Washington “Zapper” Criminal Prosecution – Use of Zapper May Have Tipped off Auditors to Unreported Cash Sales
by Department of Revenue announced on its website on February 5, 2016, that the state had filed charges against the owner of Facing East, a Bellevue restaurant, alleging among other charges the use of sales suppression software to hide cash transactions, and “pocketing nearly $395,000 in sales tax collected from her patrons.” Revenue has for many years audited small retail businesses, especially restaurants and bars, with an eye to finding unreported cash sales, but this is the first criminal case brought by the Department including a charge of use of a zapper. The zapper charge is brought under 2013 legislation which made it unlawful to use (or to perform other acts defined as wrongful) software or hardware that deletes sales transactions from register tapes.
Revenue took full advantage of the filing to bombard the news media with details of the case, which the media dutifully repeated. Publicizing the case is understandable, of course, but there is vagueness in the published releases as to how much sales tax may actually have been diverted. Without at all diminishing the gravity of the offense, if proved, we think that based on our own experience in representing businesses in audits involving issues of unreported cash sales that it is likely the $395,000 is an overestimate. We think this because of the way in which Revenue has made estimates in the past. What is more interesting, however, is that the press releases suggest that the installation of a zapper may actually have tipped off Revenue that sales tax was being under-reported. The press releases suggest that during the course of the audit Revenue auditors saw a “drop” in sales from that which the business had reported in previous tax returns, which suggested the installation and use of a zapper. Of course the economy or other market changes may come into play in bringing about a decline in sales, but Revenue’s thinking that the business had started using a zapper was plausible. If that is actually how events unfolded, then the case suggests that a businesses which installs a zapper, but had not previously had a practice of omitting appreciable cash amounts, may wave a red flag when later returns begin to show noticeably smaller sales. The risk of bringing on an audit where unreported cash sales may become an issue is dangerous, moreover, because Revenue will proceed to estimate the unreported cash amounts and, in my view, it will estimate high, in fact, very high. What might have been a few thousand dollars of cash omitted, can become tens of thousands of dollars in a final bill to the taxpayer, and may result in criminal charges.
A determination of unreported cash cases during an audit is not new, because Revenue has for years (and well before the advent of the zapper) audited businesses and prosecuted their owners for theft of collected sales tax. The way it usually works is that auditors think that they have a good idea of how much in cash receipts is standard in a given industry, and if it appears during an audit that a business has reported less than the expected cash amount, auditors may suspect that cash is being intentionally unreported. And it is usually not difficult to determine during an audit how much of the amount reported on returns was cash – auditors compare the total debit/credit amounts (usually all or most of which are reported on the tax return) with the total amounts reported on the return. The excess, if any, of reported amounts over card payments (which are known from bank records or IRS 1099-Ks) is presumably cash. If the amount of cash reported is smaller than expected, say only a few percent of the total sales reported on the return, additional amounts will be assessed for cash received. This will result in B & O and sales tax being assessed, with interest and more often than not with a 50% evasion penalty. But, while Revenue has long had tools to detect that a business has not been reporting all of its cash sales, a sudden drop in sales because a zapper is being used may give Revenue an additional detection tool.
Because many of the businesses audited are small restaurants, groceries or retailers of small goods, their records are usually poor and they may not be considered by Revenue to be adequate “books and records” as required by law. Once the records are deemed unreliable Revenue will estimate the amount of cash unreported. Revenue has ity to make estimated assessments in the absence of books and records, because the law instructs Revenue to “obtain facts and information on which to base its estimate.” Unfortunately “facts and information” are not always obtained, and the estimates are more often than not little more than “pie in the sky” guesses. This happens in part because Revenue uses unscientific methods to estimate how much cash has not been reported.
For example, Revenue sometimes relies on a series of credit card industry studies of cash v. credit card transactions in different lines of business. But the most recent of these studies is already 6 years old, and auditors have not shied away from relying on cash v. credit ratios in even older studies. We cannot discuss all of the problems with applying these studies to estimate cash sales for a Washington business – but it should be noted that the studies themselves state that consumers are showing a growing preference for card payments over cash. It also should be noted that the studies simply count the number of transactions of cash vs. card, but not the amounts of each of these transactions. Because card sales are usually larger than cash sales estimating the amount of unreported cash sales from the known amount of credit sales also throws off the reliability of estimating the amount of the assumed unreported cash transactions. Thus, because auditors take transaction numbers from older studies, because they do not take into account the increase of card usage (especially in the tech savvy East Side of Lake Washington, for example) and because auditors usually assume that unreported cash transactions would be the same amount as the larger card transactions, auditors routinely estimate unreported cash in the mid 30-40%. My office recently concluded a case where the estimated cash was a whopping 34% where my own (and very reliable) calculations showed cash sales were in the range of 17- 20%! Appeals decisions generally rubber stamp auditors’ findings on estimates and say, in effect, it is the business owner’s own fault for trying to game the system and not having good records. But, without condoning the actions of a business which does not report all of its sales, it can be argued that in its zeal to stomp out cash skimming Revenue imposes a staggering financial burden on the owners of small businesses (and their families) for amounts which they never collected in the first place.
Let’s assume that 4% of cash sales were reported on a return, while another 10% of sales above the 4% was not reported. Because auditors will reject the business’ effort to prove only 10% was omitted, Revenue might estimate that 34% was not reported. So, what a business might have expected would be an increase of tax due on 10% additional sales will turn into an increase of 34% plus a likely increase of another 17% because of a 50% penalty, for a total increase in unreported sales of 51% of the amount of reported sales. There are additional penalties and interest which will be charged, all of which will also be computed with respect to the 51% of sales amount.
How does this play into the charges filed February 5? For one thing, the amount charged as stolen appears to be an estimate and not the exact amount the press release in one place suggests. The third line of the website posting accuses the taxpayer of “pocketing nearly $395,000 in sales tax collected from her patrons,” and only later in the release acknowledges that this is the estimate which audit made. An article in the Seattle times also supports the point that the sales were estimated: “State staffers estimated Wong owed $394,835 in back taxes, based on the ratio of cash sales in the restaurant’s prior tax returns.” Because cash sales are not broken out in an excise tax return it is unclear how Revenue determined cash sales in prior returns, though as we have shown above there are usually ways to determine how much reported on a return was card sales and how much was cash. But the fact of a drop off in sales alone doesn’t answer the question, “how much was actually omitted?”
The releases we reviewed do not indicate how the auditors prepared the estimates, but if Revenue followed its standard procedures it did not actually recreate the business’ income to be consistent with pre-zapper periods reported on returns: it would have used one of its standard methodologies to boost the assumed reported income to unrealistically high levels. This is curious because the press releases and articles say that the taxpayer had two sets of books. Yet, nowhere is it indicated that a second set of books showed unreported sales tax of $395,000. And, anyway, if there was in fact a second set of accurate books, why would Revenue have to “estimate” the unreported amounts? Likely there is some dramatic hype introduced into the press releases to highlight the danger of using the zapper and the huge assessments which may result. But even so, the press releases suggest that it will be expensive if a business is caught skimming cash off its reported income, and that the advent of the zapper may give the Department of Revenue another tool with which to detect likely lack of payment.