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Von Erdmannsdorff v. Indiana Department of State Revenue

Tax Court of Indiana

September 5, 2017

JOHN AND SYLVIA VON ERDMANNSDORFF, Petitioners,
v.
INDIANA DEPARTMENT OF STATE REVENUE, Respondent.

         ON APPEAL FROM A FINAL DETERMINATION OF THE INDIANA DEPARTMENT OF STATE REVENUE

          ATTORNEYS FOR PETITIONER RANDAL J. KALTENMARK ZIAADDIN MOLLABASHY BARNES & THORNBURG LLP

          ATTORNEYS FOR RESPONDENT CURTIS T. HILL, JR. ATTORNEY GENERAL OF INDIANA WINSTON LIN PARVINDER K. NIJJAR DEPUTY ATTORNEYS GENERAL

          WENTWORTH, J.

         John and Sylvia von Erdmannsdorff have appealed the Indiana Department of State Revenue's Proposed Assessments of adjusted gross income tax (AGIT) for the 2000 through 2009 tax years. This matter concerns whether the Department's Proposed Assessments based on the best information available are valid in light of the von Erdmannsdorffs' contrary information.[1] The Court finds in favor of the von Erdmannsdorffs.

         FACTS

         During the years at issue, Mr. von Erdmannsdorff owned and operated a new and used bookstore as a sole proprietorship in the college town of West Lafayette, Indiana. (See Stipulation of Facts ("Stip.") ¶¶ 1-2; Trial Tr. at 71-72, 128, 145.) Between 2000 and 2006, the sole proprietorship was operated from several adjacent buildings under the distinct business names of "Von's Shops" and "Von's Video and Comics." (See, e.g., Stip. ¶¶ 1, 22(B)-(C), Exs. 17-J(B)-(C); Trial Tr. at 76.) Von's Shops was located within four buildings and sold an assortment of new and used books, music in vinyl and CD formats, beads, greeting cards, rocks, and other odds and ends. (See Stip. ¶ 2; Second Stipulation of Facts ("Sec. Stip.") ¶ 1, Ex. 22-J at 530; Trial Tr. at 72-73, 76.) Von's Video and Comics, located in a building adjacent to Von's Shops, purchased and sold comic books, VHS tapes, and DVDs and, in addition, rented VHS and DVD movies. (See Trial Tr. at 75-76; Stip. ¶¶ 22(B)-(C), Exs. 17-J(B)-(C).) In 2006, Von's Video and Comics closed and its inventory was moved to Von's Shops. (See Stip. ¶¶ 22(B)-(C), 22(F), Exs. 17-J(B)-(C), 17-J(F).) Consequently, Von's Shops began to rent VHS and DVD movies and sell comic books, VHS tapes, and DVDs. (See Stip. ¶ 22(L), Ex. 17-J(L); Trial Tr. at 75-80.)

         In January of 2010, while auditing Von's Shops for the 2007 and 2008 tax years, the Department asked to inspect Von's Shops' general ledgers, federal and state income tax returns, and any supporting state tax workpapers. (See Stip. ¶¶ 3, 15, Exs. 1-J, 11-J at 43.) Mr. von Erdmannsdorff replied that because his business had "been operating in the red for years[, ]" he did not owe any income tax and therefore had not filed tax returns. (See Stip. ¶¶ 15, 18, Exs. 11-J at 45, 14-J at 96; Trial Tr. at 86-87.) The Department explained that Mr. von Erdmannsdorff needed to file federal and state income tax returns for the years at issue as soon as possible and expanded the scope of its audit to include the 2000 through 2006 and 2009 tax years. (See Stip. ¶ 15, Ex. 11-J at 45, 47.)

         By the end of May of 2010, Mr. von Erdmannsdorff had provided the Department with access to, or copies of, Von's Shops' general ledgers, checkbook registers, payroll data, and expense reports for each of the years at issue. (See Stip. ¶¶ 10, 15, Exs. 4-J to 6-J, 11-J at 47-50.) Mr. von Erdmannsdorff, however, did not provide the Department with copies of Von's Shops' inventories, which would have been used to calculate its annual cost of goods sold (hereinafter, "COGS"), [2] because Mr. von Erdmannsdorff did not take inventories during the years at issue. (See Stip.¶ 15, Ex. 11-J at 47-52; Trial Tr. at 27-28, 36, 117, 161-63.) Lacking actual inventory information, the Department determined that it would rely on the general information contained in the category entitled "sole proprietorship sporting goods-hobby-book-music store" from BizStats'[3] for 2006. (See, e.g., Stip. ¶¶ 9, 11-12, Exs. 3-J, 7-J, 8-J at 35.) Accordingly, the Department used the "cost of sales financial ratio of 56.48%" from this BizStats category as the best information available to estimate Von's Shops' annual cost of goods sold. (See Stip. ¶¶ 9, 16, Ex. 3-J, Confd'l Ex. 12-J at 66-67, 69; Trial Tr. at 162-63.)

         In June of 2010, the Department explained to Mr. von Erdmannsdorff that if it did not receive all of his completed tax returns by July 30, it would issue Proposed Assessments against the von Erdmannsdorffs based on the best information available to it. (See Stip. ¶¶ 14-15, Exs. 10-J, 11-J at 51-52.) After this deadline passed, the Department issued an Investigation Summary to the von Erdmannsdorffs, detailing the basis and computation of Proposed Assessments using BizStats as the best information available. (See Stip. ¶ 16, Confd'l Ex. 12-J.) On October 26, 2010, the Department issued the Proposed Assessments imposing approximately $245, 000 in AGIT, interest, and penalties for the years at issue. (See Stip. ¶ 17, Confd'l Ex. 13-J.)

         In December of 2010, the von Erdmannsdorffs protested the Proposed Assessments. (See, e.g., Stip. ¶ 18.) At that time, the von Erdmannsdorffs presented the Department with copies of their federal and state income tax returns for the years at issue. (See Stip. ¶¶ 18, 18(A)-(T), Ex. 14-J, Confd'l Exs. 14-J(A)-(T).) In addition, the von Erdmannsdorffs provided estimates of the annual COGS derived from "reconstructed" inventories for each of the years at issue. (See, e.g., Stip. ¶¶ 18(U)-(W), 22(S), Confd'l Exs. 14-J(U)-(W), Ex. 17-J(S).)

         The von Erdmannsdorffs' estimate of the inventory for the 2000 tax year was based on the recollections of Mr. von Erdmannsdorff and his long-time employees together with the measurements of spaces that housed the inventory within Von's Shops. (See, e.g., Stip. ¶ 18(V), Confd'l Ex. 14-J(V); Trial Tr. at 91-96, 134-37, 149.) For instance, the inventories of new books and CDs were developed by approximating the historical placement of shelves and bins, confirming those placements by measuring floor space, estimating the historical inventory held on the shelves and bins, and then multiplying that total by the item's average price. (See, e.g., Stip. ¶¶ 18(V), 22(I), Confd'l Ex. 14-J(V); Ex. 17-J(I); Trial Tr. at 91-96.)

         The inventory for the 2009 tax year was developed somewhat differently, using linear measurement and physical count methodologies. (See Stip. ¶ 18(W), Confd'l Ex. 14-J(W); Trial Tr. at 87-92.) More specifically, an inventory of books was developed by first estimating the number of new or used books held on the shelves based on either the measurements of the shelves and the thickness of varying genres of new books or the measurements of the shelves alone, and then, multiplying each total by the average price of a book. (See Stip. ¶ 18(W), Confd'l Ex. 14-J(W) at 245; Trial Tr. at 89-92.) The inventory of the remaining items was developed by physically counting or estimating the number of items and then multiplying each total by the item's average price. (See Stip. ¶ 18(W), Confd'l Ex. 14-J(W) at 244, 246-47; Sec. Stip. ¶¶ 8-9, Exs. 29-J ¶¶ 10-11, 30-J at 19-20, 39-40; Trial Tr. at 88-89.)

         Finally, the inventories for the 2001 through 2008 tax years were extrapolated from the 2000 and 2009 inventories, using straight-line adjustments to track the regular flow of inventory over the ten-year assessment period. (See Stip. ¶¶ 19(A), 22(S), Exs. 15-J(A), 17-J(S); Trial Tr. at 41-46, 95-96, 115.) Indeed, the underlying assumption supporting the use of straight-line adjustments was that the incremental changes to the amount or value of inventory remained steady from year-to-year; for instance, if the amount of inventory increased by $100, 000 over the ten-year period, "then the increment would be $10, 000 per year." (See Trial Tr. at 43.) In addition, the 2001 through 2008 inventories incorporated specific short-term adjustments for any period where there was a significant change in the amount or value of inventory items. (See, e.g., Stip. ¶ 22(S), Ex. 17-J(S); Trial Tr. at 43-44, 95-96.)

         On July 20, 2011, after conducting a hearing, the Department issued a Letter of Findings denying the von Erdmannsdorffs' protest. (Stip. ¶ 23, Ex. 18-J.) Then, on October 20, 2011, the Department denied the von Erdmannsdorffs' request for rehearing. (Stip. ¶¶ 24-25, Exs. 19-J, 20-J.)

         On December 16, 2011, the von Erdmannsdorffs initiated this original tax appeal. The Department subsequently filed a motion for summary judgment, asserting that it was entitled to judgment as a matter of law because the von Erdmannsdorffs' reconstructed inventories, and thus their COGS estimates, lacked probative value. See von Erdmannsdorff v. Indiana Dep't of State Revenue, 53 N.E.3d 621, 625 (Ind. Tax Ct. 2016). The von Erdmannsdorffs filed a counter-motion for partial summary judgment, asserting that the Department made certain errors in computing their alleged AGIT liabilities for the years at issue. Id. at 626. On June 3, 2016, the Court denied the Department's motion, finding a genuine issue of material fact, and granted the von Erdmannsdorffs' counter-motion. Id. The von Erdmannsdorffs' appeal proceeded to trial in October of 2016. The Court heard oral argument on February 21, 2017. Additional facts will be supplied as necessary.

         STANDARD OF REVIEW

         This Court reviews final determinations of the Department de novo. Ind. Code § 6-8.1-5-1(i) (2017). Accordingly, the Court is not bound by the evidence or the issues presented to the Department at the administrative level. Horseshoe Hammond, LLC v. Indiana Dep't of State Revenue, 865 N.E.2d 725, 727 (Ind. Tax Ct. 2007), review denied.

         LAW

         Indiana imposes a tax at the rate of 3.4% on the adjusted gross income of residents like the von Erdmannsdorffs. See Ind. Code § 6-3-2-1(a) (2000). The Department, in turn, is charged with administering, collecting, and enforcing that tax. See Ind. Code § 6-8.1-1-1 (2000) (amended 2002); Ind. Code § 6-8.1-3-1(a) (2000). Accordingly, the Department may audit any returns filed and investigate any matters relating to the AGIT. See Ind. Code § 6-8.1-3-12(a) (2000).

         When conducting an audit, the Department may "inspect any books, records, or property of any taxpayer which is relevant to the determination of the taxpayer's tax liabilities[.]" Ind. Code § 6-8.1-4-2(a)(3) (2000). To that end, every person subject to the AGIT "must keep books and records [(e.g., invoices, register tapes, receipts, cancelled checks, or other source documents)] so that the [D]epartment can determine the amount, if any, of the person's [AGIT] liability . . . by reviewing those books and records." Ind. Code § 6-8.1-5-4(a) (2000). In addition, the person must allow the Department to inspect his books and records at all reasonable times. I.C. § 6-8.1-5-4(c). If the taxpayer fails to maintain or provide the Department with his books and records, the Department may determine the taxpayer's tax liability based on the best information available to it. See I.C. § 6-8.1-5-4(a); Ind. Code § 6-8.1-5-1(a) (2000) (amended 2006).

         ANALYSIS

         There is no dispute that the von Erdmannsdorffs did not keep books and records sufficient for the Department to determine their AGIT liabilities as required by Indiana Code § 6-8.1-5-4(a). Moreover, there is no dispute that in light of the dearth of books and records, the Department properly made the Proposed Assessments using the best information available at that time. Because certain issues regarding the Department's Proposed Assessments were resolved during the summary judgment process, the dispositive issue preserved for trial was whether the Department's Proposed Assessments based on the best information available were still valid in light of the von Erdmannsdroffs' evidence presented at trial.

         I. The von Erdmannsdorffs' COGS Estimates

         The von Erdmannsdorffs claim that the Department should have adjusted the Proposed Assessments to reflect their COGS estimates based on reconstructed inventories that are "supported by fact and [] corroborated by third party insurance records[, ]" which demonstrates their superior reliability to the information used by the Department. (See Pet'rs' Post-Tr. Br. ("Pet'rs' Br.") at 25-29.) The Department contends, however, that the von Erdmannsdorffs' COGS estimates are unreliable because their reconstructed inventories used flawed methodologies ...


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