documents of original entry supporting the entries in the books of
                account, and all schedules or working papers used in connection
                with the preparation of tax returns.

Id. at 110-15-14a.2 (emphasis added). Thus, the respondents should have retained, and been able
to produce, the cash register tapes.

       The respondents produced sales records to the Tax Commissioner that clearly failed to
include a significant amount of Asian Grill’s sales. On two days when they ate meals at the

       10
            The applicable 2003 version of West Virginia Code § 11-15-4 provides:

                (a) The purchaser shall pay to the vendor the amount of tax levied
                by this article which is added to and constitutes a part of the sales
                price, and is collectible by the vendor who shall account to the state
                for all tax paid by the purchaser.
                (b) The vendor shall keep records necessary to account for:
                (1) The vendor’s gross proceeds from sales of personal property and
                services;
                (2) The vendor’s gross proceeds from taxable sales;
                (3) The vendor’s gross proceeds from exempt sales;
                (4) The amount of taxes collected under this article, which taxes
                shall be held in trust for the state of West Virginia until paid over to
                the tax commissioner; and
                (5) Any other information as required by this article, or article
                fifteen-b of this chapter, or as required by the tax commissioner.

                                                   6
restaurant, and on three other days when they performed surveillance, the auditors witnessed
purchases that were not entered into the cash register. The auditors took specific note of purchases
that they made and personally witnessed, but most of those transactions never appeared in the
restaurant’s sales records. Moreover, the number of customer transactions counted by the auditors
during the three days of surveillance was substantially higher than the respondents claimed.
Despite demands by the Tax Commissioner, and despite the regulatory mandate to maintain cash
register tapes, the respondents never produced Asian Grill’s cash register tapes (“z tapes”). As the
Tax Commissioner explained, if all purchases had been entered into the cash register, then the
daily cash register z tapes would accurately report sales and the amount of sales tax collected.
Unfortunately, the issues in this case are of the respondents’ own making because of their failure
to record and report a substantial amount of their sales. We concur with the lower tribunals’
conclusion that the records were incomplete and inadequate.

        Also, even though they disagreed on assessment methodology, both the OTA and circuit
court agreed that the respondents had failed to remit all sales taxes that they owed. The respondents
collected sales tax from customers, but wrongfully converted and kept some of the collected tax
money for themselves. “[S]ales taxes are commonly termed ‘trust taxes’ because the business
withholds or collects the taxes on behalf of the state from a third party and holds them in trust until
remittance to the state is due.” Schmehl v. Helton, 222 W. Va. 98, 103, 662 S.E.2d 697, 702 (2008)
(internal citation and quotation marks omitted). It is evident from a review of the administrative
record that the respondents grossly violated that trust. Likewise, the OTA and circuit court agreed
that the Zhengs had failed to pay personal income taxes they owed for the unreported earnings.

        Pursuant to a legislative rule, when business and tax records are inadequate, the Tax
Commissioner uses the best information available to estimate the taxes owed: “If records are
inadequate to accurately reflect the business operations of the taxpayer, the auditor will determine
the best information available and will base the audit report on that information.” W. Va. Code R.
§ 110-15-14b.4 (1993). 11 Due to the respondents’ concealment of a significant number of
transactions, the Tax Department auditors determined that the best information in this case would
be obtained by performing surveillance to calculate a daily transaction count for the restaurant and
to then compare this data with the sales that had been recorded. The OTA found no error with this
approach.

        When reversing the OTA, one of the circuit court’s concerns was that the Tax
Commissioner “grossed up” Asian Grill’s total sales, both cash and credit, to calculate the
assessments. Because credit card sales were processed on the restaurant’s credit card machine and
the proceeds were direct-deposited into Asian Grill’s bank account, the total credit card sales could
potentially be pieced together through bank records even though the restaurant’s sales reports and
tax records were incomplete and inaccurate. Thus, the circuit court concluded that even accepting

       11
         A legislative rule has the force of a statute and is controlling. See e.g., Syl. Pt. 5, Smith
v. W. Va. Human Rights Comm’n, 216 W. Va. 2, 602 S.E.2d 445 (2004) (“A regulation that is
proposed by an agency and approved by the Legislature is a ‘legislative rule’ as defined by the
State Administrative Procedures Act, W. Va. Code, 29A-1-2(d) [1982] [now codified at W. Va.
Code § 29A-1-2(e) (2015)], and such a legislative rule has the force and effect of law.”).

                                                  7
the methodology that the Tax Department used in arriving at the percentage of unreported
transactions, only the restaurant’s reported cash sales should have been “grossed up” by sixty-six
percent. The Tax Commissioner challenges this conclusion on appeal. The respondents argue that
the circuit court was correct and that the bank records are the best information available to show
credit card transactions.

        Under the particular facts of this case, we reject the circuit court’s conclusion that only the
reported cash sales should have been increased. The conclusion that the respondents were failing
to report sixty-six percent of their sales was reached by counting total daily transactions—both
cash and credit. The auditors compared the total number of customer transactions that were
observed during surveillance, with the number of customer transactions disclosed in the
respondents’ sales records. Except when the auditors were personally inside the restaurant during
the surveillance, there was no way for them to know whether a particular transaction was paid with
cash or credit, or whether most of the customers paid with credit cards, or most paid with cash. As
such, it would be arbitrary to apply the ratio analysis to something other than the total reported
transactions. Moreover, although the respondents’ expert stated that restaurants usually do eighty
percent of their sales as credit card transactions, Asian Grill’s bank records do not reflect this
percentage of credit versus cash deposits. Under the specific facts of this case, there was no way
to know what Asian Grill’s cash sales were, and no way to know how grossly the respondents had
underreported only the cash sales. Finally, the Tax Department gave the respondents credit for all
taxes that they had already remitted, which would have been for both cash and credit transactions.

         The circuit court was also concerned with whether the Tax Commissioner had used a
statistically significant methodology to conclude that the restaurant’s sales were underreported by
sixty-six percent. The circuit court deemed it “absurd” to rely upon a single day of surveillance
data to arrive at the sixty-six percent figure, and to then apply that figure to more than three years
of reported sales. 12 The circuit court’s concerns about the amount of surveillance data are well-
taken. Although the circuit court did not decide how many days of surveillance should have been
used, a customer/transaction count made on a single day does not appear to be sufficient to estimate
more than three years’ worth of a restaurant’s sales. Indeed, the Tax Department fails to point to
any legal authority or expert opinion to support the use of this limited amount of data. We also
join in the circuit court’s criticism of the Tax Commissioner’s lack of policies, procedures, and
employee training for conducting audits of this nature.

       Nonetheless, it is unnecessary for us to determine whether “grossing up” the taxpayers’
reported sales by sixty-six percent lacked validity in this particular case because, when considering
the surveillance data, this adjustment method vastly understated the taxpayers’ actual sales.
According to the surveillance data, the amount of actual sales should be almost three times higher
than what the reported sales were (87 is almost three times more than 30). Instead, the
Commissioner only multiplied the reported sales by 1.66 to arrive at the estimated sales used for

       12
          As noted above, the respondents argued that to reach a level of statistical significance,
the auditors needed to perform twelve full days of surveillance for each of the tax years—in other
words, more than thirty-six full days of surveillance over a three-year period. The circuit court
rejected the respondents’ argument as excessive but did not specify how many days would be
needed.

                                                  8
the assessments. 13 As a result, the respondents were taxed on an amount of estimated sales that
was far less than what the Commissioner intended. Given this, we cannot say that the ultimate
result was unfair to the respondents. Rather, it appears that the respondents benefitted from the
Commissioner’s mistake. Moreover, given the lengthy passage of time and the lack of any
Department policies or procedures to guide this type of audit, it is unclear what the Tax
Commissioner would do on a remand. Because the procedure which the circuit court found was
arbitrary and capricious was not in fact used, we must reverse the circuit court’s order. 14

          Finally, we turn to the circuit court’s decision to vacate the business franchise tax
assessment. The basis for this ruling was the circuit court’s conclusion that the parties had “failed
to . . . illuminate” for the court whether the business franchise tax and the personal income tax
assessment resulted in two taxes on the same amount of allegedly underreported income. However,
this ruling fails to consider that it was the taxpayers’ burden at the OTA hearing to prove that the
Commissioner’s assessments were faulty. See e.g., W. Va. Code § 11-10A-10(e). It also fails to
consider that the taxpayers had the burden of proving their case on appeal. In effect, the circuit
court has erroneously shifted the burden of proof to the Commissioner to prove that the assessment
was correct.

       Accordingly, for the foregoing reasons, we reverse the circuit court’s February 14, 2020,
order and remand this case to the circuit court for entry of an order reinstating the OTA’s final
decision.

                                                          Reversed and Remanded with Directions.

ISSUED: June 3, 2021

       13
          In other words, even if we assume that the surveillance and ratio method that the Tax
Commissioner chose to use resulted in the best information available, the Tax Commissioner
misapplied its own methodology. The Commissioner concluded that Asian Grill was only
reporting thirty-four percent of its sales. To apply a ratio method, the Commissioner should have
divided the reported sales by thirty-four percent or multiplied the reported sales by 2.9 (that is, 30
reported sales divided by 87 counted sales, for a divisor of thirty-four percent, or 87 counted sales
divided by 30 reported sales, for a multiplier of 2.9). Instead, the Tax Department only multiplied
the reported sales by 1.66.
       14
           Although the Tax Commissioner is technically prevailing on this appeal, neither the
Commissioner nor the OTA should consider this memorandum decision as carte blanche to
continue using a single day’s worth of data to estimate many years’ worth of taxes. The
Commissioner should ensure that appropriate policies and procedures are adopted and followed to
provide a fair, evidence-based methodology if this type of surveillance and ratio method are used
in the future.

                                                  9
CONCURRED IN BY:
Justice Elizabeth D. Walker
Justice Tim Armstead
Justice John A. Hutchison

DISSENTING:
Chief Justice Evan H. Jenkins
Justice William R. Wooton

JENKINS, C.J., dissenting:

        Whether the majority finds the methodology utilized by the West Virginia Tax Department
(“Tax Department”) material or not to decide this case, I am compelled to call attention to the
arbitrary and unacceptable methodology used. I cannot, and this Court should not, 1 endorse the
haphazard surveillance method employed by the Tax Department.

        This matter began when two Tax Department auditors, Shannon Hockensmith and Cathy
Mills (“the auditors”), ate at the Asian Grill in Charleston, West Virginia, and, through personal
observations, quickly became suspicious that the Asian Grill was underreporting its sales for
consumer sales tax purposes. In particular, the auditors observed transactions that were not
processed through the cash register. These observations led to an assessment investigation of the
Asian Grill by the Tax Department. As a part of this investigation, the Tax Department conducted
surveillance from the parking lot of the Asian Grill over the course of two partial days and one full
day. Specifically, surveillance was conducted on January 20, 2011, from 9:00 a.m. to 3:00 p.m.;
on January 27, 2011, from 3 p.m. to 10:20 p.m.; and on January 28, 2011, from 10:45 a.m. to 10:15
p.m. As such, surveillance was performed for just slightly above twenty-four hours over the course
of three days. This surveillance was conducted to obtain a customer count which could later be
compared to reported sales. Specifically, as the majority of the surveillance was conducted in the
parking lot, the auditors counted actual customers who entered the restaurant. Additionally, the
auditors counted the deliveries made by restaurant employees. For orders where the auditors could
not see in the bags, each bag was counted as one transaction and each box as two transactions.

        Subsequently, the Tax Department requested various records of the Asian Grill and its
owners. The Tax Department obtained only a limited portion of the requested records, including
state and federal tax returns and a few credit card and cash receipts. After reviewing the records,

       1
           The majority did note that

               [a]lthough the Tax Commissioner is technically prevailing on this appeal,
       neither the Commissioner nor the OTA should consider this memorandum decision
       as carte blanche to continue using a single day’s worth of data to estimate many
       years’ worth of taxes. The Commissioner should ensure that appropriate policies
       and procedures are adopted and followed to provide a fair, evidence-based
       methodology if this type of surveillance and ratio method are used in the future.

                                                 10
the Tax Department found that they did not accurately reflect what the auditors 2 observed during
the surveillance. Accordingly, the Tax Department deemed the records inaccurate and incomplete.
Because the records were deemed inadequate, the Tax Department used a ratio analysis in the
audit. It was then determined that the Asian Grill was underreporting sales by sixty-six percent.
Significantly, the Tax Department used only the one full-day data for this ratio analysis. As a
result, the Tax Department essentially extrapolated one day’s (or just slightly over eleven hours)
worth of purported underreported sales to the entire three-year audit period. Based on these
numbers of sales, the Tax Department calculated unremitted sales tax and issued Asian Grill a
consumer sales and use tax assessment in the amount of $24,650.95. Pursuant to this audit, other
tax assessments were issued, including a business franchise tax assessment totaling $7,956.28 and
a personal income tax assessment of $17,139.21.

        In its decision, the majority has acknowledged, yet artfully side-stepped, the substantive
issue argued by the parties – whether the particular surveillance methodology utilized by the Tax
Department was arbitrary and capricious. Instead of addressing the substantive issue, the majority
on its own calculations determined that, whether the methodology used was arbitrary or not, the
Tax Department misapplied its own ratio to the Taxpayers’ benefit. Under the facts and
circumstances of this case, I cannot agree. The circuit court did not err in its conclusion that the
one-day surveillance method was arbitrary and capricious. The tax assessment methodology
employed by the Tax Department was wholly unacceptable and should not be condoned for use in
future matters.

       West Virginia law requires businesses like Taxpayers’ to keep complete and accurate
records for taxation purposes. Specifically, West Virginia Code section 11-15-23 provides as
follows:

               Each taxpayer shall keep complete and accurate records of taxable sales and
       of charges, together with a record of the tax collected thereon, and shall keep all
       invoices, bills of lading and such other pertinent documents in such form as the tax
       commissioner may by regulation require. Such records and other documents shall
       be preserved for a period of time not less than three years, unless the Tax
       Commissioner shall consent in writing to their destruction within that period or by
       order require that they be kept longer.

Likewise, West Virginia Code of State Rules section 110-15-14a provides, in relevant part, that

               14a.1 Every person doing business in the State of West Virginia or storing,
       using, or otherwise consuming tangible personal property purchased from a vendor,
       and every lessor and lessee of tangible personal property used in this State shall
       keep complete and accurate records as are necessary for the Tax Commissioner to
       determine the liability of each vendor or vendee for consumer sales and use tax
       purposes. . . .

       2
           A third auditor also assisted in conducting the surveillance.

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               14a.2 Each record shall consist of the normal books of account ordinarily
       maintained by the average prudent person engaged in the activity in question,
       including bills, receipts, invoices, cash register tapes, or other documents of original
       entry supporting the entries in the books of account, and all schedules or working
       papers used in connection with the preparation of tax returns.

Furthermore, West Virginia Code of State Rules section 110-15-14b provides that

               14b.1 Taxpayer records may be audited by authorized representatives of
       the Tax Commissioner at any time during regular business hours of the taxpayer at
       the discretion of the Tax Commissioner or his authorized agent or representative.
       Any person who maintains such records outside this State shall make such records
       available for audit where the general records of the taxpayer are kept.

              14b.2 The Tax Commissioner may use a detailed auditing procedure or a
       sample and projection auditing method to determine tax liability.

               14b.3 A sample and projection auditing method is appropriate if:

              14b.3.1 the taxpayer’s records are so detailed, complex, or voluminous that
       an audit of all detailed records would be impractical or unreasonable;

             14b.3.2 the taxpayer’s records are inadequate or insufficient, so that a
       competent audit for the period in question is not otherwise possible; or

              14b.3.3 the cost of an audit of all detailed records to the taxpayer or the
       State will be unreasonable in relation to the benefits derived, and sampling
       procedures will produce a reasonable result.

              14b.4 If records are inadequate to accurately reflect the business
       operations of the taxpayer, the auditor will determine the best information available
       and will base the audit report on that information.

Finally, the Taxpayers had the burden below to demonstrate the error in the assessment.

        Here, there is no doubt that the Taxpayers failed to keep records that are adequate to
accurately reflect their business operations. Accordingly, the Tax Department had the ability to
choose an alternative method for determining an appropriate assessment of these unreported taxes.
While there is some debate throughout the proceedings as to whether a sample and projection
method or a best evidence method was used, the overall issue still is whether one day of
surveillance is sufficient to estimate an appropriate assessment of three years of underreporting.
As noted by the West Virginia Office of Tax Appeals (“OTA”), there is a “visceral reaction . . . to
taking one day’s business and extrapolating that out over three years.” I agree with the circuit
court in this matter that although the methodology used was “completely arbitrary,” a bright line
rule for percentage confidence intervals should not be drawn; however, “[i]f the sampling
methodology used in the present case is the basis of an audit and subsequent assessment, then the

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sample must be large enough so as to reasonably relate to reality and not be arbitrary” and/or “used
in conjunction with more definite and complete information such as valid and complete credit card
sales records over the [specific time] period[.]”

        Another aspect of the methodology which I cannot, and this Court should not, endorse is
the inclusion of the credit card sales in the total sales utilized to determine the amount of sales tax
due. As noted by the lower court, the Tax Department acknowledged that the credit card sales
were fully reported and accurate. All receipts deposited in the bank were reported, and the full
amount of consumer sales tax was paid on those credit card sales. Still, the Tax Department
grossed up both cash and credit card sales and applied the calculated underreporting percentage to
the entire amount of sales, not just the cash sales. Asian Grill’s expert testified that credit card
sales were, on average, equivalent to approximately at least eighty percent of the revenue. The
circuit court did not err in its conclusion that applying the calculated underreporting percentage to
the credit card sales was “arbitrary, capricious, and unjust” and “should be applied only to the cash
sales that were actually reported[.]”

        Moreover, I agree with the circuit court that “[a]nother factor that lends itself to finding the
[] methodology arbitrary is the lack of training.” There was testimony before the OTA that there
is neither a training program nor any on the job training for the surveillance audits. Furthermore,
there is no manual or other direction on how to conduct the surveillance audits. Accordingly, the
methodology used in this matter to impose a tax assessment was clearly arbitrary and capricious.
Therefore, based upon the foregoing, I respectfully dissent.

       I am authorized to state that Justice Wooton joins in this dissent.

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