Prior to the COVID-19 pandemic, state revenue agencies, like the California Department of Tax and Fee Administration (CDTFA), have been trying to focus their sales tax audits on more industries they think are likely to have higher sales tax liabilities, thus bringing in the greatest revenue with the fewest resources possible. that likely have more sales tax, using as few resources as possible. Fitting the bill, CDTFA has drastically increased audits of restaurants, bars, gas stations/convenience stores, and auto dealers. All those industries are notorious for significant underreporting of California sales tax. And due to third-party reporting, they are relatively easy and efficient to audit. This article discusses the rules relating to the restaurant industry audits, as well as common sales tax audit tactics used by the CDTFA and some solutions you definitely want to know about if you are in the restaurant industry in California.
California Sales Tax Basics for Restaurateurs
Generally, the sale of tangible personal property is subject to sales tax, unless there is a specific exemption that removes it from California taxation. Food sold in a restaurant is tangible personal property because it can be seen, weighed, measured, felt, or touched. So, unless an exemption applies, it is generally taxable. Like most states, grocery store food items that are taken home for consumption are exempt from California sales tax, but there is no exemption for food sold for on premises consumption. Therefore, most items sold in a restaurant are taxable, especially when the 80/80 rule is applied, which we will discuss later.
California Sales Tax on Food Orders for Takeout and Delivery
In addition to eating in, many restaurants offer food “to-go” or delivery services. The taxability of to-go/takeout or delivery orders turns on whether the food is hot or cold. Hot prepared food sold to-go or for delivery is taxable. However, if your restaurant offers cold food for delivery or takeout, it is likely not taxable.
If your restaurant charges for food deliveries, the delivery fee is only subject to sales tax if the food order is subject to sales tax. Further, orders that include a combination of hot (taxable) and cold (not taxable) items together for a single price, makes the entire sale subject to tax.
California’s 80/80 Rule
If you operate a restaurant in California, you have probably heard of the vaunted 80/80 rule. The 80/80 rule makes it easier for CDTFA to audit you and easier for California to impose sales tax on 100% of your sales. Basically, if your sales are 80% food and 80% of the food you sell is taxable, 100% of your sales are deemed taxable unless you separately account for nontaxable sales.
Are Discounts and Tips Subject to California Sales Tax?
Taxability of tips and discounts are also common issues that come up in the restaurant industry. In California, tips are not taxable so long as they are not mandatory, and they are distributed to the employees. For example, if you automatically charge a minimum gratuity for parties of 8 or more, it is not the customer’s option and considered a taxable tip.
Discounts get a little trickier. Generally, a discount represents a reduction in sales price, and you should only apply sales tax to the discounted amount charged. For example, if you have a "buy one get one half-off" promotion during happy hour, sales tax is due on the total charge to the customer, so you aren’t collecting tax on revenue you didn’t receive.
However, a caveat arises when third parties get involved. If you receive a payment or reimbursement from a third party, such as a promotor or coupon service like Groupon, that income paid to you by the third party is taxable.
Common Tactics of California Sales Tax Auditors
California sales tax restaurant audits generally start with the auditor having an unfair advantage. That is, they already know your approximate sales because they have your 1099-k report from the IRS, which shows all credit card sales. From there, the California sales tax auditor will request bank statements, POS reports and any other documentation that will show sales. If the sales figure is less than the 1099-K, they will use the 1099-k as a basis for your total sales. If the 1099-k report plus a reasonable amount of cash sales are higher, that will be your total sales figure. Once the CDTFA auditor has a figure for “sales” (aka the highest number) they will compare it to your sales and use tax return and write up the difference as taxable. From there, you are guilty unless you can prove your innocence.
Combating a ‘guilty until proven innocent’ audit can be difficult, but not impossible. For starters, the 1099-k report relied upon by the auditor only has credit card sales. Therefore, if you can convince the auditor that the cash sales are lower than their projection, it will reduce total estimated sales and your assessment. Further, your 1099-K likely includes nontaxable items such as tips, possibly exempt delivery charges, and third-party service fees, such as Uber eats. If your restaurant is under audit, it is critical to determine your nontaxable sales and ensure they are backed out of your 1099-k report.
Strategies to Reduce a CA Sales Tax Assessment or Prevent an Audit
There are a few ways to reduce the audit assessment or possibly prevent the audit in the first place:
- Compare third-party data against your California Sales and Use Tax Return. If you know the auditor is going to access and rely upon your federal income tax return and your 1099-k report, you should pull it yourself and review for accuracy. Assuming the IRS report is accurate, compare it against your sales and use tax return, better yet, have our sales tax experts do it for you. If there are incongruities, we can help you clean up your act going forward and reduce past exposure by amending returns or filing a voluntary disclosure.
- Consider a voluntary disclosure. If you review your 1099-K’s and your federal income tax return, and it greatly exceeds your sales tax returns, you should consider a voluntary disclosure. For starters, the VDA takes penalty off the table, whereas you must fight with CDTFA to remove them later on. In addition, because VDA’s are seldom audited, you can more aggressively disclose your true sales figure, rather than having the auditor overestimate your sales for you. If you enter into VDA, the odds of being audited by the state dramatically decreases, but remember you are ineligible if California contacts you first.
- Do your homework before the audit. If you are unlucky enough to have already received an audit notice, you should do your homework immediately. You now know that the auditor is going to compare your federal income tax return, your 1099-k’s, and your POS reports to your sales tax returns for the same period. Therefore, if the auditor requests documentation that you know is going to result in higher sales amounts, you should consider not producing or if you produce, have an explanation prepared.
- Carefully Account for Nontaxable Sales. The number one nontaxable item, which is likely included in your 1099-ks, is tips. The 1099-k simply reports total dollars you received via credit card from a particular bank. If you do not have a breakdown for the tips included in total dollars received, the auditor will treat it as taxable. Having a breakdown as to the money received that is nontaxable, like tip revenue, is critical to reduce your assessment. If you cannot easily account for it, usually the IRS W-3 report will show tips paid to employees.
- Be Stingy on Providing Documentation. Generally, less is more in a sales tax audit. Provide documentation that reasonably shows your sales and nothing more. Every day we see restaurants who over provide documentation to the CDTFA sales tax auditor. The more that is provided, the more likely they will have an extravagant number to show as your taxable sales figure. You should be careful and know the answers before providing documentation. Alternatively, you should get a sales tax professional on your side who can evaluate what to and what not to provide to the auditor.
As CDTFA gets more and more third-party reporting, the easier it becomes to efficiently perform audits on industries like restaurants. Knowing how they will perform the audit is incredibly powerful because you can anticipate what they will do with the information you provide. Sometimes, no matter what is provided, a substantial assessment is inevitable. For those businesses, it makes even more sense to get out in front of the problem and amend returns or file a voluntary disclosure, so you control the narrative, instead of the CDTFA auditor. Of course, if you receive that audit notice, it is imperative to have the sales tax professional on your side to handle the audit or appeal the overinflated assessment.
Whether you need a sales tax attorney or consultant, Sales Tax Helper matches the service to meet your needs. Contact us today at 866-458-7966 for a free consultation.