Navigating Tax Audits for Restaurants: Key Areas and Compliance Tips

An audit by the Internal Revenue Service (IRS) or state and local governments can be a source of anxiety and financial strain, especially if non-compliance is found. Restaurants, with their numerous tax obligations and regulations, must be vigilant to ensure compliance. This article outlines key areas of interest for tax agencies during audits and provides tips to help restaurant owners maintain compliance.

Financial & Tax Considerations –

  • Sales and Use Tax Compliance: Restaurants must navigate various state and local sales tax obligations, ensuring correct tax charges and remittances. Purchases from out-of-state vendors might still incur use tax liabilities in the restaurant’s home state. Regularly reviewing sales items for correct tax application and assessing use taxes on out-of-state purchases can help maintain compliance.
  • Depreciation and Capitalization: The IRS examines depreciation schedules and capitalization policies to ensure proper classification and application of tax rules. States, having decoupled from federal accelerated depreciation methods, also scrutinize these areas. Implementing a capitalization policy and regularly reviewing the general ledger helps ensure correct categorization and compliance, avoiding costly amendments and penalties.
  • Franchise Fees and Royalties: For franchised restaurants, the IRS reviews the deductibility and timing of franchise fees and royalties, ensuring compliance with tax regulations. Accurate allocation and reporting of these expenses are essential to avoid issues.
  • Cash Transactions: Restaurants, being cash-intensive businesses, are closely monitored by the IRS for potential underreporting of income. Auditors will scrutinize cash register tapes, sales receipts, and bank deposits to confirm all income is accurately reported. Owners should conduct daily reconciliations and implement robust cash management controls to ensure accuracy and minimize the risk of financial loss.
  • Sponsorships and Charitable Donations: When sponsoring events or making charitable donations, the IRS assesses whether these expenses qualify as deductible business expenses or charitable contributions, requiring proper documentation. Enhanced deductions for donating unsold food must be well-supported to withstand scrutiny.

Property Considerations –

  • Gift Card and Gift Certificate Sales: Income from gift card sales must be accurately recognized for tax purposes. Additionally, compliance with unclaimed property laws regarding unused gift cards is essential. Maintaining a tracking system for these financial instruments and understanding state-specific unclaimed property laws can prevent legal issues.
  • Inventory and Cost of Goods Sold (COGS): The IRS reviews how restaurants value and track inventory and calculate COGS. Regular inventory counts and accurate record-keeping are crucial, especially for deductions related to inventory losses from spoilage, theft, or damage. This ensures accurate tax reporting and supports positions taken on tax returns.

Employee Considerations –

  • Tip Reporting Requirements: Accurate reporting of employee tips is complex but vital. The IRS reviews compliance with tip reporting and withholding, including the proper filing of forms like Form 8027. Understanding tip allocation agreements and ensuring compliance with TRAC agreements, where applicable, helps avoid significant exposure to penalties.
  • Minimum Wage and Labor Laws: The IRS and states may coordinate with agencies like the Department of Labor to verify compliance with wage and labor laws. Non-compliance can result in severe penalties and damage to a restaurant’s reputation. Operators should fully understand and regularly review federal and state labor laws, considering periodic self-audits for added protection.
  • Employee Classification: Proper classification of workers as employees or independent contractors is crucial. Misclassification can lead to significant back taxes, penalties, and interest. The IRS and states examine the level of control a restaurant has over its workers in terms of training, direction, resources, and working hours. Significant control typically indicates employee status, necessitating proper payroll tax withholdings.

Operating a restaurant involves many challenges, including navigating tax obligations and potential audits. By understanding and complying with various tax laws and regulations, restaurant owners can avoid costly mistakes. Seeking outside assistance when needed can provide additional assurance of compliance and peace of mind.