Good records give you evidence to defend your numbers. Missing records can give the auditor room to reconstruct them.

If you own a restaurant in New Jersey and receive an audit notice from the New Jersey Division of Taxation, your first reaction may be: Why me? Your second may be: We filed our tax returns. What could they possibly be looking for?

Quite a lot. Restaurants present some unique issues during a New Jersey tax audit. You may have cash sales, credit-card receipts, DoorDash or Uber Eats deposits, tips, discounts, complimentary meals, food waste, liquor purchases, employee meals and multiple vendors. Your sales may be recorded in one system while deposits appear in another.

And the State does not necessarily have to accept the sales figures shown on your tax returns simply because those are the numbers your accountant reported.

New Jersey audit procedures specifically address audits of retail food and beverage establishments. Auditors may compare what you reported with your bank deposits, point-of-sale records, purchase invoices, menu prices and other information to determine whether the restaurant’s reported sales make sense.

That is why a restaurant audit can become much more complicated—and much more expensive—than the owner initially expects.

What Does New Jersey Look at During a Restaurant Audit?

A New Jersey restaurant audit will frequently focus heavily on sales and sales tax. New Jersey’s general Sales Tax rate is 6.625%. Restaurants are responsible for properly collecting, reporting and remitting applicable Sales Tax. But during an audit, the question is not simply whether you filed your sales tax returns. The auditor may try to determine whether the sales you reported were actually all of your sales.

The auditor may request or examine records such as:

• POS reports and cash-register records
• bank statements
• merchant credit-card statements
• sales tax returns
• business income tax returns
• general ledgers
• purchase invoices and vendor statements
• menus and pricing information
• cash disbursements
• records of discounts, promotions and complimentary meals
• other source documents supporting reported sales

The important point is this: the audit does not necessarily begin and end with your tax returns. The auditor may attempt to independently determine whether those returns are accurate.

The Question Restaurant Owners Often Don’t Expect: “How Much Food Did You Buy?”

One of the most important parts of a restaurant audit may have nothing to do with your cash register. It may be your purchases.

Suppose your restaurant reported $700,000 in annual sales. The auditor reviews invoices and other records showing how much food and liquor the restaurant purchased. The auditor can then ask a very different question: If you bought this much product, and we know approximately what you charge for it, how much should you have sold?

New Jersey audit procedures permit auditors to analyze purchases and compare them with the cost of goods sold reported on the restaurant’s tax returns. If the records do not reconcile or the books are considered insufficient, the State may use an indirect audit method.

What Is a Mark-On Audit?

A mark-on analysis is essentially an attempt to reconstruct the restaurant’s sales from its purchases and selling prices. In simplified terms, the auditor looks at what the restaurant paid for its products and what it charged customers for the resulting menu items.

If the auditor determines from the restaurant’s purchases and menu prices that expected sales should have been substantially higher than the amount reported on the tax returns, the State may conclude that sales were underreported. The difference can then potentially become the basis for an additional assessment.

Once an audit methodology is applied across a longer audit period, what initially appears to be a relatively small discrepancy can turn into a very large proposed tax assessment.

Two Restaurant Audits. Two Very Different Outcomes.

We have represented New Jersey restaurant owners on both sides of this problem, and the difference good records can make during an audit can be dramatic.

In one case, the restaurant owner kept very good contemporaneous records in addition to using a point-of-sale system. He recorded what was happening in the business rather than relying solely on the numbers that happened to appear in the bank account at the end of the month. When the restaurant was audited, we had records that could be used to explain and substantiate the restaurant’s actual operations. The auditor did not have to rely primarily on assumptions about what the restaurant should have sold.

The result? The restaurant’s additional tax exposure was less than $5,000.

Compare that with another restaurant audit we handled. That restaurant did not have a POS system and did not maintain adequate records documenting its sales and operations. There were also mistakes in the information that had been reported.

Without reliable records showing what had actually occurred, the auditor used third-party purchase information and performed a mark-on analysis to reconstruct what the restaurant’s sales should have been. The resulting proposed liability was in the six figures.

Every audit is different, and those results do not guarantee what will happen in another restaurant audit. But the contrast illustrates an important lesson: when you cannot prove what actually happened in your restaurant, you may leave the State in a position to estimate what it believes happened.

“But We Throw Food Away.”

This is one reason restaurant audits need to be handled carefully. Restaurants are not mathematical laboratories. Food spoils. Drinks spill. Employees make mistakes. Customers send meals back. Owners comp meals. Employees eat meals. Restaurants run specials. Prices change. Portion sizes vary. Inventory disappears.

New Jersey audit procedures recognize that real-world adjustments exist. When performing a weighted mark-on analysis, auditors may need to account for price variations caused by coupons, specials and discounts, as well as reasonable allowances for waste, theft and spillage.

If an auditor’s assumptions do not accurately reflect how your restaurant actually operates, the reconstructed sales figure may also be inaccurate. But simply telling the auditor, “We have a lot of waste,” is very different from being able to prove and quantify it.

Your POS System Is Important—but It Is Not the Entire Recordkeeping System

A POS system can be enormously helpful during an audit, but owning one is not enough. Restaurant owners should preserve the underlying records that explain the numbers.

• If you void a transaction, document why.
• If meals are complimentary, maintain a record.
• If you regularly provide employee meals, have a consistent way to record them.
• If food is discarded because of spoilage, waste or an equipment problem, document it.
• If bottles break, alcohol is spilled or inventory is lost, keep records.
• If you run happy-hour pricing, coupons, promotions or discounts, retain evidence of them.
• If the owner puts money into the restaurant, identify the deposit as an owner contribution or loan.
• If money is transferred between accounts, document the transfer.
• If third-party delivery platforms are involved, preserve the statements necessary to reconcile gross sales, fees and net deposits.

Records Turn Explanations Into Evidence

There is a tremendous difference between telling an auditor, “We throw away a lot of food,” and being able to show records demonstrating what was discarded and why. There is a difference between saying, “Those deposits weren’t all restaurant sales,” and producing records showing that certain deposits were owner loans, transfers or other non-sales items.

An audit is ultimately about evidence. The better the restaurant’s records, the more ability the restaurant has to challenge an assumption that does not reflect what actually happened.

The 5 Numbers the Auditor May Try to Reconcile

1. Sales reported on the tax returns: What did the restaurant tell New Jersey and the IRS it sold?

2. POS or cash-register sales: What do the restaurant’s own systems say was sold?

3. Credit-card and third-party receipts: What do merchant processors, delivery platforms and other third parties report?

4. Bank deposits: How much money actually entered the restaurant’s accounts—and can non-sales deposits be identified?

5. Purchases: How much food, beer, wine, liquor and other product did the restaurant purchase, and what level of sales could reasonably have resulted from those purchases?

Ideally, these records tell a consistent story. When they don’t, the restaurant should understand why they don’t before the auditor starts drawing conclusions.

When Purchase Records Become the State’s Road Map

The State does not necessarily need your POS records to question your reported sales. Restaurants buy food and beverages from suppliers. Those vendors create records. Credit-card processors create records. Banks create records. Delivery platforms create records.

In other words, even when the restaurant’s own records are poor, third parties may have created an extensive paper trail for the restaurant. An auditor may use third-party purchase information to determine how much product the restaurant purchased and then apply menu prices, mark-on percentages or other audit techniques to estimate the amount of sales those purchases should have generated.

That can put the restaurant owner in a difficult position: the State has records showing what you bought, but you do not have adequate records showing what actually happened to it.

Cash, Delivery Apps and Liquor Sales Can Create Additional Questions

Cash-intensive businesses receive special attention because cash does not create the same third-party paper trail as a credit-card transaction. An auditor may compare POS sales, credit-card receipts, cash receipts, bank deposits and reported gross receipts. A difference does not automatically mean the restaurant concealed sales, but non-sales deposits such as owner loans, transfers or loan proceeds need to be identified and documented.

Third-party delivery platforms add another layer. The gross customer transaction, platform fees and amount ultimately deposited into the restaurant’s bank account may not all be the same number. If the bookkeeping does not properly reconcile these transactions, an audit can create apparent discrepancies that need to be explained.

Liquor, beer and wine purchases can also be compared with selling prices to estimate expected sales. The same real-world issues arise: pours are not always identical, drinks are spilled, bottles break, customers receive complimentary drinks, happy-hour prices differ from regular prices, and inventory can be lost or stolen.

Payroll and Workers Can Become Another Problem

Restaurant owners should also be careful about payroll and worker classification. New Jersey generally presumes that an individual performing paid services is an employee unless the requirements of the State’s ABC test are satisfied. Issuing someone a Form 1099 does not, by itself, make that person an independent contractor.

A New Jersey Department of Labor audit is different from a Division of Taxation sales-tax audit, but problems discovered in the restaurant’s records can create exposure in more than one area. Restaurant owners therefore need to look at the entire picture—not simply sales tax.

What If Your Records Are Incomplete?

Do not assume that missing records mean the State cannot audit you. It can mean exactly the opposite. New Jersey audit procedures permit indirect audit methods when the auditor determines that the taxpayer’s books and records are insufficient or incorrect or that internal controls are ineffective.

If there is insufficient information to perform a mark-on analysis, the State may still estimate an assessment. Bad records do not necessarily stop an assessment. Bad records may give the auditor greater ability to estimate one.

What If the Auditor Suspects Sales Were Intentionally Suppressed?

Most restaurant audits are civil tax matters. A mistake, poor bookkeeping or an unexplained discrepancy does not automatically mean someone committed tax fraud. But there is a significant difference between poor records and intentionally concealing sales.

If an auditor encounters evidence suggesting that sales were deliberately removed from a POS system, cash receipts were intentionally omitted, records were altered or destroyed, or false information was knowingly provided during an audit, the matter can become considerably more serious. Potential consequences can extend beyond an ordinary assessment of additional tax and may include substantial penalties and, in serious cases, referral for investigation.

Do not alter records. Do not recreate records and present them as contemporaneous records. Do not guess at an answer because you think it is what the auditor wants to hear. Understand the problem first and develop a strategy for addressing it.

Not Under Audit? Start Doing This Now.

1. Save Your Daily POS Reports

Keep your daily sales and closing reports, not simply monthly or annual summaries. Make sure you can distinguish among cash sales, credit-card sales, delivery-platform sales and other payment methods.

2. Keep a Void and Complimentary-Meal Log

If a transaction is voided, record why. If a customer receives a complimentary meal because of a service problem, record it. If the owner comps a table, record it.

3. Document Waste and Spoilage

Develop a simple system for recording significant food waste, spoilage, returned meals and other product that was purchased but never sold. The same concept applies to alcohol.

4. Record Employee Meals

If your restaurant provides meals to employees, establish a consistent procedure for recording them.

5. Preserve Your Discounts, Coupons and Specials

Happy hour, coupons, loyalty discounts, promotional offers and other reduced-price sales should be documented so you can show that not every item was sold at full menu price.

6. Save Your Delivery-App Statements

Preserve statements and reports from DoorDash, Uber Eats, Grubhub and other third-party platforms so you can reconcile underlying sales, adjustments, fees and net deposits.

7. Keep Your Purchase Invoices

Maintain organized records from food distributors, liquor distributors and other major vendors so that you—or your representative—can independently analyze the purchases if the State does.

8. Clearly Identify Owner Loans and Contributions

An owner putting money into a struggling restaurant does not create restaurant sales. Record owner contributions, loans and other non-sales deposits when they occur.

9. Document Transfers Between Accounts

If money moves from one restaurant account to another, make sure the bookkeeping identifies it as a transfer so the same money is not mistakenly treated as additional revenue.

10. Reconcile the Numbers Regularly

Periodically compare POS sales, merchant processing, delivery platforms, bank deposits, books and tax returns. Then compare purchases and cost of goods sold with the sales being reported.

Create an Audit File Before You Ever Have an Audit

Consider maintaining an electronic folder for each year containing the records that would be difficult to recreate later:

• daily and monthly POS reports
• void and comp records
• waste and spoilage logs
• employee-meal records
• menus and evidence of price changes
• happy-hour, coupon and promotional information
• merchant-processing statements
• DoorDash, Uber Eats and other delivery-platform statements
• bank statements
• major vendor and purchase records
• records supporting owner loans and contributions
• loan documents
• documentation of unusual deposits
• year-end financial statements and filed tax returns

You may never need the file for an audit. But if an audit notice arrives, you will be in a very different position from the restaurant owner trying to reconstruct several years of business activity from bank statements and memory.

What Happens If the Auditor Says You Owe Money?

An audit assessment is not necessarily the final word. The first opportunity to challenge questionable findings is often while the audit is still underway. That may mean challenging the auditor’s assumptions, producing additional documentation, explaining unusual transactions or demonstrating why the sampling or mark-on methodology does not accurately reflect the restaurant.

If the matter cannot be resolved with the auditor, New Jersey provides administrative appeal rights. A taxpayer who disagrees with a Division determination may file a written protest and request an informal administrative conference through the Conference and Appeals Branch. Further appeal rights may also be available. The key is paying attention to the deadlines.

What Should You Do When the Audit Notice Arrives?

Do not panic—but don’t simply forward the notice to your accountant and forget about it either. Before records are produced, you should understand:

1. What taxes and periods are being audited?
2. Exactly what records has the State requested?
3. Do your sales tax returns reconcile with your income tax returns and books?
4. Do your bank deposits reconcile with reported sales?
5. Do your POS reports reconcile with the returns?
6. How are DoorDash, Uber Eats and other third-party sales recorded?
7. Are transfers, owner contributions and loans identifiable in the bank records?
8. Do purchase records support the cost of goods sold reported on the returns?
9. Could the restaurant withstand a mark-on analysis?
10. Can you substantiate waste, spoilage, discounts, complimentary meals and other adjustments?
11. Are there payroll or worker-classification problems that need to be identified?

The time to discover these problems is before the auditor does.

Your Accountant and Your Audit Attorney Have Different Jobs

Your accountant may have prepared perfectly accurate returns based upon the information provided by the restaurant. That does not necessarily mean the accountant should be the only person developing the strategy for a contested audit.

Once the State begins questioning the books, reconstructing sales or proposing a substantial assessment, the matter becomes more than tax-return preparation. It involves evidence, audit methodology, negotiation, procedural deadlines and potentially an administrative or Tax Court appeal. For a significant restaurant audit, your accountant and tax attorney may be most effective when they work together.

The Biggest Mistake: Waiting Until the Assessment Is Huge

Restaurant owners sometimes contact us after an audit has been going on for months—or after the State has already proposed a very large assessment. By then, statements have already been made, documents have already been produced, audit assumptions may have become established, and important deadlines may be approaching.

It is usually much easier to develop an audit strategy before those things happen.

If your New Jersey restaurant has received an audit notice, the goal is not to hide records or avoid legitimate taxes. The goal is to make sure the State is working from the actual facts of your business rather than assumptions that produce an assessment your restaurant does not really owe.

The Recordkeeping Lesson Is Simple

The best time to prepare for a New Jersey restaurant audit is years before the audit notice arrives. But if the notice is already sitting on your desk, the second-best time is before you start producing records to the auditor.

Gather the POS reports, bank statements, merchant-processing statements, delivery-platform records, purchase invoices, sales tax returns, income tax returns and supporting records. Then reconcile them. Identify the differences. Understand the weaknesses. Document legitimate explanations. And determine whether the restaurant’s purchases and menu prices could produce a mark-on calculation substantially different from the sales reported on its returns.

Because when a New Jersey restaurant audit begins, there can be an enormous difference between being able to demonstrate what actually happened and having the State calculate what it thinks should have happened.

Tomes Law Firm PC

Tomes Law Firm represents New Jersey businesses in state and federal tax audits, tax disputes and tax-resolution matters. If your restaurant has received a New Jersey audit notice—or an audit is already underway—contact Tomes Law Firm before an estimated or reconstructed assessment turns a manageable problem into a much larger one.

We solve tax problems. You get peace of mind. Call us at 732-333-0681 or 833-4IRS-TAX or visit us online at tomeslaw.com