Top Areas of Tax Exposure and Audit Risk for Restaurants

Whether it be an examination by the Internal Revenue Service (IRS) or a state or local government, an audit of your books and records can undoubtedly bring unwanted anxiety, be a drain on resources, and in some cases, prove costly if your entity is found to be non-compliant. Restaurants are subject to many types of taxes, laws, and regulations therefore, it is critical that owners fully understand them and remain in compliance. To help keep your restaurant entity from running afoul of the laws and understand the top areas that are ripe for a potential examination, our DHW Retail Team discusses the topics that have historically been areas of interest for the IRS and state and local tax agencies when auditing restaurants and offers the following tips on how to remain compliant.

Cash Transactions

Cash-intensive businesses like restaurants are a primary concern for the IRS as there is generally a higher risk of underreporting income. Agents will focus efforts on examining cash register tapes, sales receipts, and bank deposits to ensure that all income is properly reported and reconciled between each data source. To ensure your entity is compliant, owners should perform daily reconciliations and place strong controls around cash management to ensure accuracy and reduce the risk of loss.

Employee Classification

The classification of workers as employees or independent contractors is a critical area. Both the IRS and states may scrutinize whether restaurant workers have been correctly classified and whether payroll taxes, such as Social Security and Medicare, have been properly withheld and paid. To ensure proper classification, it's important that owners understand the degree of control they have over the worker in connection with training, direction, tools and resources, and hours worked. If the entity has significant control over these areas, it's most likely that the worker will be deemed an employee. Failure to properly classify workers can result in back taxes along with penalties and interest that could prove costly.

Sales and Use Tax Compliance

Depending on the jurisdiction, restaurants may be subject to state and local sales tax obligations. States will verify that the restaurant is charging sales tax on the correct items and that it has collected and remitted the appropriate amount of taxes. Restaurants will often purchase items from out-of-state vendors and not be charged sales tax. However, operators must understand that they could still be liable for state use taxes in their own state on these purchases. We typically see use tax issues occur when purchasing supplies and larger ticket items such as kitchen equipment and furniture. To remain compliant, restaurants should periodically spot-check the items they are selling with sales tax and review their fixed asset and supply invoices to evaluate whether they need to self-assess use taxes on any purchases from out-of-state vendors.

Depreciation and Capitalization

Restaurants often have significant investments in equipment, furniture, and building improvements. The IRS may review depreciation schedules and capitalization policies to ensure compliance with tax rules and that proper classification and depreciation methods have been applied, as well as whether any items have been prematurely expensed instead of capitalized and depreciated. Many states have decoupled from accelerated federal depreciation methods and they too, may place heavy scrutiny on depreciation adjustments, or the lack thereof on state income tax returns. While depreciation boils down to the mere timing of the deductions, the time value of money benefit could be negatively impacted, and if amended returns are required, the potential for added interest and penalties could prove costly. As such, it's important for operators to implement a capitalization policy and review the general ledger on a frequent basis throughout the year to ensure items are properly categorized as those that can be expensed as repairs or maintenance and those that should be capitalized and depreciated.

Compliance with Minimum Wage and Labor Laws

The IRS and states may coordinate with other agencies, such as the Department of Labor, to verify compliance with minimum wage laws, overtime pay, and other labor-related regulations. Non-compliance with these laws could result in costly tax consequences, penalties, and an overall negative reputation in the local job market, which is not something that any restaurant owner needs, given the recent challenges of finding workers in the job market. As such, operators should fully understand the federal and state laws and regulations around labor and consider implementing periodic self-audits as an added layer of protection.

Gift Card and Gift Certificate Sales

Restaurants often sell gift cards or gift certificates, and the IRS may examine whether the income from gift card sales is properly recognized for income tax purposes. The IRS could also coordinate with other federal agencies, such as the Federal Trade Commission, on issues related to their expiration or the ability to redeem. States will look at whether any unclaimed or unused gift cards are properly handled in compliance with unclaimed property laws as well. As such, operators should maintain a system to track these financial instruments and understand how their state's unclaimed property laws work.

Inventory and Cost of Goods Sold (COGS)

With the numerous types of inventory-related expenses, such as food and beverages, the IRS may review how the restaurant values and tracks its inventory, as well as the accuracy of COGS calculations. As such, operators should consider counting inventory on a regular basis to ensure accuracy. Also, if the restaurant experiences inventory losses due to spoilage, theft, or damage, the IRS may review how these losses are valued and deducted for tax purposes as well therefore, it's critical that operators keep accurate records to support their positions taken on the tax returns.

Sponsorships and Charitable Donations

If the restaurant sponsors events or makes charitable donations, the IRS may review the treatment of related expenses. They will assess whether the expenses qualify as deductible business expenses or charitable contributions and whether proper documentation is maintained. While donating unsold food can bring an enhanced charitable deduction for tax purposes, the IRS could scrutinize those calculations, and thus, operators should be prepared to support these deductions upon examination.

Franchise Fees and Royalties

If the restaurant operates as a franchise or pays franchise fees and royalties, the IRS may review the treatment and timing of deductibility of these expenses to ensure compliance with regulations governing franchise arrangements, proper allocation of expenses, and accurate reporting. The IRS will review the fees and associated costs with each arrangement to determine if they are permissible to be deducted currently, or if they should be amortized for tax purposes.

Compliance with Tip Reporting Requirements

This area is full of complexity and can be a large area of exposure if restaurants are not careful to report tips received by their employees accurately. The IRS may review the restaurant's compliance with tip reporting and withholding obligations, ensuring that the proper forms, such as Form 8027 (Employer's Annual Information Return of Tip Income and Allocated Tips), are filed. If a restaurant uses tip allocation agreements or tip pools, the IRS may scrutinize whether the allocation of tips among employees is done according to applicable rules and regulations. Certain restaurants participate in TRAC agreements with the IRS, which allow them to allocate tips among employees based on a formula. The IRS may review the restaurant's compliance with the terms of the TRAC agreement and the proper reporting of allocated tips. As such, it is critical that operators fully understand these laws, the reporting agreements they enter into, and how to remain compliant.

Summary

Nobody ever said the restaurant business would be easy, and the last thing an operator needs is to spend time facing challenges with taxes and enduring examinations by the IRS or a state agency. As such, it's critical that operators fully understand and comply with the various rules, regulations, and codes around taxes and seek outside assistance before making a potential mistake that could prove costly.

Tim Reynolds is a Tax Principal at DHW with over 25 years of experience in the accounting industry. His areas of expertise include various federal and state income, transactional, and excise taxes, as well as general accounting and financial statement preparation. Additionally, Tim serves as an operational consultant for the retail, restaurant, grocery and manufacturing industries. Tim can be reached via LinkedIn, email at tim@dhw.cpa or call 828.322.2070.