Restaurant Schedule C Audit - Inventory items withdrawn for personal use

[Judy rocks]

I have an Information Document Request from the IRS with a requesting a "description and computation of the cost of inventory withdrawn for personal use". What do I tell them: "incidental"? or, "ok we'll take 5% personal use"?
Should restaurants figure a personal use % into their purchases of food? Can they deny all food purchases because we don't have a personal use amount? This seems to be a ridiculous contention. This is for a small family restaurant with a Gross of about 350K.

[JohnH]

I have an Information Document Request from the IRS with a requesting a "description and computation of the cost of inventory withdrawn for personal use". What do I tell them: "incidental"? or, "ok we'll take 5% personal use"?
Should restaurants figure a personal use % into their purchases of food? Can they deny all food purchases because we don't have a personal use amount? This seems to be a ridiculous contention. This is for a small family restaurant with a Gross of about 350K.

How about "we don't eat the stuff we cook!". ??

Was there any sort of computation for personal use in deriving the numbers on the original return? If not, then maybe you could just give them a figure and say it was based on an average of $xx per week. Maybe others will have a better suggestion. I'm assuming you are working with a COGS figure of $80K or so, based on the revenue you mentioned.

[TXEA]

To begin with, did you have a personal use adjustment to Inventory purchased (less amounts withdrawn for personal use)?

If you did, then explain the calculation of how you determined the amount. It will most likely be accepted if reasonable.

If you did not, interview your taxpayers and inquire as to their policy on taking inventory home with them. Estimate an amount if they withdraw inventory for personal use, tell the IRS an adjustment was not made, and then offer the computed amount with your computation methodology. Let the IRS know that "the clients will make every effort to handle this correctly in the future." It will most likely be accepted if reasonable and the IRS will adjust the return.

If your clients have a policy of not withdrawing inventory for personal use, then tell the IRS that they do not withdraw inventory for personal use. Give some rationale as to why they do not withdraw inventory for personal use (e.g., to set a good example for the staff).

This question came up for a reason. Most likely the computed GP% does not match within a reasonable margin of error for the IRS scores. Find out why this is the case. For example, I had one client who absorbed inventory cost increases (thus reducing GP%). I asked him why his GP% dropped compared to prior years, and he said he had to absorb the cost to keep his customers from going down the road to a competitor. I assume this is true since his products are not necessarily something that can be used personally very often.

The issue you are dealing with is a minor correspondence audit item. Keep this very simple, and explain to the IRS either the methodology used to compute the adjustment for the return, or the methodology you recommend using for the correspondence audit (assuming no adjustment was made on the return). If no inventory is withdrawn, explain the basis why the clients to do not withdraw inventory.

If your clients are withdrawing inventory from the business, then make sure they have an easy system to track this for future years.

[Judy rocks]

Cost of Goods Sold 49% of income

We are talking about a 177,500 Cost of Goods Sold
With 363,000 of income
Cost of Goods Sold is 49% of income
I just picked up this audit in progress from another accountant.
Bank statements are reconciled in Quickbooks and the entire 177,500 of Cost of Goods Sold are to legitimate Grocery Stores and Restaurant Supply Stores.
I guess the statement is in the IDR because of the high percentage.
Thanks for pointing out what I needed to notice.
Any suggestions on how to explain or handle a percentage like that??

How about "we don't eat the stuff we cook!". ??

Was there any sort of computation for personal use in deriving the numbers on the original return? If not, then maybe you could just give them a figure and say it was based on an average of $xx per week. Maybe others will have a better suggestion. I'm assuming you are working with a COGS figure of $80K or so, based on the revenue you mentioned.

[Uncle Sam]

Restaurant Personal Use Inventory

Ages ago I was a state sales tax auditor and I did have the opportunity to audit a restaurant -
Issues involving food inventory include not only inventory taken out for personal consumption, but
spoilage of inventory, of course pilferage, but very often overlooked is the unused inventory that
must be disposed of due to food being perishable.
The place I went to audit, kept a log of the cost of inventory (and quantity) that was donated to
charitable organizations before being thrown out, that reduced inventory cost, and picked up as
a charitable donation (provided it was a legit charity, and there was written evidence to prove
the donation). So missing inventory isn't always personally consumed.
And not all food consumption is done by the owner(s) - there could be a company policy with
respect to meal allowance for employees.

[Judy rocks]

All good

I have a 49% Cost of Goods Sold to Gross Income. it's a Fresh Mexican Restaurant. Is this outlandish? Your comments are very good and well taken. My concern is that maybe I should know if the 49% Cost of Goods Sold is too outlandish or not. If the 49% Cost of Goods Sold is unheard of then maybe I should be asking my client other questions.

To begin with, did you have a personal use adjustment to Inventory purchased (less amounts withdrawn for personal use)?

If you did, then explain the calculation of how you determined the amount. It will most likely be accepted if reasonable.

If you did not, interview your taxpayers and inquire as to their policy on taking inventory home with them. Estimate an amount if they withdraw inventory for personal use, tell the IRS an adjustment was not made, and then offer the computed amount with your computation methodology. Let the IRS know that "the clients will make every effort to handle this correctly in the future." It will most likely be accepted if reasonable and the IRS will adjust the return.

If your clients have a policy of not withdrawing inventory for personal use, then tell the IRS that they do not withdraw inventory for personal use. Give some rationale as to why they do not withdraw inventory for personal use (e.g., to set a good example for the staff).

This question came up for a reason. Most likely the computed GP% does not match within a reasonable margin of error for the IRS scores. Find out why this is the case. For example, I had one client who absorbed inventory cost increases (thus reducing GP%). I asked him why his GP% dropped compared to prior years, and he said he had to absorb the cost to keep his customers from going down the road to a competitor. I assume this is true since his products are not necessarily something that can be used personally very often.

The issue you are dealing with is a minor correspondence audit item. Keep this very simple, and explain to the IRS either the methodology used to compute the adjustment for the return, or the methodology you recommend using for the correspondence audit (assuming no adjustment was made on the return). If no inventory is withdrawn, explain the basis why the clients to do not withdraw inventory.

If your clients are withdrawing inventory from the business, then make sure they have an easy system to track this for future years.

[kathyc2]

You can google something like restaurant benchmark percentages to see where the number "should" be.

Some things/questions I would ask:

1) Restaurants take in quite a bit of cash and some owners may fudge the sales reported.
- Is the cost of labor in line with benchmarks or is it also high?
- Does the amount on 1099K compared to total sales seem reasonable?
- Does the profit plus any other income seem reasonable to the lifestyle lived? If not did they have savings that are being reduced or has debt increased?

2) Are there reasons that COS may be higher than industry average?
- Did owners have restaurant management experience or where they winging it?
- Is current year COS still in the high 40 range?
- Have you looked at a sampling of the grocery store receipts to verify that items purchased are all items used in restaurant?
- Are prices charged in line with similar restaurants in area or lower?
- Did they offer significant discounts to bring customers in to build a base?
- If they price out a BOM on a sampling of menu items does it come close to the 49% after allowing for reasonable spoilage?
- Did they post items that may more appropriately be classified as supplies to COS?

3) Do you know why the prior firm helping w/ audit left? If you know them to be a competent firm it may be that they found items that led them to believe there were problems with the numbers on return.

Good luck!

[Kram BergGold]

30%

From watching the Food Network, I am thinking the cost of food should be no higher than 30% of the price of an item. Restaurants that do not follow this rule usually go out of business. I think this is why this item is an issue in the examination. Let's be real, a restaurant owner has to show some food removed for personal use. I would think the food the owner consumes on premises qualifies as such. It is not a business expense unless the owner is having a business meeting or is testing new recipes. I am thinking the Examiner is looking for a substantial adjustment here like $15,000 to $25,000.

[kathyc2]

From watching the Food Network, I am thinking the cost of food should be no higher than 30% of the price of an item. Restaurants that do not follow this rule usually go out of business. I think this is why this item is an issue in the examination. Let's be real, a restaurant owner has to show some food removed for personal use. I would think the food the owner consumes on premises qualifies as such. It is not a business expense unless the owner is having a business meeting or is testing new recipes. I am thinking the Examiner is looking for a substantial adjustment here like $15,000 to $25,000.

30% is around the general benchmark, but it will vary by type of restaurant. For reference Chipolte food cost run about 35%. Not at all unusual for poorly managed establishments to have costs above 40%, especially for a low volume one such as this.

Employee meals consumed on premise for the convenience of employer are a non-taxable fringe. Are you saying that does not extend to owner? Would it be different if S-corp and owner is also an employee?

[JohnH]

30% is around the general benchmark, but it will vary by type of restaurant. For reference Chipolte food cost run about 35%. Not at all unusual for poorly managed establishments to have costs above 40%, especially for a low volume one such as this.

Employee meals consumed on premise for the convenience of employer are a non-taxable fringe. Are you saying that does not extend to owner? Would it be different if S-corp and owner is also an employee?

Seems that 30% vs 40% COGS is a stretch, even taking into account low volume and/poor management. But 30% vs 49% is getting outside the believablity zone. I don't think IRS is likely to be sympathetic to "we just aren't very good business managers" as an explanation. There definitely should be some readily-apparent compelling reasons to explain this situation. If not, then the response to the inquiry isn't lilkely to go well and next thing you know you'll be sitting in a room with an auditor and a bunch of shoeboxes.

You said you took this over form someone else, and another very good question which was asked of you is why is the prior accountant no longer involved? I have that same question. Maybe they did a poor job of classification and allowed lots of non-COGS items to slip into the COGS. Or perhaps the client isn't being very forthcoming and the preparer resigned. Maybe there's an issue with the client's payment habits. (Bad business operators tend to pay their bills late, which indirectly takes us back to excuse #1).

Anyhow, here's another important question for you. Did you get a sizable retainer before taking this project on? If not, then this might be a good time to find an exit strategy.

[kathyc2]

Seems that 30% vs 40% COGS is a stretch, even taking into account low volume and/poor management. But 30% vs 49% is getting outside the believablity zone. I don't think IRS is likely to be sympathetic to "we just aren't very good business managers" as an explanation. There definitely should be some readily-apparent compelling reasons to explain this situation. If not, then the response to the inquiry isn't lilkely to go well and next thing you know you'll be sitting in a room with an auditor and a bunch of shoeboxes.

You said you took this over form someone else, and another very good question which was asked of you is why is the prior accountant no longer involved? I have that same question. Maybe they did a poor job of classification and allowed lots of non-COGS items to slip into the COGS. Or perhaps the client isn't being very forthcoming and the preparer resigned. Maybe there's an issue with the client's payment habits. (Bad business operators tend to pay their bills late, which indirectly takes us back to excuse #1).

Anyhow, here's another important question for you. Did you get a sizable retainer before taking this project on? If not, then this might be a good time to find an exit strategy.

John, a couple of years ago I would have been in almost total agreement with that. I have a restaurant client that has margins close to that amount. I've seen the owners make one bad decision after another beginning with going against my recommendation and buying a non-profitable restaurant that had been closed for a couple of months. They had absolutely no restaurant experience but just thought (hoped?) it would work out. Sysco had done an analysis that their prices should be higher to obtain the benchmark percent. The volume never recovered to what it was under previous owner and raising prices would have decreased clientele even more. They were bleeding money every month, but they had another highly profitable business that was providing cash. Finally after 2 years and 100K loss they took my advise and closed it. In short, although the COS seems high there may be reasons and it may or may not be an accurate number.

Would exiting the audit have liability? It seems that if the second accountant left, the IRS might come to the conclusion that the books are highly erroneous and increase audit scope. If that would be the case could the restaurant owner claim Judy was the cause??

[JohnH]

John, a couple of years ago I would have been in almost total agreement with that. I have a restaurant client that has margins close to that amount. I've seen the owners make one bad decision after another beginning with going against my recommendation and buying a non-profitable restaurant that had been closed for a couple of months. They had absolutely no restaurant experience but just thought (hoped?) it would work out. Sysco had done an analysis that their prices should be higher to obtain the benchmark percent. The volume never recovered to what it was under previous owner and raising prices would have decreased clientele even more. They were bleeding money every month, but they had another highly profitable business that was providing cash. Finally after 2 years and 100K loss they took my advise and closed it. In short, although the COS seems high there may be reasons and it may or may not be an accurate number.

Would exiting the audit have liability? It seems that if the second accountant left, the IRS might come to the conclusion that the books are highly erroneous and increase audit scope. If that would be the case could the restaurant owner claim Judy was the cause??

I don't dispute that there may be valid reasons for a higher-than-normal COGS. There are also many reasons that badly-managed restaurants fail, with the leading causes being too-expensive rent & other overhead, and incompetent management of employee payroll, neither of which find their way into COGS.

But with alll our speculation here (which we all enjoy doing, especiallly during the off-season) I get the feeling that Judy isn't getting any satisfactory answers from the client. Otherwise we'd be dissecting the veracity of what the client has told her rather than brainstorming all the "what if's". We have also been speculating about why the first preparer exited, and Judy either don't know the reason(s) or hasn't felt comfortable sharing that info. Is any of this known, and might it impact the discussion here?

As for whether the client might blame the exit of a second preparer for an expansion of the audit, who knows? I think it's likely, since a desperate client flounders around for anyone to blame. But does such an assertion carry any preparer liability with it? I don't think that dog willl hunt.

At the end of the day, the client is responsible for the figures on the return, and how they got to the point of being audited is practically irrelevant (unless if perhaps you were the original preparer). But for what it's worth, I think the reply to the existing inquiry is just going to open the door to an expansion of the audit. If there were a good explanation for a 49% COGS, Judy would already have it. So her risk of the client trying to blame her for the expansion of the audit is probably no greater by withdrawing that it would be if she continues.

Maybe others will have a more optimistic assessment to counter or expand upon what I am saying...

[TXEA]

I think everyone is making more of this issue than is necessary. Assuming your new clients are not making a mess of the books, then this should be a simple correspondence audit. Trying to standardize GP% for a restaurant is a fools game. For example, a lunch crowd restaurant will have a lower GP% than a restaurant that has a dinner crowd (assuming equal type restaurants). Some accountants allocate 263A costs to COGS and some don't. A restaurant that serves alcohol and mixed drinks will have a higher GP% than one that does not (if they know what they are doing). A restaurant that serves steaks will have a lower GP%.

Given the above, ask or look for the following:

1. Are they withdrawing inventory?
2. Sysco pays rebates to some restaurants. Are they depositing them?
3. Add the Costs of Goods Sold and the labor costs. If these add up to more than 70% of sales, then costs are too high. If they are self-employed (Schedule C) you will need to compute the value of their labor to include with the labor cost.
4. Ask to see their menu price calculations. How do they determine what to charge for each menu item?
5. Do they trust their employees? Is food going out the back door?
6. Did they take a physical inventory?
7. If they use a comprehensive restaurant management system, review the annual report for total sales, COGS, and labor costs. Does this match reasonably close to the tax return?
8. Do they deposit all cash daily (less drawer needs)? If the owners wait tables, do they deposit their tips?
9. Are they compliant with tip reporting on the W-2's (not related to COGS, but an indicator of good management and accounting)?
10. What do they do with excess prepared food at the end of the day?


Give a good review of their general operating expenses. Do they appear ordinary an necessary and reasonable?

If all these are fine, then just respond to the notice as I mentioned earlier. However, do keep in mind that business owners who withdraw inventory from the business for personal use should always keep a log of the activity. Without the log, your clients are inviting trouble.

[TaxGuyBill]

I'll add one more thought:

Have them closely track inventory/COGS for 1 month, including any wasted product (I would take pictures) and product brought home. If the inventory/COGS for that month is reasonably close to the COGS on the tax return, that's strong evidence that the COGS is correct. If it's not, the taxpayer will need to explain why things are noticeably different.

I also like the idea that TXEA brought out about other things added to COGS. Try to figure out if the COGS on the tax return is only for food, or if other things were added to it (such as labor, etc.).

[Burke]

Very interesting thread. I would assume that the same considerations would apply to catering businesses. Research I have done has an average of 33% for food costs relative to sales. It also indicates labor paid at these events should also go into COGS. (I have seen it done as a separate cost on Sche C.) If included in COGS, it is way out of whack.