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Click here to listen to audio interview on Michael Rasmussen
It’s the old “carrot and stick” approach: if you, as an operator, do not keep a clean, reliable set of books and records for your restaurants, the IRS will do it for you – their way! Whether you decide to use the cash method (cash receipts and disbursements), the accrual method (inventory, accounts receivable and accounts payable), or the mandatory IRS method, if your records are inadequate here is what you risk:
STICK: Treasury Regulations authorize the IRS to compute income in accordance with whatever method that clearly reflects income. If the taxpayer keeps no records, or the financial records are inadequate and/or unreliable, the IRS can use the “ingredient markup” method to determine taxable income, as determined by various tax cases. In addition, the Tax Court has allowed the use of third party supplier records in calculating the cost of goods and the gross profit resulting from business activities.
The ingredient markup computation is an indirect method used to reconstruct the gross receipts of a restaurant. In one significant case, the Tax Court ruled in favor of the IRS’ use of this methodology where the taxpayer failed to keep adequate records for the pizza restaurant’s sales, cost of sales, and the expenses. Not all of the restaurant’s receipts were deposited and some of the expenses were paid in cash, without receipts. The IRS used supplier information to reconstruct the income by estimating the number of pizzas which could be made from the amount of flour, sauce and cheese purchased during the years being examined.
The IRS is also allowed to use alternate methods of determining income to prove skimming of cash. For example, the IRS will contact former employees since these individuals know exactly how the restaurant was operated and may be helpful in identifying schemes used by the owner. The former employees can also confirm allegations to solidify the findings. In addition, the IRS can go to the restaurant’s bank and ask the head teller if the restaurant staff comes in and makes cash conversions (small bills into large denominations).
It is important to stress that these methods are not intended to be used on all cases, but rather can be used once it has been determined that the taxpayer’s financial books and records cannot be relied upon.
The IRS and other taxing agencies have contacted experts in the restaurant accounting field to find common methods and indications of under-reporting of income. These methods are documented and used as a road map for the tax agent when a restaurant is selected for an audit of its books and records. Examples include recording a smaller sales amount on the daily operating report than is shown on the cash register Z tape, regular cash overages, collecting side income (such as vending) and not including the income on the daily operating report, or collecting from special customers, parties, and banquets and not reporting the income on the daily sales reports.
Altogether, the IRS has over 49 identified areas that are investigated if a restaurant is selected for examination. Most restaurant operations are subject to over 18 taxing agencies, from income tax to employment tax to sales tax to property tax, and the list goes on and on. All of them require some form of information relating to the books and records of the restaurant. Through technology, these agencies are able to share information with each other. For example, the IRS and many state franchise tax organizations will inform each other upon the completion of any audits performed.
So, the question is not if your books and records will be requested -- it is when and by whom.
CARROT: The benefits of a well kept set of books and records cannot be over-emphasized. Here are two of the most important:
All owners, when writing their initial business plan, are asked to identify an exit strategy from the restaurant operations, particularly if your restaurant organization has a partner, or incurred financing to begin operations. How much might an operator could receive as a sales price when the time comes is a question I am asked frequently. So I interviewed many brokers who buy and sell restaurants routinely, and the following three traits provided the most value in obtaining the best sales price:
First, that systems were in place documenting how each menu item was prepared and priced.
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Second, the existence of a customer list of restaurant patrons for the last 90 days that included telephone numbers, addresses, and anniversary and birthday dates.
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Finally, a complete three-year set of books and records including financial statements, bank statements, sales tax returns, payroll tax returns, corporate income tax returns, and employee records that all agree to each other.
Another major benefit of being focused on accurate books and records is to decrease theft. Restaurant industry specialists have identified more than 100 ways to steal from a restaurant (which the IRS may also use in an audit). Schemes used by employees (primarily by bar employees), outside parties (vendors), managers, bookkeepers, or other individuals with total system access are well documented. Procedures to limit these exposures are available in trade seminars and materials for the operator to review.
Take the time to create an accurate set of restaurant books and records. The immediate savings from keeping the pulse of food and labor costs and reducing the cost of theft in its many forms will more than outweigh the cost of tracking the numbers. Not to mention the improved peace of mind.
Knowing that an operator’s books and records will be inspected at some point by any one of over 18 different regulatory agencies, plus knowing you will increase the value of your restaurant when you decide to sell, makes the need to maintain a proper set of books as simple as knowing to put cheese on PIZZA!