The tax attorneys at Nardone Law Group in Columbus, Ohio, routinely advise individuals and businesses on state and federal tax issues, including those involving the Ohio Department of Taxation (the “Department”). When faced with a sales tax audit, appeal, or other litigation, many owners of bars and restaurants find themselves in unfamiliar territory. Throughout this article, we will discuss why it is important for bar and restaurant owners to understand the methods used by the Department to perform sales tax audits, and why we would encourage them to take proactive steps to avoid an assessment, or overassessment, of sales tax due.
Direct Audit Method
During a direct sales tax audit, the Department will seek to obtain the taxpayer’s primary sales records directly from the taxpayer, including the taxpayer’s sales receipts and reports generated by its point of sale (POS) system, and the taxpayer’s invoices reflecting all inventory purchased by the taxpayer during the audit period. If the taxpayer is able to produce its primary sales records, then the Department will typically perform a “test-check” of the records by comparing the taxpayer’s purchase invoices to its sales receipts for a sample portion of the audit period. The Department will perform the “test-check” to verify whether the inventory purchased by the Taxpayer during the sample period coincides with the taxpayer’s sales during that same period. This analysis assumes that the taxpayer sold all inventory purchased during the sample period. If the purchases and sales match-up during the test-check period, then the Department will typically determine that all taxable sales are accounted for.
The Department will then compare the taxpayer’s actual taxable sales (as determined from the taxpayer’s primary sales records) to its sales tax reports filed with the Department, to ensure that all taxable sales were reported, and that all sales tax was collected and remitted. If there are no discrepancies, then the Department will generally complete the audit with no determination of liability. Many times, however, bars and restaurants fail to properly maintain their primary sales records, or there is a large discrepancy between the taxpayer’s purchase invoices and its sales records for the sample period. In order to avoid the Department using an indirect approach to estimate sales tax liability, it is important for bars and restaurants in particular to keep detailed reports due to the cash basis on which many liquor establishments operate. If the taxpayer’s primary sales records are inaccurate or incomplete, then the Department will use an indirect audit method to estimate the taxpayer’s taxable sales and sales tax liability.
Indirect Audit Method
If the Department concludes, after the test-check, that the taxpayer’s sales records do not match-up with its purchase records, then the Department will use an indirect method to estimate the taxpayer’s taxable sales. In the event the taxpayer has not maintained all of its purchase invoices during the audit period, this indirect method will often involve the Department gathering such information, typically in summary form, directly from beverage distributors. The Department will use this information to compute a mark-up, taxable sales, and related sales tax, rather than calculating sales tax based on actual sales records. The Department uses this approach to estimate the sales tax owed by the taxpayer during the audit period, and then compares that number to the sales tax that was reported and remitted to the Department by the taxpayer, in order to determine the taxpayer’s assessed liability.
In the bar and restaurant industry, the Department will typically use a unit-volume method in order to calculate the “mark-up” of purchased inventory. In addition to obtaining the purchase records directly from the distributors, the Department will also obtain a drink list, pricing information, and other relevant information from the taxpayer. In the absence of supportable information provided by the taxpayer, it will then make assumptions regarding things like the number of drinks that can be poured from a bottle, and standard drink size (e.g., 1.5 ounces for a mixed drink, 6.3 ounces for a glass of wine, etc.). The Department will use this information to compute a weighted average mark-up, and then multiply the mark-up by purchased inventory to arrive at an estimated taxable sales figure for the audit period.
Problems for the bar owners arise when they are unable to provide the auditor with accurate information regarding drink size, pricing, and drink specials or promotions. Again, in the absence of this information, the auditor may make numerous assumptions regarding the number of drinks that can be poured from a bottle, drink sizes, spillage, and breakage. The most important factors in the unit volume method are the unit price and drink size. Inaccurate assumptions by the auditor or information from the taxpayer can significantly impact the audit results. However, the mark-up method may only be used when there is support that the taxpayer’s records are inadequate. Further, there are proactive steps a bar owner can take in order to avoid the mark-up method and achieve the most accurate reflection of their taxable sales.
How to Keep Adequate and Complete Records to Avoid Inaccurate Mark-Ups
An honest and conscientious taxpayer who maintains required records has a right to expect that those records will be used in a complete audit. For this reason it is important for bar or restaurant owners to track and document things such as losses due to breakage, theft, or spillage, pricing, drink specials, and serving size, and to also employ ways to reduce inventory losses.
1. Track and Document Breakage. Losses of inventory in the bar and restaurant industry may include spillage (typically over-pouring), spoilage (i.e., bottles with a bad seal), pilferage (loss due to employee or customer theft), breakage (i.e., broken bottles), and loss due to complementary drinks from the bar tender. Accounting for these losses is necessary because Ohio law contains no required allowance for losses due to spillage, breakage, or pilferage. The presumption is that all alcoholic beverages purchased from a distributor will be resold to the customer. The taxpayer bears the burden of demonstrating what happened to its inventory. If the taxpayer is able to provide specific documentation, such as daily summaries documenting inventory lost to breakage or spillage, and detailing the size, brand, and type of lost inventory, then the auditor will be more inclined to accept this as documentation supporting the loss. In addition to tracking and documenting inventory losses, bar and restaurant owners can use various tactics, such as placing video cameras to identify, count and correct the effect of such acts.
2. Document Prices. As previously stated, pricing is critical when using the unit volume method to calculate estimated mark-ups and estimated gross sales. During the audit, the taxpayer should ensure that pricing and estimated mark-ups are adjusted and calculated to reflect all distinct happy hour, seasonal, and promotional pricing in effect during each separate month, quarter or year. The taxpayer should be able to provide evidence for the special pricing, as well as evidence as to the length of time over which the specials were offered. Otherwise, the auditor may use current regular sales pricing mark-ups against past periods for which much lower pricing was in place, resulting in an overstated assessment of additional sales tax due.
3. Document Serving Size. If the taxpayer does not provide accurate serving size information, the assumed mark-up will likely be overstated. To avoid this, the bar or restaurant owner should be able to provide the auditor with evidence of distinct serving sizes, and to the extent that the bar uses larger or distinct glass sizes, it should provide evidence of that as well. Absent credible evidence of serving size, the auditor may calculate the estimated mark-up on the assumption that all bars use 1.5 ounces of liquor in all mixed drinks, and that 12 ounces of beer and 5 ounces of wine is being poured per drink.
4. Hire Independent Auditors. Bar owners should also consider hiring independent auditors to conduct unannounced audits of their sales.. If these audits are done prior to a state audit, the results of these detailed reports can be used as compelling evidence to contradict the assumptions made by the auditor with regard to breakage, pricing, or mark-ups.
5. Invest in a Sophisticated Cash Register. Bar owners should invest in a relatively sophisticated cash register or point of sale system, and inventory tracking software, that is able to provide detailed sales reports and track items like complimentary sales and loss of inventory.
6. Train Employees. Bar owners should properly train their employees on proper drink sizes to avoid the over-pouring of drinks, to implement procedures to avoid loss of inventory due to breakage and spillage, and to properly document such losses of inventory. In some instances, it may be beneficial to hire a third-party consultant to provide a training session to bartenders or servers.
7. Keep Records and Reports for at least Four Years. The statute of limitations in Ohio, for which the state can audit a taxpayer and assess for unpaid tax, is four years. For this reason, all primary sales reports and records, including sales receipts, purchase invoices, inventory records, and documentation of inventory losses should be maintained for at least four years.
Contact Nardone Law Group
If you are the owner of a bar or restaurant and you are facing a sales tax audit by the Ohio Department of Taxation, or you would like further advice on ways to keep adequate and complete records to avoid inaccurate mark-ups, you should contact Nardone Law Group. We have vast experience representing bars and restaurants in sales tax audits, examinations, and litigation with the Ohio Department of Taxation. Contact us today for a consultation.