Deter Underreported Sales with Three Audit Rights

Renting to a tenant on a percentage rent basis can be rewarding if the tenant operates a profitable business—and accurately reports its gross sales. The higher the profit, the higher the amount you can collect from the tenant. But if the tenant underreports its sales, you'll get paid less than you are entitled to under the lease.

Limiting your tenant's right to audit your books and records is very important. But you should be equally concerned about strengthening your own audit rights so that you can thoroughly examine your percentage rent tenant's books and records—which will reveal whether the tenant is paying the correct amount of rent. Include the following three rights in your audit provisions to protect yourself from being deprived of percentage rent.

Right to Tenant Records

You won't be able to perform an audit in the first place if your tenant doesn't keep adequate books and records or throws them out after a short period of time.

“To do a comprehensive audit, you need access to all books and records that reflect the tenant's business revenue and sales-related expenses—not just its sales records,” says international financial management consultant Kenneth S. Lamy. “It's useless to have a right to look at books and records in an audit if you haven't required the tenant to create and hold on to those books and records,” Lamy points out.

Your lease's audit provisions, like our Model Lease Clauses: Spell Out Required Books and Records, should do the following:

List “complete and full” books and records tenant must keep. Be aware that “true and accurate books of account and records,” are not sufficient because the language doesn't say precisely which books or records the tenant must keep. Without a clear-cut list, a tenant could refuse to give you certain items—like cash register tapes—claiming that the lease doesn't require it to save them. Or a tenant may not even bother to prepare items that aren't listed in the lease. Instead, require the tenant to keep “complete and full” books and records.

You won't be able to accurately calculate the tenant's gross sales using incomplete information. So your list of required books and records should be as broad as possible. Records relating to “general business” activity should be included in the list. For example, the tenant should compile and keep financial journals, sales summary records of its cumulative monthly sales, and general ledgers that contain a running account of sales and expenses in a given month, says Lamy.

Include in the list items that would show information verifying the tenant's sales activities, such as: cash register tapes; a day-end summary from a cash register; prenumbered sales slips; detailed daily sales reports; and financial statements. (Cash register tapes are a good way to review every sale that took place in the tenant's store; prenumbered sales slips are a tool for checking their sequence to verify that all sales were included in the gross sales statement.)

Additionally, your tenant's bank statements, daily bank deposit records, and deposit slips should also be required records—they can help you determine if your tenant's total revenue is higher than the gross sales it's reporting.

Make sure you can check the tenant's purchases and pricing by listing invoices and receiving records (to see if the tenant is buying much more than it's selling) and pricing schedules in the audit provisions.

Check with an independent accountant about what documents they'll need to perform the audit. Accountants typically need tenants’ federal, state, and local income tax returns; state and local sales tax reports; settlement statements (showing any money received from a subtenant, concessionaire, or licensee); and documents and detailed records verifying exclusions or deductions.

Also, because you may need to audit the subtenant's, concessionaire's, or licensee's books and records, too, to verify all the sales made at the space, it's a good idea to require the tenant to ask any subtenant, concessionaire, or licensee in its space to prepare and save the same types of books and records it must keep [Clause I, par. a].

Require tenant to keep books and records for at least three years. The time period for how long the tenant should have to keep the books and records is negotiable, but three years is the industry standard, notes Lamy. Three years’ worth of books and records should provide enough material to perform cost-effective and complete audits, he explains. And you probably won't get any objection to that time period from your tenant, because it must keep many items for six years anyway to comply with IRS and state record-keeping requirements [Clause I, par. b].

Require tenant to keep books and records separate. The provisions should obligate the tenant to keep the listed books and records separate from its other business documents and in one location, which should help make an audit less time-consuming and more efficient. That way, you and your auditor won't have to travel all over to review scattered documents, Lamy points out [Clause I, par. b].

Be prepared to compromise with a tenant that negotiates to make its books and records available only at its accountant's office or at one regional office, if the tenant is a chain. “These are common compromises,” says Lamy.

Right to Audit Tenant Records

An audit of a percentage rent tenant can achieve only as much as the lease allows. So it's crucial for you to spell out all your rights and options in the audit process, stresses Lamy. Include these key protections in your lease to ensure a successful audit:

Look at tenant's books and records. Carve out the right in your audit provisions to look at the books and records you've required your tenant to keep [Clause II, par. a]. Otherwise, the tenant could try to withhold them from you, warns Lamy.

Audit tenant at any time. Ensure in the lease that you will have the right to audit the tenant whenever you wish. This gives you maximum flexibility to take the audit approach that works best for you, says Lamy [Clause II, par. a]. For example, some owners audit a random selection of their tenants each year. Other owners audit only those tenants they suspect are misreporting on gross sales statements. Still other owners combine the two approaches, performing random audits and checking on tenants they suspect are underreporting their sales.

Don't agree to give advance notice. Many leases require you to give the tenant notice of the audit—for example, you have to wait three days from the time you notify the tenant that it will be audited. This is a bad idea, emphasizes Lamy. Leave yourself the option to audit with no notice to your tenant by reserving in your lease provisions the right to perform a surprise audit immediately if you suspect a tenant may alter its books or “misplace” some records once it knows it's facing an audit.

Audit subtenants, licensees, and concessionaires. To verify that a tenant's gross sales statement is accurate, you should be able to check every sale your tenant makes in its space. That means getting the right to audit a tenant's subtenant, licensee, or concessionaire [Clause II, par. a]. Also make sure that you can hold the tenant responsible for any of its mistakes [Clause II, par. g]. You may need this clout to make the tenant take action against its subtenant, licensee, or concessionaire, which generally is responsible only to the tenant.

Look at books, records of other stores. The right to look at the books and records of the tenant's other stores will help you verify the gross sales of another store that has violated a radius restriction, Lamy points out [Clause II, par. b]. But be prepared for a tenant with a lot of negotiating power to refuse to let you look at the books and records of its other locations.

Make tenant responsible for reconstruction. You shouldn't be responsible for reconstructing your tenant's incomplete books and records if they are disorganized. Requiring your tenant to reconstruct incomplete books and records by going through sales slips and cash register tapes, among other items, at its own expense should deter it from keeping messy paperwork [Clause II, par. d(i)].

You can give the tenant further incentive to keep its files neat by giving yourself the right to charge it a fixed amount if it fails to reconstruct the incomplete books and records. The fixed amount should be paid as additional rent for the period in question, Lamy suggests. [Clause II, par. d(ii)].

The fixed amount charged for a failure to reconstruct records necessary for an audit generally ranges between 10 percent and 50 percent of the tenant's minimum rent for the period in question. But 25 percent to 30 percent is considered reasonable, says Lamy. For example: You're auditing the tenant's gross sales for calendar year 2009, for which period the tenant paid a total minimum rent of $50,000. You discover during your audit that certain bank deposit records and sales slips are missing. Because the lease allows you to charge the tenant 25 percent of minimum rent for incomplete records, the tenant must pay you additional rent of $12,500 ($50,000 x 25%).

Keep in mind, however, that if the tenant thinks that the fixed amount percentage is too high and doesn't reflect a realistic percentage rate, it might argue that the penalty is unenforceable. (Before setting a fixed amount, check with your attorney that the percentage rate is permissible in your state.)

Copy books and records. If your tenant contests the result of your audit later, copies of the books and records you've required the tenant to keep could be critical. That way, you'll have proof to support your conclusions [Clause II, par. c].

Right to Remedies

You can negotiate several remedies in your lease's audit provisions to protect yourself if you discover that your percentage rent tenant has underreported its gross sales—and, as a result, its percentage rent.

Audit cost. Require your tenant to pay for the full cost of the audit, as well as for the unpaid portion of its percentage rent [Clause II, par. e(i)]. The tenant will often refuse to pay the cost of the audit unless the error in gross sales exceeds a certain amount or percentage, so be prepared to be tough on that point during negotiations.

Interest. Require the tenant to pay interest on the unpaid percentage rent [Clause II, par. e(i)]. Having a lease that requires the tenant to make up only the underreported amount will deprive you of any interest or profit you could have earned on the percentage rent if it had been paid on time.

Try making the interest rate as high as is legally possible, which will give the tenant an incentive to give you correct information at the time of the original sales reporting. Lamy suggests starting your lease negotiations by proposing that the tenant pay 18 percent interest. In his experience, the tenant will accept paying interest, but will often insist on a lower rate, which you can negotiate as necessary. (Prior to negotiations, check the maximum interest rate allowed in your state; if it's lower, charge that maximum.)

Termination. Give yourself the right to terminate the lease if the tenant's error turns out to be substantial. Often, a large error probably isn't just a result of carelessness or a bookkeeping mistake. It's probable that the tenant intentionally underreported its sales. A termination option should allow you to end the lease with the tenant, whom you'll want the right to remove from its space, if the gross sales shown in the audit exceeds the amount the tenant reported by more than 3 percent [Clause II, par. e(ii)]. Be prepared to deal with your tenant's attempt to increase the percentage—for example, to 4 percent or 5 percent.

Overreported sales charge. While a tenant that has overreported its sales hasn't deprived you of any interest or profit you could have earned on percentage rent, you still have to pay for the cost of the audit. Specify in your lease that if your tenant has overreported, you'll give it a credit toward its future rent for the overpaid amount—after deducting the cost of the audit from the tenant's credit [Clause II, par. f]. If the tenant balks at paying for the audit, explain that it would not only have lost the overpayment, but also possibly repeated the error in future years if you hadn't performed the audit.

Insider Source

Kenneth S. Lamy: President, The Lamy Group, Ltd., 1303 W. Causeway Approach, Mandeville, LA 70471; (800) 999-5269; www.thelamygroup.com.