Sales tax audits in the restaurant industry are inevitable, especially with states like California needing money due to the economic downturn. The problem is not the audit, but the typical results – a large assessment of tax, penalties, and interest.

Audits typically encompass a four-year period and the list of documents that will be requested by the auditor is extensive. The auditor will ask to set up an initial meeting with the owner and/or the owner’s representative (CPA, etc.) at the place of business. During that meeting, the auditor will ask a comprehensive list of questions to develop an understanding of the business AND the possible areas of exposure for the business owner. The auditor will also ask the taxpayer to fill out a “bar fact sheet” with them at that time. Both are extremely important to give thought to and answer correctly. 90% of all assessments from audits can be minimized or reduced to zero with the proper understanding of what the auditor is after and a plan to refute the auditor’s claims. If the “bar fact sheet” is filled out incorrectly and the assessment issued, it can be difficult (but not impossible), to change the results.

The State Board of Equalization (BOE) audits by reviewing Cost of Sales purchase invoices. They utilize the purchases to understand what the sales should have been by using what’s called the “mark up” method. This process compares purchases of products and compares it to the selling prices listed on the menu – the result are percentages (%’s) they apply to actual purchases to derive sales numbers. More often than not the resulting sales numbers are significantly different than sales reported.

In addition to underreporting of sales, the BOE will look at other issues that many taxpayers report incorrectly, including automatic gratuities, self-consumed / use tax, comps, catering, delivery, etc.

One very important by-product of an assessment of sales tax for “underreporting of sales” is that the states share information with the IRS. The IRS is very interested to know if a taxpayer is not reporting all their sales. If you think the sales tax assessment from California is significant, wait until you get an income tax bill from the IRS, which was all derived from the BOE audit!

Keep in mind it does not matter that you are reporting ALL of your sales and dealing with other issues mentioned above properly – the BOE’s process is flawed and initial results more often than not are incorrect… but at the end of the day, it is the taxpayer’s responsibility to disprove the assessment.

The bottom line does not take the BOE lightly as they can be the most difficult government agency to deal with simply due to their methodology. If you do not understand all the issues – get help from a professional who knows the industry and how the BOE audit process works.

Author: Ann M. Santia, Senior Accountant