Restaurant Sales Tax Audit Mistakes That Cost Over $100,000

What Data Does the State Use to Identify Your Restaurant for a Sales Tax Audit?

Departments within individual states gather data from many sources. Audit notices represent the final building block in a prolonged state data gathering process.

Analysis of Third-Party Data and the Cross-Reference of Your Returns

State revenue departments cross-reference your tax returns against your payment processor data. The restaurant sales data reported by your payment processors (Square, Toast, and Clover) are reported in a 1099-K and sent to state revenue agencies. Sales tax auditors compare the payment processor's reported data against your taxable sales. The audit notice is triggered by a significant difference. Alcohol, food, and beverage distributors report their sales to the state and your sales tax auditor has access to those reports. Auditors then determine your probable sales and compare your reported sales to this sales projection. How beer and cigarette purchase data can lead to audits is a pattern we see repeatedly across states.

Use of Distributor Invoices

Alcohol, food, and beverage distributors sell to restaurants and report their sales to the state as well. This sales data provides the auditor a basis for a sales projection and the sales auditor evaluates the reported sales against this sales projection. This sales forecasting methodology is documented in the Illinois Restaurant Sales Tax Audit and is used in the Ohio Restaurant Sales Tax Audit.

Differences Among Locations Can Trigger Audits

For multi-location operators, auditors can look at one location if they identify a material difference among reported figures across the group. Consider a group of three locations where each underreports by $2,000 to $3,000 per month. The tax liability per location would be $72,000 to $108,000. Across all three locations, the exposure would be greater than $200,000 before we begin working on the case.

What Mistakes in Sales Tax Administration Cause Audits to Cost Restaurants Over $100,000?

When record-keeping patterns emerge consistently through the course of an audit, auditors know they're onto something. There are two main problems that show up time and time again.

Over Reporting Sales of Exempt Food

In several states, including NY, IL, NJ, OH and CA, the rules regarding the taxation of prepared food are specific and complex. There is a fine line between food types that are grocery store-type exempt foods and prepared foods that are taxable. This is based on the manner in which the food was prepared, the package in which it was offered for sale, whether it was sold to be consumed on premises, and whether it was sold to be consumed immediately. Even more difficult is proving legitimate exempt sales on audit. The New York Sales Tax Guide for Restaurants and Bars walks through how these classifications work in practice.

Restaurant owners are incorrect in these classifications more often than not. They are inclined to sell more of their prepared food as exempt sales than is actually the case. In some instances, packages that have been prepared but not sold for immediate consumption can be exempt. Food that is sold for immediate consumption is never going to be exempted. If a restaurant reports an exempt percentage that is markedly higher than what is normal for their establishment, then the difference is considered to be sales that should have been reported.

This has left many restaurants that were previously profitable in financial ruin because the owners were completely unaware of the violation. When distributor invoices were requested by auditors and the product mix was compared to the exempt percentage for which the returns were filed, by then, the exemption claim had already done the damage.

The Return-Filing Gap That Compounds Over Three Years

Sales tax under-reporting at a rate of $2,000 per month equals a base tax of $72,000 to $108,000 over a typical 36 month audit period. With statutory penalties and interest, more than 95% of my clients arrive at more than $100,000 before we even start working.

Most clients are not committing fraud. Many clients have mistakenly configured POS systems for certain menu sections, sales from deliveries that were not reconciled and reported, comp records that were selectively omitted, none of these would require fraud to amount to a six-figure tax debt.

In some situations, businesses get behind and will get caught up next month. Next month becomes next month. Before you know it, you are 6, 9, 12 months behind. When the audit notice comes at this stage, pure panic sets in and knowing how to defend it is critical.

Not handling the audit properly and professionally can also result in criminal liability. In most jurisdictions, the obligation for sales tax does not remain with the business. If owners personally made tax decisions for the business, they may be personally liable. If the tax obligation is for a collected-but-not-remitted tax, the personal liability may come very quickly. Our post regarding personal sales tax liability for business owners explains how personal sales tax claims are pursued by states.

The notice has arrived. The owner is trying to play along and look good, so they round up everything: Z-tapes, bank statements, records. When the Z-tapes show $120,000 in sales tax collected over three years, and the state records show only $48,000, the owner has shown the auditor evidence of a trust fund violation.

Most states do not consider a civil shortfall of remitted sales tax. Once the customer pays the tax, the state has the right to it. In New York, sales tax not remitted is a tax fraud act as stated in Tax Law Section 1801(a)(5). This type of fraud can be prosecuted as a Class E felony when the unremitted amount exceeds $3,000 (Section 1803), or as a Class D felony at $10,000 (Section 1804). In Illinois, failure to remit sales tax as an agent of the state may be a Class 3 felony under 35 ILCS 120/13 when the unremitted amount is $300. Evading the payment of sales tax under 35 ILCS 120/13(b) can be a Class 1 felony when the amount is above $100,000. These are the laws in effect. Circumstances and how a case is handled dictate the case results. Before giving a record to a state auditor, we strongly advise you get a lawyer to review all of your records. This is exactly what our audit defense team does.

Talking to an Auditor without a Lawyer

The first contact from an auditor, be it a call, a meeting, or an email, is an evidence gathering opportunity for the state. Anything you say without counsel is permanently recorded.

A statement such as we always charged tax on dine in orders but weren't sure about to go orders provides the auditor with a sample frame. These auditors are adept at finding additional tax liability. That's how these exams are constructed.

The correct response to initial contact with an auditor is to inform them of receipt of the contact, provide your attorney's contact information, and to remain silent until representation is in effect.

What Should Be the First Three Concerns After Being Notified of a Sales Tax Audit?

No Notification? The Voluntary Disclosure Window

If you know sales taxes have not been remitted and have not received an audit notification, voluntary disclosure agreements are often the most helpful tool available. These voluntary disclosure agreements capped the back-year period, significantly reduced or eliminated penalties, and eliminated the risk of a criminal investigation for failing to remit collected duties. However, being registered in the first place may inhibit your ability to do a VDA in many states. Further, when an audit is initiated, the voluntary disclosure program is closed.

Notification Has Been Received

You should avoid providing documents and answering audit questions until your attorney examines the records in question. This initial contact can determine the scope and length of an audit and can increase risk, liability, and penalties from inaccurate responses. It can lead to an extended review and the imposition of high monetary penalties with attendant personal and criminal exposures.

Generally a seasoned sales tax professional or attorney is the right hire for a sales tax audit. Even more specific, a sales tax audit of a restaurant has unique and predictable issues that can only be learned by handling frequent audits in this space. For example, they often involve methodologies such as POS sampling, cash payment sampling, and criminal investigation referrals that go beyond standard CPA practice. If collected-but-not-remitted tax is in your case, the next step is a sales tax lawyer. Salestaxlegal.com provides the defense you are looking for.

The assessment on your desk is not final. What happens in the next 30 days will determine that. Reach out to Sales Tax Helper or call (866) 458-7966 before you respond to anything.

Frequently Asked Questions

What are the consequences of collecting sales tax and not remitting it to the state?

In most states, that is a criminal offense rather than a civil offense. Once a customer pays sales tax, that becomes the property of the state. Not remitting it is considered a violation of trust in most jurisdictions. It is a more serious offense than the typical underpayment. In New York, the unremitted amount becomes a Class E felony under Section 1801 of the Tax Law once it exceeds $3,000 in a given year. In Illinois, the same is a Class 3 felony under 35 ILCS 120/13 once the amount is greater than $300. In both states, the class of the felony increases with higher amounts.

As a restaurant owner, can I be personally liable to a sales tax audit?

Yes, and most of the time it is a complete surprise to a restaurant owner. In most states, the sales tax obligation does not end with the business. Revenue departments do not hesitate to go after owners personally, as well as officers and managers who made the decisions. In the case of collected-but-not-remitted tax, personal liability is high and it does not go away if you close or dissolve the business.

How do states find out my restaurant is underreporting sales tax?

States begin to audit you if there are discrepancies between sales tax filings, income tax filings, 1099-K reports from payment processors, distributor purchase records, and bank deposit records. A revenue gap across these records shows taxable sales that are underreported. States begin to audit when these discrepancies are evident. Months of underreporting sales tax are unlikely to trigger a major sales tax audit. A consistent discrepancy of sales tax underreporting over the next 12 to 36 months is more likely to trigger a major sales tax audit.

What is the criminal exposure for collected-but-not-remitted sales tax in New York and Illinois?

In New York State, sales tax that is collected but not remitted is considered tax fraud, and is addressed in Tax Law Section 1801(a)(5). Tax fraud is considered a Class E Felony for a failure to remit sales tax of $3,000 or more in a given year. It is considered a Class D Felony when the sales tax collected but not remitted is $10,000 or more. In Illinois, the failure to remit collected sales tax is considered a Class 3 felony with a sales tax evasion amount of $300 or more. The Illinois sales tax evasion statute, 35 ILCS 120/13, contains a series of class escalations: a Class 4 felony for less than $500, Class 3 for $500 to less than $10,000, Class 2 for $10,000 to less than $100,000, and Class 1 for $100,000 or more. The final outcome is dependent upon the facts and the discretion of the prosecutor.

What should I do when I receive a sales tax audit notice for my restaurant?

Note the date listed on the notice. This establishes the deadline. Do not contact the auditor. Do not send any records. Do not presume that the period listed is the only period that is subject to the audit. You should start collecting what is available to you. This includes Z-tapes, bank statements, sales tax returns, and invoices from the distributors. Do not present any of this to the auditors until you familiarize yourself with the documentation. You should then find and hire a sales tax attorney to represent you for these types of restaurant audits. Your tax returns should be handled by a general CPA. Sales tax issues should be handled by a sales tax attorney.

What happens if I miss the deadline on a sales tax audit notice?

Missing the response deadline on an audit notice does not make the audit go away. It accelerates it. The auditor moves forward without your input, which typically means they use the most aggressive projection methodology available. In New York and Illinois, missing a response deadline can also eliminate certain procedural rights during the appeal stage. The moment you receive the notice, the clock is running. Do not wait.

Can a voluntary disclosure agreement help after I've already received an audit notice?

No. Once an audit is initiated, the VDA window closes. This is one of the most painful lessons restaurant owners learn too late. The VDA is only available before the state makes contact. If you have collected tax and not remitted it but have not yet received a notice, that window is still open and the terms are significantly better than anything available once the audit begins.

About the Author

Gerald J. "Jerry" Donnini II is a sales tax attorney and the founder of Sales Tax Helper, a national platform that helps businesses find, fix, and prevent sales tax exposure before it becomes a problem. Over a 15-year career, he has represented businesses in more than 5,000 sales tax audits, appeals, and disputes across 40+ states. He holds an LLM in Taxation from New York University, is co-author of a CCH treatise on state sales and use tax, and serves as an adjunct law professor. Jerry has saved businesses more than $500 million in sales tax assessments. His framework, Find It. Fix It. Defend It., guides businesses from initial nexus diagnosis through voluntary disclosure and, when necessary, full audit defense.