The city is seeking more than $500,000 from the developers of The Oread hotel after a city-ordered audit found the development group filed incorrect sales tax returns in order to receive sales tax rebates from the city and the county.

The improper reimbursements, which were paid from January 2010 through May 2015, total $429,594.74. The city is charging developers $63,320.11 in interest, as well as the cost of the audit, which is estimated at slightly more than $27,000. The total bill is almost $520,000.

City officials sent a letter to the developers Wednesday demanding repayment by Dec. 31.

The findings of the development group’s actions — some of which are thought by the auditing firm to violate Kansas law — have been forwarded to the Kansas Department of Revenue.

“This is certainly a situation that was not contemplated by the city, that something like this would be occurring,” Interim City Manager Diane Stoddard said. “In this particular case, we worked hard to get to the bottom of what was occurring, and, in the end, we want what is fair to the city.”

Stoddard said she spoke Wednesday morning with Thomas Fritzel, a Lawrence businessman who leads the development group behind The Oread.

“He indicated to me that he wanted to resolve the matter,” she said.

Fritzel did not answer a phone call Wednesday evening seeking comment for this story.

Findings

The final report from the audit, which was conducted by Wichita-based Allen, Gibbs & Houlik, focused on Oread Wholesale L.C., a business owned by Fritzel, who also is a leader of the group that developed The Oread hotel.

As previously reported, Oread Wholesale is registered with the Kansas Secretary of State’s office as having an office at The Oread, 1200 Oread Ave.

Businesses located at 1200 Oread Ave. are part of a special taxing district approved by city commissioners in 2008. That special taxing district allows the hotel’s development group to receive a rebate on a large percentage of all local sales taxes collected at 1200 Oread Ave. In addition, the property is part of a transportation development district that allows businesses at 1200 Oread to charge an extra 1 percent sales tax.

That audit alleges Oread Wholesale would buy items — everything from construction materials to supplies for The Oread hotel — from vendors without paying a sales tax. Oread Wholesale then would “sell” those items to other companies in which Fritzel has an ownership interest. The sales would be recorded as occurring at 1200 Oread Ave., which means the sales taxes paid by Fritzel’s companies would largely be rebated back to the Fritzel-led development group.

The audit alleges Oread Wholesale wasn’t actually selling any goods or services to the companies, but rather was just being reimbursed by the Fritzel-led firms. The auditors contend Oread Wholesale should have paid sales tax on the items when they were first purchased, and that sales tax would not be subject to be rebated back to the hotel development group.

The special taxing district has generated more than $3 million in sales and property tax reimbursements from the city since its creation.

Stoddard said that when the redevelopment agreement went before the Lawrence City Commission in 2008, it was not known that a wholesale company would be located there.

A reporter went to The Oread in November to find Oread Wholesale’s registered office but could not locate one.

In addition to questions about whether Oread Wholesale was truly engaged in retail sales, auditors discovered most of Oread Wholesale’s transactions — 69 percent — were made outside of the special taxing district. The city gave reimbursements to The Oread based off of “materially inaccurate” sales tax returns filed by Oread Wholesale, the report states.

As an example, auditors found that materials purchased by Oread Wholesale for the construction of the Varsity House apartment project were delivered to Varsity House at 1043 Indiana St. According to city maps of the special taxing district, Varsity House falls outside its boundaries. But Oread Wholesale maintained Varsity House was inside the district.

The report goes on to say the circumstances surrounding Oread Wholesale “strongly suggest” developers created and used the business only to improperly increase the amount of sales tax reimbursements to The Oread.

Fritzel told auditors the wholesale business was used to purchase property in bulk — and without sales tax — and then sell it to The Oread, Eldridge Hotel and Varsity House, all of which Fritzel partially owns.

Each month, Oread Inn and DFC Company of Lawrence L.C. — the name of the group that owns Varsity House — reimbursed Oread Wholesale for the materials they purchased. Oread Wholesale would charge Kansas sales tax to those reimbursements. Then, The Oread would include that sales tax in its request for city reimbursements.

“There doesn’t appear to be any other reason to have the entities work in the way they were working, other than to have the effect of increasing sales within the district,” Stoddard said.

Further, auditors said in their report that they thought Oread Wholesale violated Kansas law by improperly using a Kansas Resale Exemption Certificate for all of its purchases.

Auditors wrote that the transactions between Oread Wholesale, The Oread hotel and DFC do not count as “retail sales” under the Kansas Retailers’ Sales Tax Act because there was no exchange of property. Oread Wholesale should have been paying taxes on all of its purchases, the audit reads.

Process

The city worked to engage an auditing firm after the Journal-World inquired about Oread Wholesale — based on an anonymous tip — in February.

An “Understanding of Engagement” with Allen, Gibbs & Houlik was signed in May. A copy of that document was obtained by the Journal-World through an open-records request in November.

Stoddard said the arrangement with the auditing firm did not go before the City Commission at the time because “we did not know the extent of the issues.”

City Attorney Toni Wheeler said another reason the arrangement was not made public was because it’s a “legal dispute” and the city did not want to “forecast what our legal theories might be.”

A statement sent Wednesday from the city said it has been “as transparent as possible at appropriate points in the process of review.”

Auditors first met with Fritzel on June 16. For the next five months, Oread Wholesale “resisted the city’s efforts” to review the business’ books and records, the report states. It wanted the auditing firm to “substantially” modify its standard confidential disclosure agreement.

Prior to the audit, the city had not been receiving the business’ sales tax returns “in a timely manner,” Stoddard said.

Oread Wholesale told the city it had destroyed all of its books and records prior to January 2012. Its practice was to do so because of a Kansas Department of Revenue policy that requires businesses to retain only three years’ worth of records.

It was found that Oread Wholesale also filed forms with the state to amend some of its sales tax returns after the city contacted the business about the audit, the report states. The changes reduced net sales within the special tax district by nearly 62 percent.

Before they had access to Oread Wholesale’s books, auditors used numbers from 2015 to estimate The Oread hotel had received $470,003.20 in improper reimbursements. Auditors sent to Oread Wholesale a letter demanding repayment of that amount on Nov. 13.

Ten days later, Oread Wholesale provided auditors with two boxes containing copies of documents the business used to prepare its monthly sales tax returns. The documents, dated January 2012 through June 2015, were used to determine that Oread Wholesale was overpaid a total of $429,594.74.

Future dealings

Commissioners have been planning to discuss early next year possible changes to the city’s economic development incentives policies. Mayor Mike Amyx said Wednesday that transparency requirements for businesses receiving public incentives would be part of those talks.

The city does not currently have access to all of the invoices for sales within special taxing districts, Stoddard said.

She noted the city would consider strengthening agreements such as the one it has with The Oread to improve access to records for the purpose of auditing.

“We certainly want to learn everything we can with this kind of situation and do what we can moving forward to make sure it doesn’t happen,” Stoddard said.

Because of the findings of The Oread audit, the city has been looking into Lawrence’s other special taxing districts. So far, Stoddard said, no issues have been found.

According to the city’s 2014 report on economic development support and compliance, there are two other transportation development districts: The Free State (Bauer Farm) district and the Ninth and New Hampshire district.

There also are two other tax increment financing districts: the Downtown 2000 district and the Ninth and New Hampshire district.

“We haven’t at this point noted any abnormalities,” Stoddard said.

When asked whether the special tax district at The Oread would remain intact, she said the city is “looking at all of our options.”

“Our first interest is to get a response to the demand letter we have sent,” she said.

When asked about the city’s future dealings with the development group, Amyx said the audit’s findings “would be a factor.” Stoddard said the findings would have to be weighed by the City Commission.

“Anyone we enter into agreements with, yeah, there’s trust, as there is in any business relationship,” Amyx said. “You rely on partnership.”