/ Small Business Sales Tax

Every Restaurant is at Risk of a Sales Tax Audit. Here's Why...

Worried about having your business audited? If you own a restaurant or bar, perhaps you should be.

There are a number of factors that can cause a business to catch the eye of their state auditor, not the least of which is what industry they operate in. Specific industries are at much higher risk, and bars and restaurants fall firmly into this category. Why, you ask?

Keep reading to learn about industry risk factors, common mistakes that lead to audits, real-life audit stories, and what you can do to avoid a tax audit.

First, let’s evaluate why businesses get audited in the first place.


Thanks to a number of industry-specific factors, bar and restaurant owners face a higher audit risk.

Audit Risk Factors for Bar & Restaurant Owners

Your state board of equalization continually monitors which industries are most compliant with tax laws, and which are least compliant. For the reasons listed below, bars and restaurants frequently land on the “least complaint” list.

  • Lots of Cash Transactions
    If your business is partially or fully cash-based, your audit risk increases significantly. A point of service (POS) system tracks electronic payments, which leaves less room for number fudging. With cash, paper trails are limited, and there’s a lot more opportunity for fraud.

  • High Employee Turnover
    If you have a staffing issue at your bar or restaurant, beware. Disgruntled employees frequently call the state tax hotline to report prior employers for violations, and each call that comes through increases your odds of an audit.

  • Working with Volatile and Expensive Items
    Food and liquor are prone to spillage and spoilage, which makes restaurants easy targets for auditors. High-end bars and restaurants that purchase lots of expensive items, like top-shelf liquor or expensive seafood, also have an increased audit risk.

Being in a high-risk industry alone isn’t enough to result in receiving a tax notice, however. First, your business has to make an error that’s noticed by the state.


Businesses with lots of spoilage, like restaurants, face an increased audit risk.

Most Common Restaurant Errors that Lead to Audits

There are three main things businesses do that result in an audit:

  • Underreport Sales Tax
    This error is frequently seen when restaurants underreport cash sales, neglect to tax taxable items, or use flawed math when they calculate dine-in versus to-go orders. We’ll offer real-life examples of each of these errors a bit later in the post.

  • Underreport Use Tax
    If you’re a caterer or event coordinator who purchases products that you then charge your clients to rent (like a dance floor), make sure you’re appropriately calculating use tax. Regulations are different in each state, so it’s important to review your local laws.

  • Disallowed Spillage and Spoilage
    Sometimes, restaurant owners say they spilled or spoiled food they used to avoid paying taxes on it. If the state notices higher-than-average or increasing spillage and spoilage reported on your tax forms, it’s likely to trigger an audit.

Another common error that can result in an audit include:

  • Ballpark Revenue Reporting
    If you consistently report rounded numbers to the state tax board, it will become apparent that you’re submitting ballpark sales. For example, if every return you submit reports that you made exactly $250,000 - the state is going to want to take a closer look.


Establishments that serve expensive liqours also have a higher audit risk.

Putting it All Together

After learning all the risks, it becomes apparent why bars and restaurant owners are more likely to get audited. For starters, you’re in a high-risk industry that deals with lots of spillage and spoilage. In many cases, you may experience fairly high employee turnover, and likely have a percentage of cash transactions. Put these things together, and you’re dealing with three major audit risk factors. If you’re also reporting round numbers on tax returns and taking excessive deductions, you can all but guarantee you’re going to get an audit notice at some point.

Real-Life Examples: Stories from a Senior Auditor

No better way to learn than from real life experience, so we decided to share a few stories from a senior sales tax auditor. No business names will be used to protect the not-so-innocent.

  • A Deli Story
    A deli owner was reporting $1,000 a day in sales, which works out to $70 a day in sales tax. His cash-only business was small potatoes in the grand scheme of things, but because of his cash-only setup, he caught the tax board’s attention.

    The auditor decided to waive the audit. That is, until three police officers enjoying free sandwiches approached him. The officers asked him not to hassle the owner, which led to a change of heart and the auditor drafted audit paperwork. It turns out, the deli owner didn’t have any records for his cash transactions and was underreporting sales by 10X. Needless to say, he got a hefty bill for back taxes owed.

  • A Big Tip-Off
    In a bar or restaurant, as long as tips are optional, they are not taxable. But if you have a policy in place that requires a certain percentage tip for parties of X or more, you have to pay sales tax on those tips. Our auditor found himself at a large chain handling a case where a bar and grill was neglecting to charge sales tax on mandatory tips, and they owed hundreds of thousands in back taxes. This is an easy mistake to make -- and can be a very costly one -- so make sure you’re compliant!

  • Bad Estimates
    Many states require that restaurants charge different sales tax rates for dine-in and to-go orders, and coffee shops are no exception. In California, dine-in orders are taxable, and to-go orders are not. Our auditor was asked to evaluate the percentage of to-go orders at a California coffee house that was reporting that 80% of their business was to-go.

    It turns out the shop had calculated their to-go rate at 8am on a Monday morning at a location that services primarily business commuters. They applied that 80% rate to all their locations, at all hours, and used it to report sales and use tax. Unfortunately, their logic was deeply flawed and further investigation by the auditor found they were overreporting to-go orders by 27%.


Excessive spillage and spoilage are both contributing factors that can trigger audits.

Creative Ways Auditors Analyze Underreported Sales Tax

Math and accounting seems like the most straightforward way to calculate how much a business is underreporting their sales tax, but it’s not always the most accurate. Read on to get insider insights on how sales tax auditors use other techniques to calculate how much businesses owe on back taxes.

  • Cost of Living Analysis
    An auditor will take a look at your personal finances and any clues that suggest you’re living a more affluent life than your sales tax reporting suggests. For example, if you show up at your restaurant in a Ferrari, sporting expensive designer clothes and jewelry every day, but report a meager wage, that’s a red flag. Your auditor can analyze how much more money you’d need to make than you’re reporting to maintain your lifestyle and can use that information to calculate how much you owe.

  • Inventory Analysis
    In the deli example above, the auditor was able to calculate how much the owner was underreporting sales by evaluating a bakery delivery. Owners typically don't order way more or less fresh stock (in this case, bread) than they’ll sell through in a day. The auditor counted the number of rolls that were delivered, considered the size of the sandwiches served, and did some basic math to figure out the deli’s actual daily sales.

  • Bank Account Analysis
    Auditors can get access to your business bank accounts to evaluate how your deposits compare with what you reported to the government. If your reported sales don’t match your daily deposits or vice versa, your auditor can use that information to calculate how much you’ve been underreporting sales and how much back tax you owe.

  • Business Analysis
    In the coffee shop example explained above, our auditor had to figure out what the actual percentage of to-go orders was to calculate how much tax was owed. He landed at 57%, a figure he came up with by visiting multiple locations at different times of day and counting how many people took their orders to go. That’s 27% lower than the figure the business had been reporting. He then applied his findings to past sales to identify how much money the coffee shop owed in unreported taxes.

  • Bar Pour Tests & Secret Shoppers
    If an auditor believes your bar spillage reports are high, they’ll do a pour test. That means they’ll have one of your bartenders pour them a shot. Then, they’ll measure volume and calculate how many drinks you can get out of a bottle. Once they’ve calculated that number, they’ll review your tax forms to identify any discrepancies. Be aware too, that since bartenders tend to over pour on pour tests to assist with any fudged numbers, auditors frequently come back a time or two and secret shop your bar. The bottom line is, report accurately and make sure your bartenders pour consistently.

Don’t underestimate your auditor’s creativity. They have many clever ways to calculate how much you owe and won’t settle for paperwork you provide to them. Your best mode of defense? Avoid an audit!


A high volume of food waste can get an auditor's attention.

5 Things Restaurant Owners can do to Avoid an Audit

Now that you understand what not to do to avoid an audit, let’s take a look at a few things you should do to avoid a visit from your friendly state auditor.

  • Keep good records of cash transactions
    If your business has multiple registers for cash and credit transactions, or if you frequently accept both forms of payment, make sure you have good records. If you keep manual records and reconcile your paper tape each night, make sure to ring up all transactions on your register and to have a readily-accessible paper trail that makes it easy to prove how much money you accepted. Also, make sure your bank deposits match your reported earnings. Better yet, use a POS system that can handle both cash and credit transactions and fully reconcile both at the close of business each day.

  • Try to avoid high employee turnover

    Focusing on maintaining a positive work environment that promotes employee retention is a great way to lower your audit risk. Keeping your employees on good terms can help you avoid any unwanted disgruntled hotline tips that can lead to an audit.

  • Make sure employee meals and mandatory tips are taxed appropriately

    As illustrated in the Big Tip-Off example above, not charging sales tax on mandatory tips is a big no-no, as is neglecting to charge tax on employee meals. Make sure you understand what’s taxable and what isn’t and that your systems are set up to calculate your ticket totals appropriately.

  • Be careful when combining taxable and nontaxable items
    Sometimes, you’ll have taxable and nontaxable items on the same ticket. For example, if you build tax into drink prices to make it easier to deal with cash, be sure to enter your data into your point of sale system accurately. Most modern POS systems can help you manage this effectively by automatically handling calculations, but the system working correctly is dependent on your diligence in entering everything into the system correctly.


Using measured pourers and training staff to pour consistently can help you avoid an audit.

  • Effectively Log Spillage and Spoilage
    It’s essential to have an inventory tracking and spillage and spoilage reporting system in place that all your managers know how to follow. Keeping good records, being able to use predictive ordering to avoid stock issues, and keeping spillage and spoilage in check will help you avoid an audit.

Now you understand:

  • why bars and restaurants have a higher audit risk
  • what mistakes you can make to trigger an audit
  • how real-life bar and restaurant owners have triggered audits
  • how auditors calculate how much money you owe
  • specific things you can do to avoid an audit

Take this information to heart and use it to keep your bar or restaurant in the good graces of your state tax board.


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