John and Sylvia Von Erdmannsdorff v. Indiana Department of State Revenue , 82 N.E.3d 952 ( 2017 )

ATTORNEYS FOR PETITIONER: ATTORNEYS FOR RESPONDENT:
RANDAL J. KALTENMARK CURTIS T. HILL, JR.
ZIAADDIN MOLLABASHY ATTORNEY GENERAL OF INDIANA
BARNES & THORNBURG LLP WINSTON LIN
Indianapolis, IN PARVINDER K. NIJJAR
DEPUTY ATTORNEYS GENERAL
Indianapolis, IN
FILED
IN THE Sep 05 2017, 4:27 pm
CLERK
INDIANA TAX COURT Indiana Supreme Court
Court of Appeals
and Tax Court
JOHN AND SYLVIA )
VON ERDMANNSDORFF, )
)
Petitioners, )
)
v. ) Cause No. 49T10-1112-TA-00093
)
INDIANA DEPARTMENT OF STATE )
REVENUE, )
)
Respondent. )
ON APPEAL FROM A FINAL DETERMINATION OF
THE INDIANA DEPARTMENT OF STATE REVENUE
FOR PUBLICATION
September 5, 2017
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
Portions of the evidence are confidential information. Accordingly, the Court will provide only
that information necessary for the reader to understand its disposition of the issues presented.
See generally Ind. Administrative Rule 9.
2
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
2
“Cost of goods sold” refers to the number of inventory items “that are being removed or sold
as part of the normal business cycle[.]” (Trial Tr. at 27-28.) “Cost of goods sold generally is
computed under a formula that starts with beginning inventory, adds purchases, [and then]
subtracts ending inventory[.]” (Trial Tr. at 28.)
3
“BizStats is an online provider of free business statistics and financial ratios.” von
Erdmannsdorff v. Indiana Dep’t of State Revenue, 53 N.E.3d 621, 623 n.3 (Ind. Tax Ct. 2016)
(citation omitted).
3
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
4
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
5
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.
6
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
7
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 and are not
corroborated by the insurance records.4 (See Resp’t Redacted Post-Trial Br. (“Resp’t
4
The Department has also claimed that the Court should not consider the von Erdmannsdorffs’
COGS estimates because doing so requires the Court to incorporate a federal tax law doctrine,
the Cohan Rule, into Indiana’s tax laws. (See Resp’t Redacted Post-Trial Br. (“Resp’t Br.”) at
16-18.) The Court, however, finds that it does not need to invoke the Cohan Rule to consider
the von Erdmannsdorffs’ evidence because, as explained during the summary judgment
proceedings, nothing within Indiana’s AGIT statutory scheme “expressly precludes taxpayers
from offering evidence [to the Court that was] generated post-audit” and the Court’s statutorily
prescribed de novo standard of review contemplates the introduction of such evidence. See
von Erdmannsdorff, 53 N.E.3d at 625. See also e.g., Edward Rose of Ind., LLC v. Metro. Bd. of
Zoning Appeals, Div. II, Indianapolis-Marion Cnty., 907 N.E.2d 598, 604 (Ind. Ct. App. 2009)
(defining “de novo judicial review” as the “‘nondeferential review of an administrative decision,
[usually] through a review of the administrative record plus any additional evidence the parties
present’” (citation omitted)).
8
Br.”) at 11-16.)
A. The Reconstructed Inventories
As mentioned, the von Erdmannsdorffs’ inventories for each of the years at issue
were reconstructed using several different methodologies. The Department claims that
these inventories are unreliable because they: 1) were not contemporaneously
prepared, 2) estimated the number of books, 3) estimated the cost of inventory, 4) used
straight-line adjustments, and 5) included property held for rent, not for sale. (See
Resp’t Br. at 10-16; Oral Arg. Tr. at 47-48, 51.)
1. Contemporaneous Preparation
The Department contends that the von Erdmannsdorffs’ reconstructed
inventories were infirm because they were prepared at different times by different
individuals who relied on nothing more than “tape measure[s] and memories up to a
decade old.” (See Resp’t Br. at 4, 11-15.) Moreover, the Department asserts that the
reconstructed inventories are unreliable because the von Erdmannsdorffs completed an
inventory for the first time in June of 2010, nearly six-months after the close of the 2009
tax year, not contemporaneously at year-end as required by Treasury Regulation §
1.471-1. (See Oral Arg. Tr. at 42, 51; Resp’t Br. at 14-15.)
During the years at issue, Indiana incorporated by reference certain provisions
of the Internal Revenue Code and its related regulations by defining adjusted gross
income under IRC § 62 as the starting point for calculating an individual’s Indiana
adjusted gross income. See IND. CODE § 6-3-1-3.5(a) (2000) (amended 2002). In turn,
Section 471 of the Internal Revenue Code provides the general rules for performing
inventories. See generally I.R.C. § 471 (2017); Treas. Reg. §§ 1.471-1 to -10 (2017)
9
(collectively, the “Inventory Rules”). The Inventory Rules provide that “[i]n order to
reflect taxable income correctly, inventories at the beginning and end of each taxable
year are necessary in every case in which the production, purchase, or sale of
merchandise is an income-producing factor.” Treas. Reg. § 1.471-1. Cases interpreting
the Inventory Rules, however, merely explain that their methodologies must conform as
nearly as possible to the customs and best accounting practices of a trade or business
and clearly reflect the income. See, e.g., Thor Power Tool Co. v. C.I.R., 439 U.S. 522,
531 (1979) (quoting Treas. Reg. § 1.471-2(a)(1); Van Pickerill & Sons, Inc. v. U.S., 445
F.2d 918, 920 (7th Cir. 1971). See also Wal-Mart Stores, Inc. & Subsidiaries v. C.I.R.,
153 F.3d 650, 656 (8th Cir. 1998) (explaining that the rule requiring year-end inventories
for books was repealed in 1922).
The Department offered no evidence or legal authority to support its argument
that the von Erdmannsdorffs did not use a proper method to reconstruct their
inventories or that their failure to contemporaneously prepare their inventories
undermined their credibility. The von Erdmannsdorffs, on the other hand, offered expert
testimony by, Mr. Richard Bartholomew, an attorney and certified public accountant,
who is the Director of Tax Services at the Lafayette, Indiana accounting firm of Girardot,
Strauch & Company. (See Stip. ¶ 13, Ex. 9-J; Trial Tr. at 16-21.) Mr. Bartholomew both
advised Mr. von Erdmannsdorff on reconstructing inventories and prepared and filed Mr.
von Erdmannsdorff’s federal and state income tax returns for the years at issue. (See
Trial Tr. at 21-22, 36-37.)
Mr. Bartholomew testified that when a ten-year assessment period is at issue,
the month that the reconstructed inventories are completed is of minimal importance
10
because the beginning and ending inventory figures even out over the entire period.
(See Trial Tr. at 69.) Mr. Bartholomew further testified that the methodologies used to
reconstruct Von’s Shops’ inventories (e.g., physical counts, estimations, measurements,
and memories) were consistent with industry practices and clearly reflected Von’s
Shops’ income. (See Trial Tr. at 31-41, 52-56, 63-64; Trial Ex. 4-P.) Moreover, the trial
evidence established that the 2009 physical count inventory was completed at the end
of 2009, not in 2010 as the Department has alleged. (See Trial Tr. at 87-97; Stip. ¶
18(W), Confd’l Ex. 14-J(W) at 244; Sec. Stip. ¶¶ 8-9, Exs. 29-J ¶¶ 10-11, 30-J at 19-20
(demonstrating that the 2009 physical count inventory was actually completed in
December of 2009 and the inventory of books for 2009 was completed before July of
2010).) In light of this unrebutted evidence, the Department has not shown that the von
Erdmannsdorffs’ reconstructed inventories are unreliable on the basis that they were not
contemporaneously prepared.
2. The Inventory Of Books
The Department also contends that the 2009 inventory of books lacks probative
value because it “was not an actual count [of books], but [rather] an estimate based on
the size of shelving.” (See Resp’t Br. at 15; Oral Arg. Tr. at 41-43.) Without providing
any evidence or legal authority as support, the Department asserts that the von
Erdmannsdorffs should have “count[ed] all the books[ because] that’s what other
bookstores do.” (Oral Arg. Tr. at 43.)
Mr. Bartholomew, however, explained that the Department’s conception of the
physical count methodology is a misnomer because the method does allow estimates of
homogenous items, such as books, that are based on identifiable standards (e.g.,
11
volume, size, inches). (See Trial Tr. at 32-33.) Mr. Bartholomew also testified that Mr.
von Erdmannsdorff’s grouping of the books, based on their size and genre, was
consistent with industry standards. (See Trial Tr. at 32-33, 60.) Consequently, the von
Erdmannsdorffs’ evidence refutes the Department’s claim that the inventory of their
books was not probative because it utilized an estimate, not an actual count.
3. Estimated Inventory Costs
Next, the Department argues that the von Erdmannsdorffs’ reconstructed
inventories are not reliable because they “did not include any tracking of the [actual]
value of [the] inventory[,]” but instead used estimated costs. (See Resp’t Br. at 15; Oral
Arg. Tr. at 43-44.) This argument, however, is unavailing given that Mr. Bartholomew
testified that when it comes to reconstructing inventories over a ten-year period, the
average price of homogenous items “is normally the most reasonable” way to value the
items. (See Trial Tr. at 33-34, 60-61.) Consequently, the Department has not shown
that the reconstructed inventories are unreliable because they used an item’s estimated
cost rather than its actual cost.
4. Straight-line Adjustments
The Department also claims that the reconstructed inventories are unreliable
because they incorporated straight-line adjustments. (See Resp’t Br. at 15.) The
Department explains that while the von Erdmannsdorff’s spent a “great deal of time and
energy highlighting the changes in their business and the market for their goods[,]” they
failed to capture those changes by using straight-line adjustments that treated the
“inventory [as if it] continued to grow or shrink at the same rate each and every year.”
(Resp’t Br. at 15.) The von Erdmannsdorffs’ unrebutted trial evidence refutes this claim
12
as well.
During the trial, Mr. von Erdmannsdorff and Mr. Bartholomew explained that the
reconstructed inventories used additional short-term adjustments to capture abnormal
changes in inventory, including the rapid disposition of the VHS and CD inventories and
the increased purchases of other items, such as used books, DVDs, and beads. (See
Trial Tr. at 44-46, 72-86, 95-96, 112-13; Stip. ¶¶ 19(A), 22(S), Exs. 15-J(A), 17-J(S).)
(See also Trial Tr. at 122-31.) Mr. von Erdmannsdorff also presented several articles
that not only detailed the gradual decline of VHS tapes and CDS in their respective
industries, but also substantiated his claim that his VHS tape and CD inventories
became obsolete during the years at issue. (See Stip. ¶¶ 22(K)-(L), 22(N)-(O), Exs. 17-
J(K)-(L), 17-J(N)-(O); Pet’rs’ Second Req. Judicial Notice, Exs. AA - PP.) (See also,
e.g., Trial Tr. at 43-44, 56.) Moreover, the fact that Von’s Video and Comics closed in
2006 and moved the remaining VHS tapes and comic book inventory to Von’s Shops in
spaces once occupied by CDs, further substantiates Mr. von Erdmannsdorff’s claim
regarding the obsolescence of his VHS tape and CD inventories. (See, e.g., Trial Tr. at
75-86, 123-30; Stip. ¶¶ 22(B)-(D), Exs. 17-J(B)-(D).) Consequently, the Court finds the
Department failed to show that the reconstructed inventories’ use of straight-line
adjustments rendered them unreliable.
5. Rental Property
Finally, the Department claims that the reconstructed inventories are not reliable
because they improperly treated property held for rent (i.e., the VHS tapes and DVDs)
as if it were property held for resale. (See Resp’t Br. at 10.) The Department explains
that the VHS tapes and DVDs should have been depreciated as rental property, not
13
included in COGS as if they were inventory. (See Resp’t Br. at 10 (citing I.R.S.
Publication 946 at 5 (2010).) The Department’s claim is unpersuasive for two reasons.
First, the unrebutted evidence established that Mr. von Erdmannsdorff sold VHS
tapes and DVDs during the years at issue and that their useful lives were, at times, less
than one year. (See Stip. ¶ 2; Trial Tr. at 83, 118, 129-30.) Second, although IRS
Publication 946 contains information regarding the treatment of inventory, the
Department did not show the Court how the Publication established that the von
Erdmannsdorffs erred when they included the VHS tapes and DVDs in their
reconstructed inventories. See I.R.S. Publication 946 at 5 (2010). Consequently, Mr.
von Erdmannsdorff could choose whether to recover the cost of the property by
expensing it, depreciating it, or including it in the COGS. See, e.g., Rev. Rul. 89-62,
1989-1 C.B. 78 (1989) (regarding expensing and depreciation); Retail Indus. Audit
Technique Guide, 2009 WL 9522670, at *49 (I.R.S. Feb. 2009) (regarding depreciation
and COGS). Therefore, the Department has not shown that the reconstructed
inventories are unreliable on this basis either.
B. The Insurance Records
During the trial, the von Erdmannsdorffs presented copies of insurance records
from a 2005 “fire loss and insurance claim” for Von’s Shops that valued its inventory at
$1,649,146 as of November 29, 2005. (See Sec. Stip. ¶ 2, Ex. 23-J.) The insurance
company arrived at that value by conducting an inventory of Von’s Shops based on an
actual count of its merchandise and cost information derived from its written invoices
and from Mr. von Erdmannsdorff. (See Trial Tr. at 97-99, 109, 132-34; Sec. Stip. ¶ 2,
Ex. 23-J at 539.)
14
The Department claims that the insurance records do not substantiate the von
Erdmannsdorffs’ reconstructed inventories because they “clearly state that they rely on
information provided by [the von Erdmannsdorffs], but no documentation has been
provided to this Court” to prove that the information is accurate. (See Resp’t Br. at 14;
Oral Arg. Tr. at 49-50.) The Department further claims that the insurance records
themselves are unreliable because the von Erdmannsdorffs and the insurance
company’s interests were “directly aligned[:]”
The insurance company would have had a financial interest in
minimizing [its] liability for damage, which would have been
accomplished by understating the amount and value of the
inventory owned by [the von Erdmannsdorffs]. Similarly, the [von
Erdmannsdorffs] . . . have an interest in minimizing the amount of
inventory on hand during the [years at issue], as this would reduce
their taxable income and minimize any tax liability.
(Resp’t Br. at 14.)
The von Erdmannsdorffs’ trial evidence, however, demonstrated the reliability of
the insurance company records as corroboration for their estimates. The trial evidence
showed that the insurance company conducted an independent, third-party count of
Von’s Shops’ actual inventory in processing the insurance claim. (See Trial Tr. at 97-
98, 132-34.) Moreover, Mr. von Erdmannsdorff testified that although used book
vendors usually did not provide him with invoices, he did provide the insurance
company with used book invoices when he had them. (See Trial Tr. at 111-12.)
The Department has provided nothing more than allegations that the insurance
company’s inventory is unreliable, presuming the Court will find this conclusion self-
evident. The Court does not find, however, that the insurance company’s inventory is
inherently unreliable simply because it used cost information based on written invoices
15
and Mr. von Erdmannsdorffs’ estimates. Furthermore, the Department’s suggestion that
the insurance company’s records are not reliable because the von Erdmannsdorffs and
the insurance company’s interests were “directly aligned” is unavailing because it is a
bald allegation lacking evidentiary support. See, e.g., Knox Cnty. Prop. Tax
Assessment Bd. of Appeals v. Grandview Care, Inc., 826 N.E.2d 177, 184-85 (Ind. Tax
Ct. 2005) (providing that when allegations are unsupported by factual evidence they
remain mere allegations).
Here, the unrebutted evidence shows that the insurance company valued Von’s
Shops’ inventory at $1,649,146 as of November 29, 2005, and Mr. von Erdmannsdorff
valued Von’s Shops inventory at $1,770,552 as of December 31, 2005. (See Sec. Stip.
¶ 2, Ex. 23-J at 530, 539-43; Stip. ¶ 22(S), Ex. 17-J(S).) There is no indication that Mr.
von Erdmannsdorff relied on the insurance company’s records in arriving at his
valuation. (See Stip. ¶ 22(S), Ex. 17-J(S); Trial Tr. at 97-98; Sec. Stip. ¶ 2, Ex. 23-J at
530.) Indeed, the evidence shows that Mr. von Erdmannsdorff relied on the 2000 and
2009 Inventories to arrive at his valuation. Consequently, the Court finds that the
insurance records do corroborate the von Erdmannsdorffs’ reconstructed inventories.
II. The Department’s COGS Estimates
As previously mentioned, the Department based its COGS estimates for all the
years at issue on the 2006 BizStats’ compilation of business data from the category
labeled “sole proprietorship sporting goods-hobby-book-music stores.” The von
Erdmannsdorffs claim that the Department’s COGS estimates are not reliable because
they a) were derived from a BizStats category that is not comparable to Von’s Shops
and b) produced COG estimates that are inconsistent with several other undisputed
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facts. (See Pet’rs’ Br. at 12-25; Oral Arg. Tr. at 4-7.)
A. The BizStats Category
The Department asserts its COGS estimates are reliable because they were
based on the BizStats category that “accurately describes several of the industries in
which [Mr. von Erdmannsdorff’s] business was engaged,” given that he has admitted to
selling books, music, and several hobby items (e.g., beads, rocks, and guitar strings).
(See Resp’t Br. at 9-11 (citing Trial Tr. at 73, 114); Oral Arg. Tr. at 37-39.) Moreover,
there is no dispute that Von’s Shops rented VHS tapes and DVDs and sold comic
books, new/used books, music in vinyl and CD formats, beads, greeting cards, rocks,
VHS tapes, DVDs, guitar strings, and several other items. At first blush, therefore, the
name of the BizStats category itself, “sole proprietorship sporting goods-hobby-book-
music store,” suggests that it includes businesses like Von’s Shops. Its very name,
however, also suggests that it includes businesses dissimilar to Von’s Shops (i.e.,
sporting goods stores) and excludes others that are similar (i.e., video rental stores).
Consequently, additional details regarding the actual make-up of the businesses in the
BizStats category are needed to ascertain whether any of these facial differences may
have an impact on the reliability of the Department’s COGS estimates. See, e.g.,
Peters v. Garoffolo, 32 N.E.3d 847, 853 (Ind. Tax Ct. 2015) (stating that to establish the
comparability of real property, the proponent of the evidence must explain the
characteristics of the subject property, how those characteristics relate to those of the
purportedly comparable properties, and how any differences between the properties
affected their relative values).
During the trial, one of the Department’s witnesses explained that BizStats
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classifies businesses consistent with the six-digit North American Industry Classification
System (NAICS) code5 contained on taxpayers’ federal income tax returns. (See Trial
Tr. at 181.) While Mr. von Erdmannsdorff’s federal income tax returns contained two
different six-digit NAICS codes, his reporting does not indicate whether the
Department’s chosen BizStats category is consistent with his NAICS codes, nor does
his use of the NAICS codes shed light on the actual make-up of the BizStats category.
(See, e.g., Stip. ¶¶ 9, 18(B), 18(F), Ex. 3-J, Confd’l Exs. 14-J(B) at 103 (Line B), 14-J(F)
at 125 (Line B).) Moreover, the Department did not provide any specific details
regarding the BizStats category businesses, such as the number of sporting goods
stores or music stores, the sizes of the stores, or the geographic locations of the stores.
(See, e.g., Trial Tr. at 167-69.)
In contrast, the von Erdmannsdorffs’ evidence demonstrated that their COGS
estimates for Von’s Shops’ new books and music inventories were higher than the
BizStats sales financial ratio of 56.48%. (See Stip. ¶ 22(H)-(I), 22(K)-(L), Exs. 17-J(H)-
(I), 17-J(K)-(L), Trial Tr. at 101-102.) They also demonstrated that factors unique to the
video rental and music industries rendered Von’s Shops VHS and CD inventories
increasingly obsolete. Thus, the von Erdmannsdorffs demonstrated that the
Department failed to account for factors that may have caused the COGS of businesses
in the BizStats category to vary from the BizStats figure of 56.48% that the Department
used for its COGS estimates. (See Trial Tr. at 167-68.) Given the totality of the
evidence, and the lack thereof, it is unreasonable to infer that the BizStats category the
5
“The North American Industry Classification System (NAICS) is the standard used by Federal
statistical agencies in classifying business establishments for the purpose of collecting,
analyzing, and publishing statistical data related to the U.S. business economy.” North
American Industry Classification System, U.S. CENSUS BUREAU,
https://www.census.gov/eos/www/naics/index.html (last visited Sept. 5, 2017).
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Department used is comparable to the business profile of Von’s Shops. Therefore, the
Court finds that the Department’s use of the BizStats category for a sole proprietorship
sporting goods-hobby-book-music store detracts from the reliability of its COGS
estimates.
B. Other Inconsistencies
The von Erdmannsdorffs also contend that the Department’s COGS estimates
are not accurate because they “produce[d] ending inventory increases, inventory
turnovers, and gross profit margins” that are inconsistent with the facts. (See Pet’rs’ Br.
at 18-19.) The Court will address these three claims in turn.
1. The Ending Inventory Increases
The von Erdmannsdorffs first assert that the Department’s COGS estimates are
inaccurate because they showed that Von’s Shops’ ending inventory had continued to
increase each year during the ten-year assessment period. (See Pet’rs’ Br. at 19-23
(citing Trial Tr. at 48-51, Trial Ex. 3-P; Stip. ¶ 22(X), Confd’l Ex. 17-J(X) (indicating that
the Department’s ending inventory figures for the years at issue were 318% higher than
those of the von Erdmannsdorffs)).) The von Erdmannsdorffs maintain that inventory
increases were neither realistic nor plausible because their unrebutted evidence shows
they had reduced their existing inventory and purchased fewer new items during that
period in response to both the obsolescence of VHS tapes and CDs and the closure of
Von’s Video and Comics. (See Pet’rs’ Br. at 20-22.) (See also, e.g., Trial Tr. at 73-82,
122-30, 147-48; Stip. ¶¶ 22(G)-(L), Exs. 17-J(G)-(L).)
The Department does not dispute that its COGS estimates indicate that Von’s
Shops’ inventory increased during each of the years at issue. (See generally Resp’t Br.;
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Oral Arg. Tr. at 30-54.) Without directly addressing this argument, however, the
Department counters that its use of BizStats’ data was proper because when it used the
total sales and total purchases data that Mr. von Erdmannsdorff had provided during the
audit to determine Von’s Shops’ COGS, “the resulting calculations distorted [the von
Erdmannsdorffs’] income.” (See Resp’t Br. at 6 (citing Stip. ¶ 16, Confd’l Ex. 12-J at 67;
Trial Tr. at 164).) The Department’s response is unpersuasive for two reasons.
First, while the Department’s argument suggests that its authority to use BizStats
and the manner in which it used the BizStats data are at issue, they are not. Rather,
the present issue simply concerns the accuracy of the Department’s COGS estimates
given the evidence introduced at trial. Second, the evidence on which the Department
has relied indicates that it believed that the use of total purchases would overstate
Von’s Shops’ COGS due to the amount of its obsolete inventory; it does not indicate,
however, that the Department actually performed any calculations to verify that belief.
(See Stip. ¶ 16, Confd’l Ex. 12-J at 67; Trial Tr. at 164.)
The United States Tax Court has explained that
[t]he cost of goods sold is determined by adding to opening
inventory for the year the purchases (cost of goods acquired during
that year) and subtracting from that sum the closing inventory
(goods still on hand at the end of that year). Thus, any
undervaluation of ending inventory for a taxable year increases the
cost of goods sold, decreases the income from sales, and results in
a lower profit for that year.
Primo Pants Co. v. C.I.R., 78 T.C. 705, 723 (T.C. 1982). Consequently, because the
ending inventories derived from the Department’s COGS estimates are not supported
by the evidence, it is more probable that the Department’s COGS estimates are too low
and that its calculations of the von Erdmannsdorffs’ taxable income for the years at
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issue are too high. Accordingly, on this basis, the von Erdmannsdorffs have shown that
the Department’s COGS estimates are less reliable than theirs.
2. Inventory Turnovers
The BizStats data states that inventory as a percentage of sales for a sole
proprietorship sporting goods-hobby-book-music store is 20.52%. (Stip., ¶ 9, Ex. 3-J.)
The von Erdmannsdorffs contend that “[t]his means that, on average, [the] businesses
[within this BizStats category] turned their inventory over nearly 5 times in 2006[,]” but
the Department’s COGS estimate only “produce[d] an inventory turnover [for Von’s
Shops] of once every 2.88 years.” (See Pet’rs’ Br. at 23-24; Pet’rs’ Post-Trial Reply Br.
at 2-3.) Moreover, the von Erdmannsdorffs’ evidence shows that “Von’s Shops barely
turned its inventory over once” during the 2006 tax year. (See Pet’rs’ Br. at 23-24 (citing
Trial Tr. at 49-51; Trial Ex. 3-P, Table 4; Stip. ¶ 22(X), Confd’l Ex. 17-J(X)).)
The Department, on the other hand, maintains that the von Erdmannsdorffs are
wrong because:
[i]nventory as a percent of sales is a distinct metric from inventory
[turnovers]. Although the [von Erdmannsdorffs] attempt to imply
that this figure means that inventory was flipped over 5 times, it can
also indicate other phenomena. A lower figure for inventory as a
percent of sales can indicate obsolescence, where some items in
inventory are sold that were not replaced. This would lead to an
increase in sales and a decrease in inventory.
(Resp’t Br. at 10.) The Department, however, has not supported this contention with
any binding authority, persuasive authority, or evidence. Therefore, the Court declines
to give any weight to the Department’s claim in this regard.
3. Gross Profit Margins
Finally, the von Erdmannsdorffs claim that its evidence demonstrates that Von’s
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Shops sold music and books at steep discounts and purchased other items at rates
exceeding the BizStats sales financial ratio of 56.48%; thus, its gross profit margins for
those items were substantially less than the BizStats gross profit margin of 43.52%
relied on by the Department. (See Pet’rs’ Br. at 24-25 (citing Stip. ¶¶ 9, 18(V), Ex.3-J,
Confd’l Ex. 14-J(V); Trial Tr. at 101-03, 105, 151).) In response, the Department merely
states that its COGS estimates are accurate because its audit figures are consistent
with certain census data. (See Resp’t Br. at 18-19.)
The census data on which the Department relies concerns the same BizStats
category that the Court found detracts from the reliability of the Department’s COGS
estimates. Accordingly, the census data sheds no further light on the composition of the
BizStats category. See, e.g., Annual Retail Trade Survey Methodology, U.S. CENSUS
BUREAU, http://www.census.gov/retail/arts/how_surveys_are_collected.html (last visited
Sept. 5, 2017). Consequently, the census data does not rebut the von Erdmannsdorffs’
evidence concerning the gross profit margin inconsistencies. Therefore, the Court finds
that the Department’s COGS estimates unreliable on this basis as well.
CONCLUSION
For all the reasons stated above, the Court finds that the Departments Proposed
Assessments, while properly based on the best information available when originally
issued, should have been adjusted to reflect the more reliable evidence presented
during the administrative protest and the original tax appeal. Accordingly, the Court
finds in favor of the von Erdmannsdorffs and against the Department.
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