The Methodology Behind a State Sales and Use Tax Audit of a Bar

There are only a few court decisions that address the issues facing a bar in a sales and use tax audit. Those courts have found favorably for the state. The state is using this success to expand its approach in the sales and use tax audits of bars. Historically, the state would only reject the taxpayer’s reported figures and apply an indirect audit method when the bar being audited had poorly maintained business records. Now, the state applies its indirect audit methods in any situation, even when the bar’s records are good and match its returns. Bar owners should be prepared for this.

The most common indirect audit method that the state uses to determine a bar’s total alcoholic sales is the unit and volume method. This method begins with the auditor determining the amount of liquor and beer the bar purchased over a period of time. These amounts are usually obtained from the bar’s suppliers. The auditor then divides the amount of beer and liquor purchased by a number that is supposed to be representative of one serving of beer and one serving of liquor. Auditors will usually use twelve ounces of beer per serving and one ounce of liquor per serving. When the total number of estimated servings the bar could have made is determined, the auditor multiplies these totals by the average price of a serving of beer or liquor at that particular bar, and then adds the two amounts. 

This sum represents the estimated total sales the bar would have if every drink were made and served perfectly.  Fortunately, this is not the end of the analysis.

The courts have decided that, because the world is not perfect, the unit and volume method should allow for a percentage of the alcohol purchased to be considered lost due to “spillage.” This percentage is meant to account for the liquor and beer that is lost during the storing, making, and serving of the drinks. The percentage the courts generally subtract from the bar’s total estimated servings ranges from 5% to 10%.

In addition to the spillage rate, there is a “shrinkage” rate. The shrinkage rate is the difference between what the bar uses as its serving size versus the state’s standards. There is no standard shrinkage rate that courts apply. Bars that “free-pour” their drinks will find that too often the amount of liquor they use to make one serving far exceeds the state’s standard. Some other reasons to justify the shrinkage rate are the drinks that are given away for promotions and employee or owner consumption.

Convincing the state to consider the spillage and shrinkage rates is the most difficult, but also most important, obstacle a bar faces when confronted with this indirect audit method. Without considering these percentages, the state’s total estimated sales during a period can look dangerously high. This can result in a burdensome sales tax obligation and, even worse, a personal obligation for the bar owners for unreported income. To avoid this result, it is important that the bar gives the state enough information to support the bar’s proposed shrinkage and spillage rates.