Restaurants: The Top Three Triggers of Sales Tax Audits

California restaurants operate under some of the most complex tax and reporting rules in the country. Between sales tax, use tax, cash handling, tip reporting, and new gratuity regulations on the horizon, even well-run businesses can find themselves facing a CDTFA sales tax audit.

In this video, John highlights three of the most common triggers of a California sales tax audit. This article expands on those points and provides a deeper look into how audits work, what CDTFA reviews, and what restaurants must understand about tips, gratuities, and the new OBBBA rules that will soon reshape reporting responsibility.

The Reality of CDTFA Sales Tax Audits for Restaurants

Restaurants are one of the highest-audited industries in California. CDTFA targets them because:

• Large portions of sales may be cash
• Tips and gratuities create reporting complexity
• POS and recordkeeping practices vary widely
• Menu pricing and discounting can create discrepancies
• Alcohol sales add another layer of recordkeeping

Because of these factors, CDTFA applies stricter oversight to restaurants than to many other types of businesses.

Three Major Triggers of a Sales Tax Audit (as John explains)

1. Inadequate or Missing Records

Restaurants that do not use a POS system or rely on handwritten tickets face increased scrutiny. Without consistent documentation, CDTFA may:

• Reconstruct sales based on industry markers
• Apply markup formulas to estimate unreported revenue
• Increase taxable sales based on ingredient purchases
• Assume underreporting and issue assessments accordingly

Even minor gaps in documentation can lead to large adjustments.

2. Unreported Cash Transactions

Cash is a major focus in every restaurant audit. CDTFA compares:

• Reported sales vs. cash register totals
• Bank deposits vs. declared taxable sales
• Supplier invoices vs. expected food/drink output

If cash deposits appear low compared with industry ratios, CDTFA may infer skimming or unreported sales.

3. Failure to Properly Report Tax on Gratuities

Tips are one of the most misunderstood components of sales tax reporting.
Some tips are taxable. Some are not. It depends entirely on how the tip is structured.

CDTFA focuses on whether a restaurant correctly distinguishes between:

• Mandatory gratuities
• Automatic service charges
• Discretionary (voluntary) tips
• Pooled tips
• Credit card tips

Restaurants that fail to report taxable gratuities often face penalties and expanded audit scope.

Who Is Responsible for Reporting Tips?

Tip reporting involves a division of responsibility between the employer and the employee. Misunderstanding this division is another common audit trigger.

Employer Responsibilities

California restaurants must:

• Report taxable mandatory gratuities as part of gross sales
• Maintain accurate, contemporaneous records of tip distribution
• Track tip pooling and mandatory service charge allocations
• Ensure payroll tax compliance for reported employee tips

Employers must also comply with federal rules requiring them to allocate tips if reported employee tips fall below a certain percentage of sales (the “8 percent rule”).

Employee (or Contractor) Responsibilities

Employees are responsible for:

• Reporting tips they personally received
• Reporting their share of pooled tips
• Reporting cash tips that never entered the POS system

If a worker fails to report tips, CDTFA can still pursue the employer if the business lacked adequate verification procedures.

Are Contractors Responsible for Reporting Tips?

If a restaurant improperly classifies workers as independent contractors (e.g., banquet staff, delivery drivers, event servers), tip reporting becomes even more complicated.

CDTFA will examine:

• Whether these individuals should have been employees
• Whether the restaurant used “contractor status” to avoid payroll reporting
• Whether tip income was diverted from taxable wages

If the worker should have been classified as an employee, the employer is liable for the payroll tax associated with those tips.

This is another area where AB-5 and federal contractor rules intersect with CDTFA sales tax audits.

The OBBBA Gratuity Rules: What Restaurants Need to Know

The Opportunity for Better Business and Better Accountability Act (OBBBA) introduces new clarity around gratuities. When the law takes effect (expected implementation date pending regulatory completion), OBBBA will standardize how gratuities are treated.

Key OBBBA Gratuity Provisions

• Voluntary Tips Are Not Taxable
  If a customer independently chooses the tip amount, no sales tax applies.
• Mandatory Gratuities Will Be Taxable
  Service charges added automatically (common for large parties, banquets, resort fees, or delivery charges) will clearly remain taxable.
• Clear Disclosure Requirements
  Restaurants must differentiate between voluntary and mandatory charges on all receipts and menus.
• Greater Enforcement
  CDTFA will have more straightforward guidelines for reviewing gratuity categories during audits.

Why This Matters

The new rules eliminate ambiguity that has historically existed around service charges. However, they also increase the likelihood that CDTFA will enforce compliance aggressively once the framework is in place. Restaurants should begin preparing now by:

• Updating POS systems
• Training staff on tip vs. service charge distinctions
• Reviewing menus, contracts, and banquet agreements
• Ensuring gratuity categories are clearly labeled

Types of Sales Tax Audits Restaurants May Face

CDTFA conducts several types of audits, depending on the nature of the suspected issue.

1. Standard Sales and Use Tax Audit

The most common audit. CDTFA evaluates:

• Reported taxable sales
• Cash vs. credit card sales
• POS data
• Purchase records
• Tip reporting practices
• Bank deposits

2. Cash-Intensive Business Audit

Designed specifically for restaurants and hospitality businesses. CDTFA may:

• Recalculate sales using ingredient purchases
• Apply industry ratios to estimate true revenue
• Examine seating capacity, table-turn rates, or menu prices

3. Fraud or Intentional Underreporting Audit

Used when CDTFA suspects purposeful omission.
Consequences escalate significantly, including civil fraud penalties.

4. District Office or Investigator-Initiated Audit

Triggered by whistleblower complaints or observed irregularities.

How CDTFA Reconstructs Sales

If records are incomplete or inconsistent, CDTFA may use:

• Markup analysis
• Bank deposit analysis
• Cash flow reconstruction
• Observation-based estimates
• Purchase-to-sales ratio comparisons

Once CDTFA reconstructs sales, it becomes the business’s burden to disprove the agency’s numbers.

How to Reduce Exposure Before an Audit Expands

Restaurants can protect themselves by:

• Using a reliable POS system
• Reconciling cash daily
• Keeping detailed gratuity and service charge records
• Documenting tip pooling structures
• Matching bank deposits to daily sales
• Ensuring mandatory gratuities are properly taxed
• Reviewing OBBBA compliance now, before the rules take effect

Early evaluation of your books and practices is the best way to prevent a three-year audit from expanding into multiple years of assessments.

When to Contact Milikowsky Tax Law

If your restaurant has received a CDTFA notice, if tip reporting practices are unclear, or if you believe OBBBA rules may impact your operations, contact Milikowsky Tax Law for a confidential assessment.

Our team has decades of combined experience handling CDTFA, EDD, and IRS audits for California restaurants and hospitality businesses.