Can the state base my tax bill on a sample of my sales, and who has to prove my exemption certificates covered the items?

Plain-English summary

McClintock Paper, Inc. is a wholesaler that sells paper products, mostly to businesses and government agencies — around 100 sales a day (roughly 25,000 a year). The Department audited it for January 1992 through April 1995 and assessed $13,983.28 in gross receipts tax, plus penalty and interest (Assessment No. 1972612). Because the transaction volume was so large, the Department didn't review every sale; it sampled — picking the high, low, and average business months each year, then the 5th and 15th working days of each selected month, then the first ten invoices each day on which no tax had been charged. It computed an error rate from the disallowed deductions in that sample and applied it to the full year. McClintock protested, and Hearing Officer Ellen Pinnes upheld the assessment on every ground.

1. Sampling audits are fine if the sample is representative — not necessarily "statistically valid"

McClintock's main argument was that the sample wasn't "statistically valid" (its margin of error couldn't be mathematically determined), so the Department couldn't extrapolate it to a full year. The Hearing Officer rejected this: there is no requirement that an audit sample be statistically valid — only that it be representative of the transactions being sampled. By law, the assessment is presumed correct, and the taxpayer bears the burden of proving it wrong (§ 7-1-17(C); Regulation TA 17:4). McClintock never showed the sample was unrepresentative: it conceded its transactions didn't vary by time of day, didn't argue the chosen days were unusual, and pointed to no atypical transaction in the sample. Judgmental (non-statistical) sampling is standard audit practice in New Mexico and other states.

Worse for McClintock, it refused the Department's offers to run a second audit on a different sample and to consider a self-audit McClintock could design itself. It declined, insisting auditing was the Department's job — which "misconstrues the applicable law." General complaints that a sample lacked statistical validity, without evidence that it produced an inaccurate result, don't carry the taxpayer's burden.

2. Resale-deduction items must actually be resold — and the taxpayer must prove it

Within the sample, the Department disallowed some deductions because McClintock had no non-taxable transaction certificate (NTTC) (which McClintock didn't contest) and others because the items sold weren't sold for resale — things like guest checks, filter cones, garbage can liners, pan liners, trays, and towels. Under § 7-9-47, receipts from selling tangible personal property are deductible if the buyer resells it (including nonreturnable containers that become part of the product — Regulation GR 47:2(A); food-packaging materials — Regulation GR 47:24, which also lists garbage can liners and paper towels as non-deductible).

McClintock was correct in principle that even an item listed as non-deductible (a can liner, a pan liner used to wrap tamales) becomes deductible if the buyer actually resells it. But the burden was on McClintock to prove those specific buyers did so — and it failed. Saying items "can be" or "often are" used to package food isn't proof that the particular purchasers in the disallowed sales used them that way. McClintock kept no records of buyers' intended use, presented no testimony from its salespeople or customers, and admitted it didn't train salespeople to confirm that purchased items fell within the buyer's NTTC. A seller who accepts an NTTC remains responsible for ensuring the goods are actually deductible under it (Regulation GR 43:9) — especially for items normally taxable.

3. Penalty and interest upheld

The negligence penalty (§ 7-1-69(A)) applied: McClintock acted negligently by not checking whether NTTC-covered items were truly sold for resale, and it disregarded the rules outright when it admitted it wouldn't charge tax even on clearly non-deductible items, to avoid losing customers. Interest (§ 7-1-67) is mandatory — "shall be" paid at 15% per year with no exceptions (State v. Lujan). The protest was denied.

What this means for you

The state can tax you on a projection from a sample of your sales

For a high-volume business, the Department doesn't have to examine every transaction. It can review a representative sample, calculate an error rate, and apply it to the whole period. The sample doesn't have to be "statistically valid" in a formal sense — it just has to fairly represent your business. If you think a sample is skewed, you have to show it, with specifics.

An assessment is presumed correct — the burden to disprove it is yours

New Mexico law (§ 7-1-17(C)) puts the burden on you to prove an assessment is wrong. Complaining about the Department's method isn't enough; you must produce evidence that the result is inaccurate. If the Department offers you a re-audit or the chance to run your own sample, take it — refusing and insisting "that's the auditor's job" is a losing strategy.

"Sold for resale" turns on actual resale, and you must document it

An exemption for resale applies only if your buyer actually resells the item. Even items a regulation lists as non-deductible can qualify if genuinely resold — but you must prove that specific buyers did so. Keep records of how buyers use what they purchase, and be ready to back it up with testimony or affidavits, not general statements about typical uses.

Accepting an exemption certificate doesn't end your responsibility

Having a valid NTTC on file isn't a blanket pass. You remain responsible for confirming that the specific items you sell tax-free actually fall within the certificate's terms (Regulation GR 43:9). Train your salespeople to check that each purchase fits the exemption, and be especially careful with items that are normally taxable.

Don't skip charging tax just to keep a customer happy

McClintock admitted it wouldn't charge tax even on clearly taxable items when a buyer bought a mix, for fear of losing the sale. That admission was treated as disregard of the rules and helped justify the penalty. Charge the tax that's due; absorbing or waiving it to please customers exposes you to assessment, penalty, and interest.

Common questions

Q: The Department taxed me based on a sample, not my actual sales. Is that allowed?
A: Yes, for high-volume businesses. The Department may review a representative sample and project an error rate across the period. The sample need not be "statistically valid" — only representative of your business.

Q: I think the sample was too small or unfair. How do I fight it?
A: You must show, with evidence, that the sample was unrepresentative or produced an inaccurate result. General objections aren't enough. If the Department offers a re-audit or a self-audit, use it to build your proof — the burden of disproving the assessment is on you (§ 7-1-17(C)).

Q: I sell items my customer resells (like packaging). Aren't those automatically tax-exempt?
A: Only if the buyer actually resells them, and you can prove it for the specific sales at issue. Even items a regulation lists as non-deductible can qualify if genuinely resold — but "these items are often used that way" won't satisfy your burden without records or testimony about the actual buyers.

Q: I have the customer's exemption certificate on file. Doesn't that protect every tax-free sale to them?
A: No. You still must ensure the specific items you sell tax-free are deductible under the certificate's terms (Regulation GR 43:9). For items that are normally taxable, you have to confirm the buyer intends a deductible use.

Q: Can I avoid a penalty if I acted in good faith?
A: Not here. The penalty applies to negligence or disregard of the rules. Failing to verify resale use is negligence, and deliberately not charging tax on clearly taxable items — as McClintock admitted doing to keep customers — is disregard of the rules. Interest is mandatory regardless.

Citations and references

Statutes and regulations:

• § 7-1-17(C) NMSA 1978 — an assessment of tax is presumed correct; the taxpayer bears the burden of showing it is incorrect; TRD Regulation TA 17:4
• § 7-9-47 NMSA 1978 — receipts from selling tangible personal property are deductible if the buyer resells the property, by itself or in combination with other property
• TRD Regulation GR 47:2(A) — nonreturnable containers used to package property that become part of the product are considered sold for resale and deductible
• TRD Regulation GR 47:24 — materials restaurants and food sellers use to package or wrap food for sale are deductible; the regulation also lists items not sold for resale (e.g., garbage can liners, paper towels)
• TRD Regulation GR 43:9 — a seller who accepts an NTTC remains responsible for ensuring that goods sold under the certificate are properly deductible within its terms
• § 7-1-69(A) NMSA 1978 — 2%-per-month penalty (up to 10%) for failure to pay tax due to negligence or disregard of rules
• § 7-1-67 NMSA 1978 — interest "shall be" paid on tax deficiencies at 15% per year, with no exceptions

Cases cited:

• State v. Lujan, 90 N.M. 103, 560 P.2d 167 (1977) — the word "shall" in a statute is mandatory rather than discretionary unless a contrary legislative intent is clearly shown (applied to mandatory interest)

Source

• Listing: New Mexico Decisions & Orders
• Decision post: McClintock Paper, Inc.
• Decision PDF: D&O 96-28

Original ruling text

BEFORE THE HEARING OFFICER
OF THE TAXATION AND REVENUE DEPARTMENT

IN THE MATTER OF McCLINTOCK PAPER, INC.
Docket No. 96-09-06
Tax I.D. No. 01-793209-00 2 NO. 96-28
Assessment No. 1972612

DECISION AND ORDER

This matter came on for hearing on November 12, 1996 before Ellen Pinnes, Hearing

Officer. McClintock Paper, Inc. ("the Taxpayer") was represented by Gregory DuBrock, CPA. Jim

McClintock, owner of McClintock Paper, also appeared at the hearing and testified on behalf of the

Taxpayer. The Taxation and Revenue Department ("the Department") was represented by Gail

MacQuesten, Special Assistant Attorney General. The parties submitted their closing statements to

the hearing officer in writing on November 19, 1996, and the hearing proceedings concluded at that

time.

Based upon the evidence and arguments presented, IT IS HEREBY DECIDED AND

ORDERED AS FOLLOWS:

FINDINGS OF FACT

1. Assessment No. 1972612 was issued to the Taxpayer on October 23, 1995, for

$13,983.28 in gross receipts taxes due for January 1992 through April 1995. Interest and penalties

were added to the principal amount.

2. The Taxpayer filed a timely protest of the assessment by a letter from its

representative dated November 3, 1995.

3. The Taxpayer, a corporation, is in the business of selling paper products. Most of its

business consists of sales at wholesale to businesses and government agencies.

4. The Taxpayer has a continuing customer base, with many repeat transactions to

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existing customers.

5. The Taxpayer makes approximately 100 sales in a typical business day.

6. The Taxpayer's transactions typically do not vary significantly based on the time of

day at which they occur.

7. In 1995, the Department performed an audit of the Taxpayer for the period from

January 1992 through April 1995. This audit was performed through a review of the Taxpayer's

records.

8. The audit did not review all transactions that occurred during the audit period of

three years and four months. Instead, because of the large number of transactions that had taken

place during that time, the Department reviewed a sample of transactions from the period.

9. The sample consisted of certain transactions occurring in three months in each full

calendar year, with those months being the high, low, and average business months for each year.

For 1995, in which only four months were included in the audit period, the Department reviewed

only one month, the average month.

10. For each month selected, the Department reviewed transactions occurring on two

days in the month -- the fifth and fifteenth working days of each month. These days were deemed to

be representative of the Taxpayer's business so as to allow the Department to extrapolate the results

for these days to the Taxpayer's business as a whole. For each such day, the Department reviewed

the first ten invoices on which no gross receipts tax on the sale was shown as having been collected

by the Taxpayer.

11. The sample was selected according to the audit manual regularly used by the

Department's auditors and according to standard Department practice.

12. The sample selected by the Department was not "statistically valid", in the sense that

the margin of error applicable to the sample could be mathematically determined.

13. The sample used by the Department was selected based on the auditor's judgment

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that it would provide an accurate representation of the Taxpayer's business.

14. The population of transactions from which the sample was selected was fairly

homogeneous in that transactions did not vary greatly among themselves in terms of the size of the

transaction, customer base involved, and types of items sold.

15. The sample has not been shown not to be representative of the Taxpayer's business.

16. In response to the Taxpayer's challenge to the validity of the sample, the Department

offered to select a different sample and recalculate the error rate based on the new sample. The

Taxpayer rejected this offer.

17. The Department also offered to consider the results of a self-audit performed by the

Taxpayer on a sample of the latter's choosing, if the Taxpayer chose to do one. The Taxpayer

declined to perform its own audit, arguing that it was the job of the Department, not the Taxpayer, to

do the auditing work.

18. The Taxpayer was advised by the Department that, by statute, the Department's

assessment is considered to be correct, and that the Taxpayer had the burden of showing that it was

incorrect.

19. The Department's use of a "judgmental", or non-statistically valid, sample is

consistent with the practice of tax departments in other states.

20. The Department's auditors determined, as to each invoice reviewed, whether receipts

from the sale were properly deductible from gross receipts for gross receipts tax purposes. If the

deduction was proper, no error was found. If the deduction was determined to be improper, an error

was considered to have occurred.

21. Based on the findings from the audit sample, an error rate was calculated for each

year in the audit period. That error rate was then applied to the full year in order to determine the

amount of the assessment.

22. Of the ten months selected for review, no errors ultimately were found in four. This

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included one of the three months selected in 1992, two of the three months selected in 1994, and the

one month selected in 1995.

23. In the six months in which errors were identified, such errors were found in one to

three invoices each month out of the twenty transactions reviewed for that month.

24. The Department removed one large transaction from the sample, for purposes of

computing the error rate, because it was unusually large and therefore was considered not

representative. Unpaid taxes were assessed on this sale, but it was not included in the calculation of

the error rate that was applied to the full year's sales.

25. Another unusually large transaction included in the review was found not to be in

error but was retained in the sample for purposes of calculating the error rate. This had the effect of

reducing the overall error rate for that year, to the Taxpayer's benefit.

26. The Department disallowed deductions for sales of certain items because the

Taxpayer did not have a non-taxable transaction certificate (NTTC) from the purchaser or because

the transactions did not constitute sales of tangible personal property for resale. For example,

deductions for sales of guest checks, garbage can liners, pan liners, and filter cones were deemed to

be improper because these items typically are used by the purchaser rather than being resold as part

of the product sold to the ultimate customer.

27. Following completion of the audit, the Department adjusted the error rates downward

based on additional information provided by the Taxpayer which showed that it in fact had an NTTC

covering the sale or that certain transactions initially deemed to be in error were in fact legitimate

deductions.

28. The Taxpayer conceded that it was not entitled to deductions for sales of such items

as guest checks and filter cones, but contends that some of the items disallowed are in fact resold by

its customers as part of the food products sold by those customers. For example, the Taxpayer

stated that garbage can liners are often used to package food for sale, and that pan liners may be used

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for such purposes as wrapping tamales.

29. Although the Taxpayer presented testimony that items such as garbage can liners,

pan liners and trays can be and often are used to package food for resale, it did not show that the

items were so used by the purchasers in the disallowed transactions.

30. Discussions between the Taxpayer and its customers regarding the use of items

purchased from the Taxpayer and whether such items are deductible from gross receipts take place

between the customers and the Taxpayer's salespeople. The Taxpayer has a staff of approximately

four salespeople at any given time.

31. The Taxpayer does not train its salespeople regarding the proper use of non-taxable

transaction certificates. Before making a sale, the salespeople check to see whether the customer

has an NTTC on file with the Taxpayer. However, they are not trained to inquire as to whether

specific items purchased fall within the deduction authorized by the NTTC.

32. The Taxpayer did not maintain records, in the form of notations on the NTTCs or

otherwise, on how buyers intended to use items now claimed to be deductible from gross receipts.

33. If a customer purchased both deductible and non-deductible items, the Taxpayer's

practice was not to charge tax on the latter, out of concern that it would lose the sale to a competitor

if it did so.

DISCUSSION

The Taxpayer challenges the assessment on two grounds: first, that the sample used by the

Department's auditors to compute the assessment was invalid, and second, that some of the

deductions disallowed in specific transactions included in the sample should have been allowed.
Validity of the sample used to determine the error rate and calculate the assessment

The Department's audit of the Taxpayer covered a period of three years and four months.

Because of the large number of transactions that took place during that period,1 the Department's

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In a typical business day, the Taxpayer makes approximately 100 sales. On an annual basis,

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auditors selected a sample for review rather than performing a detailed audit of all transactions. The

deductions claimed for the reviewed transactions were determined to be either proper or improper.

An error rate was computed on the basis of these findings. The error rate calculated for each year

was then applied to the full year to determine the amount of tax underpaid by the Taxpayer.

The Taxpayer does not argue with use of a sample rather than a detailed audit of all

transactions during the audit period. However, the Taxpayer challenges the sample used by the

Department on the grounds that it is not statistically valid. The Taxpayer argues that the

Department cannot use the results of such a sample to extrapolate to a full year's receipts.

The Taxpayer has cited no authority that requires the Department to use a "statistically valid"

sample for the purpose of calculating and assessing underpaid taxes. The issue is not whether the

sample used was statistically valid, but whether it was representative of the universe being sampled,

so that its results could be extrapolated to the universe as a whole. The Taxpayer has not shown that

the sample was unrepresentative or that its use resulted in an incorrect assessment.

The fact that another method might have been used does not render the Department's method

invalid. The issue is not whether there is a different, or even better, method, but whether the

Department's assessment is incorrect. By law, that assessment is presumed to be correct and the

taxpayer has the burden of showing that it is otherwise. §7-1-17(C) NMSA 1978; TRD Regulation

TA 17:4.

The Taxpayer here chose to ignore both the presumption of correctness and its burden to

overcome that presumption. McClintock Paper was given repeated opportunities to present

evidence to show that the Department's assessment was incorrect. In response to the Taxpayer's

contentions that the sample was inadequate, the Department offered to perform a second audit based

on a different sample, and to consider the results of any self-audit performed by the Taxpayer. The

Taxpayer rejected the offer of a second audit and declined to perform its own audit. While a

this is some 25,000 transactions.

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re-audit by the Department might have suffered from the same alleged deficiencies that the Taxpayer

objected to in the initial review, any self-audit by the Taxpayer could have been structured to

eliminate those objections. The Taxpayer refused to perform such an audit because it believed that

the Department, not the Taxpayer, should do the work. This misconstrues the applicable law. It is

the Taxpayer, not the Department, that is charged by law with showing the inaccuracy of the

assessment.

Even at the hearing, the Taxpayer made no real attempt to show the incorrectness of the

assessment. It repeatedly argued that the sample was not statistically valid, but offered no authority

or evidence to show that it provided an inadequate basis for the assessment. General allegations of

lack of statistical validity are insufficient to sustain the burden of proving the assessment to be

incorrect.

In performing its audit, the Department selected a sample that it believed would be

representative of the Taxpayer's business. It selected two working days in each month reviewed,

precisely because they were considered to be like any other working day in the Taxpayer's business.

The Taxpayer did not argue that these days were in any way unrepresentative of its business

operations. The Department reviewed the first ten invoices each day on which no tax was charged;

the Taxpayer conceded that its transactions did not vary according to the time of day, so that the first

ten in any day were presumably representative of the full day's business. The Taxpayer made no

showing that any of the transactions included in the sample was unusual or should have been

excluded from the sample.

The issue is not whether a different sample might have been used, but whether the sample

used by the Department was unrepresentative of the Taxpayer's business, so that the results generated

from that sample were inadequate to support the assessment. While the Taxpayer has asserted that

the sample was inappropriate, it has not shown the sample to be unrepresentative or otherwise

demonstrated that the audit results were inaccurate.

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Specific transactions

Within the sample reviewed in the Department's audit, certain transactions were found to be

in error on the basis that either the Taxpayer had no NTTC to support the claimed deduction, or the

product sold did not qualify for the deduction because it was not an item sold for resale by the

purchaser. The items included in the latter category included guest checks, pan liners, garbage can

liner bags, filter cones, trays and towels. The Taxpayer does not challenge the findings based on

lack of an NTTC, but it contends that some of the disallowances in the second category were

improper.2

The Gross Receipts and Compensating Tax Act provides that receipts from selling tangible

personal property are deductible from gross receipts if the purchaser resells the property either by

itself or in combination with other tangible personal property. §7-9-47 NMSA 1978.

Nonreturnable containers which are used to package property and which become part of the product

are considered property sold for resale, and receipts from sales of such items are deductible for gross

receipts tax purposes. TRD Regulation GR 47:2(A). A separate regulation specifically pertaining

to restaurants reiterates that materials used by restaurants and food sellers to package or wrap food

for sale are deductible sales within this statutory section. Regulation GR 47:24. That regulation

also enumerates certain items that are not considered items sold for resale, because they are not

resold by the buyer. That list includes, inter alia, garbage can liners and paper towels. Id.

The Taxpayer argued that some of the disputed items, including can liners, pan liners, and

trays, can be and are used by its customers to package foods for resale, and thus qualify for the

deduction provided by §7-9-47, notwithstanding their enumeration as non-deductible items in

Regulation GR 47:24. The Taxpayer is correct that receipts from sales of these items are deductible

if they are in fact resold by the purchaser, even if such use is not the one for which the item may have

2
As the Taxpayer's protest letter acknowledges, the majority of the assessment resulted from
lack of NTTCs, with a much smaller portion resulting from "wrong category" classifications.

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been designed and despite their specification in the regulation as non-deductible. However, the

burden was on the Taxpayer to show that the items were in fact resold by the purchaser. This was

not done here.

A contention that items such as trays and garbage can liners may be and often are used to

package food for sale is not tantamount to a showing that the specific purchases on which the

Taxpayer did not pay gross receipts tax were so used. The Taxpayer presented no testimony of

specific uses of the items by specific purchasers involved in the disallowed transactions, to show that

the errors found in the Department's audit had not occurred.3 The Taxpayer acknowledged that it

had no records showing how the items were to be used by the buyers. It acknowledged further that

it did not train its salespeople to ascertain the uses of various items purchased by a buyer who had

presented an NTTC, to ensure that all items purchased came within the terms of the NTTC. It

admitted that, where a buyer purchased both deductible and non-deductible items, it would not

charge tax even on the clearly non-deductible items, for fear of antagonizing the buyer and losing the

sale.

No testimony, either oral or in the form of affidavits, was presented from any of the

Taxpayer's salespeople, who participated directly in the sales and who might have had greater direct

knowledge of the uses to which the items purchased were put. Moreover, the Taxpayer did not

supplement the knowledge of its own staff by calling any of its customers as witnesses to testify to

their use of the items purchased from McClintock Paper, or by presenting affidavits from them to

that effect.
3
The Department made a number of adjustments to the original audit findings before the
assessment was issued. Compare Ex. 3, an earlier work paper of disallowed deductions, with Ex. H
and p. C3.4 of Ex. 2, listing the errors on which the assessment was ultimately based. Certain
transactions involving sales of pan liners and can liner bags, originally disallowed as products not
subject to the deduction, were subsequently allowed by the Department, presumably because the
Taxpayer presented evidence that the items were used by those purchasers to package items and
were resold by the purchasers.

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A taxpayer who accepts an NTTC continues to be responsible for ensuring that goods sold

under the certificate are properly deductible within the certificate's terms. Regulation GR 43:9.

The Taxpayer here was responsible for confirming that the items on which tax was not charged, by

virtue of the NTTC submitted by the purchaser, were in fact deductible under the certificate. Where

items are of a type that is normally subject to tax, such as garbage can liners that would ordinarily be

used for a non-deductible purpose, the Taxpayer was obligated to determine that the buyer intended

to use them for a deductible purpose. This the Taxpayer did not do.

Penalties and interest

Interest and penalties were imposed by the Department on the amount assessed against the

Taxpayer for unpaid tax. Penalties may be imposed where failure to pay the tax results from

negligence or disregard of rules and regulations. §7-1-69(A) NMSA 1978. The Taxpayer did not

raise a specific objection to the penalty imposed by the Department. In any event, the evidence

established that the Taxpayer acted negligently within the meaning of this section, by failing to

ascertain whether items sold under the protection of an NTTC were in fact items sold for resale by

the purchaser. In addition, the Taxpayer acted with disregard for applicable rules and regulations, as

it admitted when it acknowledged that it would not charge the tax to a buyer purchasing both taxable

and non-taxable items. Penalties were thus properly added to the amount of the assessment.

Section 7-1-67 NMSA 1978 provides that interest "shall be" paid on tax deficiencies, at the

rate of fifteen percent per year. Pursuant to well settled rules of statutory construction, the word

"shall" is mandatory rather than discretionary, unless a contrary legislative intent is clearly

demonstrated. State v. Lujan, 90 N.M. 103, 560 P.2d 167 (1977). Section 7-1-67 requires that

interest be imposed on the amount of any unpaid taxes. No exceptions to this rule are provided for.

Thus, interest on the amount of the tax deficiency was properly included in the assessment.

CONCLUSIONS OF LAW

1. By its representative's letter of November 3, 1995, the Taxpayer filed a timely protest

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of Assessment No. 1972612. Jurisdiction thus lies over the parties and the subject matter of this

protest.

2. The Taxpayer improperly deducted certain receipts from gross receipts and failed to

pay applicable gross receipts tax thereon, and the Department's assessment for such unpaid tax (as

adjusted pursuant to agreement reached with the Taxpayer in the course of the hearing proceedings)

is proper.

3. The Taxpayer failed to establish that the assessment was incorrect.

4. Because the Taxpayer did not pay the taxes owed at the time they were due, interest

was properly imposed on the deficiency at the statutory rate.

5. The Taxpayer's failure to pay the taxes was due to negligence and/or disregard of

applicable rules and regulations, and penalties were properly imposed on the unpaid amounts.

For the foregoing reasons, the Taxpayer's protest IS HEREBY DENIED.

DONE this 16th day of December, 1996.

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