IRS Increasing Audits of Small Businesses – Are You Ready?

July 25, 2010 | by Richard Yelton
IRS Increasing Audits of Small Businesses – Are You Ready?

Over the past several years, the IRS examination of small businesses, which it defines as those with assets less than $10 million, has significantly increased.  In fact, a recent report by Syracuse University’s Transactional Records Access Clearinghouse (“TRAC”) shows that IRS audits of small businesses has increased by 30% over the last five years.  Surprisingly, that same report showed that the audit of large businesses, defined as those with assets greater than $250 million, have actually decreased by 33% over the last five years.  With this increase in IRS scrutiny, small businesses must be ever mindful of maintaining internal controls and excellent books and records to support their tax filings.

For pizza restaurants in particular, the IRS has identified those areas with the greatest risk of errors, on which an examiner should focus.  In that regard, the IRS has developed specialized audit procedures to review those selected areas.  The most significant source of errors identified by the IRS related to pizza restaurants is the proper reporting of total revenues.
In its review of total revenues, the IRS will often begin by comparing daily POS system information and the related bank deposits.  This procedure should provide the examiner adequate comfort that revenues have been properly recorded.  However, if the examiner has difficulty using this procedure to tie out total revenues, other indirect methods may be used to estimate pizza sales.  Those techniques may include:

Ingredient mark-up calculation:  The IRS agent may test the restaurant’s reported pizza sales by reference to the amount of ingredients, such as flour, cheese and sauce, purchased during the year.  The agent would also need specific pizza recipe information, such as the amount of ounces of flour, cheese and sauce that are used in making a large cheese pizza.  Based on this information, the examiner may attempt to approximate the number of pizzas sold during the year, and estimate the total revenues from pizza sales accordingly.    

Pizza box usage:  The IRS agent may also test the reported pizza sales by reference to the number of pizza boxes used during the year.  This test is much more subjective than the mark-up calculation since the examiner must consider the ratio of dine-in customers for whom a pizza box may not be used and take-out or delivery customers served by the restaurant.

As you can imagine, each of these methods can result in an unreliable estimation of total revenues by the IRS examiner.  For example, factors such as food spoilage are often not considered within these calculations.  As a result, such indirect methods of estimating revenues could lead to a proposed adjustment by the IRS examiner, and additional income taxes assessed. Unfortunately, such an assessment could have possibly been avoided if the pizza restaurant owner had maintained a more reliable set of records to support its sales activities.

For larger pizza restaurants that tend to have more internal controls in place, an IRS agent may be able to verify total revenues without having to use any indirect methods in the process.  In that situation, the agent may focus more on the deductions and income tax incentives claimed, including:

Costs of intangible items:  There are many intangible costs unique to the restaurant industry, such as franchise costs and liquor license costs, which must be spread over 15 years, even though the useful period of such costs may be considerably less.  Restaurants that either immediately deduct such costs or amortize them over shorter periods may find themselves with disallowed tax deductions upon examination.

Employment related tax credits:  Restaurants are eligible for several tax incentives related to its workforce, most commonly including the Work Opportunity Tax Credit (WOTC) and the FICA Tip Tax Credit.  Since recent legislation has made these credits even more beneficial for restaurant owners, IRS agents approach these credits with even greater scrutiny.  Accordingly, restaurants should be certain to properly maintain the related documentation, including certified employment forms, that are often required to claim such credits.  

The overall IRS examination rate for small and mid-size businesses is still relatively low, even considering the recent increases.  However, restaurant owners should remain focused on maintaining proper internal controls and reliable books and records.  Doing so will not only make an IRS examination less painful, but will allow the restaurant to maximize its long-term profitability and growth.

Topics: Business Strategy and Profitability, Human Resources, Independent Operation

Richard Yelton
Richard Yelton is a principal at Windham Brannon in Atlanta. His specialties include restaurant and hospitality tax, mergers and acquisitions, and more. Visit him at the Windham Brannon website. wwwView Richard Yelton's profile on LinkedIn

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