Historically, those restaurants that have excellent internal controls, manage the restaurant accordingly and are not afraid to report all their income are often the most successful restaurants. Well, it also helps to have good food (and wine :)). If you do this correctly, you will have nothing to fear even when the IRS comes knocking on your door.
So how does this audit thing work? What exactly should I be doing as an owner to make sure that my restaurant is successful?
The way this usually starts is with a letter from the IRS. You roll your eyes and open the envelope and sure enough, you’ve been selected for an audit. First off, don’t freak out, you actually should feel proud that they selected you. Again, if you’ve done nothing wrong, you have nothing to fear. This is a chance for you to impress them. I actually told my clients that this is an opportunity to WOW the IRS with the way business is suppose to operate.
You must understand, they don’t send out some kid that just graduated from college. The auditor is trained in the restaurant industry via the Market Segment Program. So this guy is going to know his stuff. There is a series of steps in the audit and it will take a couple of months to complete. The onsite part is really only a day or two and the rest is done back at his office. You must also understand that more than likely he is auditing several restaurants at the same time. So it isn’t like he spends two months just on you. It is more like one week of work on your restaurant over several months.
The following is short list of the respective steps:
- An initial interview to establish a basis for the audit
- Documentation and confirmations are exchanged
- If applicable, the IRS conducts alternative testing methods including the ingredient markup computation, laboratory testing and refreshment analysis
- Opportunity to respond to discrepancies
The following sections describe each of the above steps and identify some tools or processes you should have in your business to comply with best practices.
Initial Interview – The Setup
The goal of the IRS agent is to determine if you are under reporting your income. In the cash intensive restaurant industry there is a lot of opportunity for skimming. A secondary issue relates to improper reporting of tip income. As an owner of a restaurant, you should file your annual Form 8027 and have available your monthly Form 4070A which is a schedule in Publication 531.
To establish a baseline and gain an understanding of your business, the agent conducts an initial interview with you and your management team. His goal, catch you in a lie. Again, if you have done nothing wrong and run a good business, you don’t have to worry about this at all. Some of the questions he’ll ask include:
- Provide a list of suppliers and vendors.
- How did you get started in the pizza business?
- How did you capitalize the restaurant?
- Do you have relatives working in the restaurant?
- Do you have a separate bank account for the business and for your personal expenses?
- How many days a week are you open and what are your hours?
- Ratio of sit down customers to take outs?
- What is the volume of pizza sales?
- Ratio of the varieties of pizza based on the menu?
- Is soda sold via fountain or via containers (bottles or cans)?
- The auditor will dig into the menu and ask detail questions related to each item such as ingredients, the number of dough balls made each day, where are the respective ingredients purchased and where does the shop buy its pizza boxes?
Again, the goal is to establish facts in order to catch the owner in a lie. If the auditor can prove that the owner has misled him, the auditor is allowed to use Alternative Testing Methods which are generally unbeneficial to the restaurant. Allow me to illustrate how the auditor catches the owner in a lie:
Notice in the questionnaire portion he asked the name of the supplier of the pizza boxes? Also, he asked the ratio of dining in and take outs. Once he has confirmed the pizza box count for an entire year, he can then use the take out ratio to determine the range associated with overall sales of take outs. With this volume, he then can calculate the dining in volume of sales. Add the two together and he has idea of the total sales. Of course there is some adjustment for the doggie bag concept but you get the idea.
The auditor’s next step is to get all the detail paperwork from your bookkeeper and/or accountant and begin the process of confirming purchases from the respective suppliers. He does this by sending a supplier feedback form to the respective supplier. An example would be a request made to your meat supplier. He’ll want to know the volume of pepperoni purchased in the respective tax year. Along with other confirmed amounts, he’ll compare this to your purchase receipts to determine any errors. So as an example, if your receipts indicate that you purchased 1,700 pounds of pepperoni in the tax year in question and the supplier identifies 1,720 then the auditor will be comfortable with your value.
He’ll confirm several different ingredients and if there is agreement between what the suppliers state and your records, he’ll have no other option than to believe your expense calculation. Other forms of confirmations include talking with your bread vendor and identifying the number of rolls you purchase for your grinders. For those readers in the south or western part of our nation, ‘Grinder’ is a term used in the northeast and refers to a submarine sandwich or hoagie.
In his initial interview with you, one of questions will be how many grinder rolls to you discard daily due to damage, staleness etc. Often, many pizza restaurant owners tell the IRS agent that they return the unused portion back to the bread vendor. One of the questions to the bread vendor is: How many rolls are returned? In the bread industry, the usual arrangement between the bread supplier and the restaurant is a discounted price for the roll contingent on no returns. Notice how the IRS agent is trying to catch the owner in a lie?
Mostly the auditor is trying to determine the true volume of food purchased including alcoholic beverages, sodas, and other refreshments. Using this volume of food and beverages, he can then determine the general range of sales. If your reported income falls within this range, the audit is pretty much done.
There will be other forms of confirmations including reviewing the lease agreement, discussions with your landlord and even a contact communication with the gaming machine vendor. The whole goal is to gain an understanding of the volume of customers and the food consumed as a measurement against the volume of sales.
If the agent feels management has misled him or outright lied to him he is entitled to use alternative methods to determine the volume of sales.
Alternative Testing Methods
In a pizza restaurant court case, Maltese v. Commissioner, T.C. Memo. 1988 – 322, the tax court held that because the taxpayer failed to keep adequate records and paid for purchases using cash, alternative methods of determining income were acceptable. This means that if you demonstrate poor management in operating your pizza restaurant it is OK for the IRS to determine your income using methods that to me are just shy of guessing. These methods include the ingredient markup computation, laboratory testing and beverage computation. The following sections describe each and the fallacy of the respective method:
Ingredient Markup Computation
Once the auditor has established the ingredients to your recipe, he can then use the actual confirmed purchases as provided by suppliers to calculate the number of pizzas you serve in any given period. The most common ingredient is flour. Remember, the auditor has knowledge of the amount of flour to make a single pizza. Based on this information, it is a simple mathematical reconstruction to determine the total number of pizzas made in a period of time. With this information, based on the sales price per pizza, pizza sales volume can be calculated.
One of the primary issues related to this computation lies in the beginning and ending inventory balances related to the flour in the pantry for the restaurant. Another factor not considered exists with the waste issue per pizza and any damaged flour, e.g. bags that are broken or that have been discarded due to unsanitary conditions.
To augment the flour formula, the agent will actually purchase a pizza from your restaurant and send it to a laboratory for analysis. The laboratory weighs the respective ingredients and based on the results, the agent can simply backwards engineer the number of pizzas made to determine the total pizza sales. This process is done with grinders and other meals to finally determine the total sales of the restaurant.
The best example is for the agent to purchase several pepperoni pizzas and the laboratory will weigh the pepperoni and determine the average pepperoni weight per pizza. Then using the engineered formula of weight loss due to cooking, the laboratory can then determine the precooked weight per pizza for the pepperoni. Using the confirmed purchases of pepperoni from suppliers, the auditor can then determine the total number of pepperoni pizzas sold in a given time period. There is a national standard that indicates that in certain regions, pepperoni pizzas are an estimated percentage of the total pizzas sold in any establishment. Using simple volume times sales price from the menu and you get total sales.
The biggest flaw with this testing method relates to the statistical deviation of only testing limited data points over a large pool of data. This means the flaw with this is that the agent is testing one or two pizzas and extrapolating this information over several thousand for an entire year. In testing analysis this is referred to as a high risk of sampling error. In addition, spoilage is often not considered in the final formula. When the formula is based on cheese, many pizza eaters will request and often purchase double cheese. This greatly affects the outcome.
Like most men, I love a beer with my pizza, actually a couple of beers with my pizza. If my wife were not around, I would probably drink too many beers. My wife and I will drink a pitcher of beer with our pizza meal. I am willing to bet that this is normal across the United States. Statistically, there is data indicating the normal beer consumption per pizza consumed. Using this information, the agent only needs to know how much beer you buy in a given period of time. As with the ingredient markup computation, he simply backwards calculates the number of pizzas sold and then multiplies this by the sales price and you get total pizza sales for the period of time.
The fallacy of this is based on the particular style of restaurant you have. If you are a more family friendly environment catering to young families with young children, odds are that soda sales are more common than beer sales. If your restaurant is a boutique style with customized pizza selections, chances are you offer spirits and wines with the meal. This thins out the beer consumption and therefore the formula is not applicable.
Some other tools the agent will use include:
- Counting the number of tickets the servers turn in for a particular shift and matching this against the total sales journal for that same shift
- Comparison of cash, checks, debit card and credit card payments by customers and comparison to industry and geographical statistics
- Review the cash payments ledger to the respective vendors, is there a clear separation of sales deposits and the cash used to pay vendors; is there a petty cash journal/ledger
- Communication with former employees and current employees
- Eating at the restaurant prior to the initial interview
So it is important to use some common sense if the auditor resorts to using alternative methods to determine the total sales volume. A good CPA can easily identify the fallacies of each method. But really the best way to eliminate the use of alternative methods is to have a well managed restaurant. Use internal controls over receipts and make daily deposits that correlate with the sales recorded. Use modern restaurant software to properly account for sales. Instruct staff to follow procedures to the ‘T’. Use modern technology and restaurant profit and loss statements to properly establish trend lines and ratios.
WOW the agent and you’ll get a clean bill of health in the results.
Notices and Results
The biggest problem with the IRS is that they think every taxpayer cheats. So they will do whatever they can to find something on you. You have to make this so clean that the agent’s supervisor will dictate termination of the audit so the agent can move onto obvious tax cheats.
This information is conveyed via results and notices from the IRS. Most auditors will have a sit down with you afterwards and explain the results. If you complied with the law and ran a good establishment, there will not be an issue. But, if there are issues, you’ll get several notices.
Typically the IRS will give you an opportunity to refute any negative results and explain the discrepancies. If no agreement is reached, the IRS notifies you of the tax discrepancy and for you, the next step is via the judicial process. The difficult part of the judicial process is that you have to pay the tax, penalties and interest first before you can go to court. Often just the initial costs for a legal battle will well exceed the total tax obligation. In general, if it is less than $10,000, pay the bill and move on with life.
Some final advice, it is by far cheaper and superior to run a by the book restaurant than to try and cheat the IRS. I often shake my head when a client describes their techniques because I point out the real positives of having a well managed restaurant. Typically the taxpayer pays no more than 30% as taxes on net incomes. So even if you were to take a net $100 per day, which I find difficult to fathom in a small business restaurant, you are talking about $36,000 per year. The combined tax on this is around $12,000.
You are willing to risk your business and your family’s livelihood over $1,000 per month? Better yet, if your business is performing this well, you should entertain expanding the business to more locations. The banks will love to loan you money with that kind of performance. Think bigger and better instead of trying to cheat your way to avoiding taxes. Seriously, figuring out how much a restaurant makes in revenue isn’t rocket science. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you.