TABLE OF CONTENTS - · PDF fileTABLE OF CONTENTS PIZZA RESTAURANT Page ... Providence District, the initial screening process was undertaken by comparing gross receipts to purchases

TABLE OF CONTENTS

PIZZA RESTAURANT

Page

INTRODUCTION............................................. iii

CHAPTER 1 -- THE PIZZA INDUSTRY - SKIMMING, CASHPAYROLL, CASH PURCHASES.............................. 1-1

CHAPTER 2 -- SELECTION OF PIZZA ESTABLISHMENTSFOR EXAMINATION...................................... 2-1

CHAPTER 3 -- PREAUDIT.................................... 3-1

CHAPTER 4 -- INITIAL INTERVIEW ........................... 4-1

CHAPTER 5 -- EXAMINATION TECHNIQUES...................... 5-1

CHAPTER 6 -- CONFIRMATION OF PURCHASES................... 6-1

CHAPTER 7 -- OVERVIEW OF THE INGREDIENT MARKUPCOMPUTATION.......................................... 7-1

CHAPTER 8 -- PIZZA AND GRINDER LABORATORY TESTINGShopping Phase................................... 8-1

Laboratory Testing............................... 8-2

CHAPTER 9 -- COMPUTATION OF GRINDER AND PIZZA SALES

Pizza............................................ 9-1

Grinder.......................................... 9-2

Additional Considerations........................ 9-3

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CHAPTER 10 -- BEVERAGE COMPUTATION

Cans/Bottles of Soda and Beer.................... 10-1

Premix Soda...................................... 10-1

Draft Beer - Calculation for Kegs................ 10-1

CHAPTER 11 -- SECOND METHOD OF DETERMINING UNREPORTEDINCOME/PROOF OF SKIM..................................... 11-1

CHAPTER 12 -- RELATED EMPLOYMENT TAX ISSUES.............. 12-1

CHAPTER 13 -- INADEQUATE RECORDS NOTICE.................. 13-1

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INTRODUCTION

A project was conducted by the Providence District onthe pizza industry. Because pizza restaurants arebasically cash businesses, the potential for skimmingexists. The type of entities discussed in this guideare the family owned mom and pop types of establish-ments. The "chain" or "franchise" types of pizzaparlors are not addressed in this guide due to thenature of their operations, that is, the close controlmaintained by the franchise of these establishmentsdoes not lend itself to the approaches discussed inthis guide.

Overall, documentation of income and expenses in thisindustry has been found to be lacking. In mostinstances, the cash register tapes are not retainedand income is not deposited intact. There isgenerally little or no documentation to verify thegross receipts reported on the tax return. Purchasesare often paid in cash and the purchase invoices arenot kept. Employees are often paid in cash,sometimes, in order to avoid the payroll taxes.

The Providence district used the unit volume markupcomputation to attempt to overcome these obstacles.The project group found that it was necessary tocontact the pizza restaurant suppliers to obtain theoriginal purchase invoices on all identified cases.The ingredients purchased and used in the making ofpizzas and grinders were used to determine total pizzaand grinder sales.

Anyone considering the use of this technique shouldcontact their District Counsel prior to initiating anyaction in order to get Counsel’s opinion on using thisapproach. In any of these examinations, an attemptshould also be made to use a conventional indirectmethod such as a bank deposit analysis, net worthcomputation, source and application, etc. tocorroborate the amount of the understatement. Themost critical aspects to the success in this approachis the ability to document purchases and conduct adetailed interview with the owner of the business.

If feasible, use of a project coordinator will limitthe examiners’ time on the cases. The coordinatorwill be responsible for coordinating and overseeingthe entire project. Securing all third party invoicesand obtaining the laboratory testing results can bedone by the coordinator. The specifics on the audit

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procedures are discussed in more detail in latersections.

Note: The term "grinder" is used throughout thisaudit guide. The term grinder refers to the type ofsandwiches which are sold by pizza restaurants in theProvidence District. Grinders may be referred to as"submarines" or "hoagies" in other locations.

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Chapter 1

THE PIZZA INDUSTRY - SKIMMING, CASH PAYROLL, CASH PURCHASES

It has been suggested that skimming may be common inthe pizza industry. The Providence District’sexaminations support a finding that skimming ofreceipts and understatement of purchases in the pizzaindustry is not unusual. The task is to identify andexamine those pizza establishments in which skimmingtakes place to achieve greater compliance in theindustry.

Information obtained from various sources in Providencestrongly indicate that the practice of paying employees"off the books" is common in pizza restaurants.Moreover, purchases are often paid in cash with noinvoices or receipts to document the expenses.

By obtaining supplier invoices and compiling thequantity of ingredients purchased for the pizza andgrinder items, the number of pizza and grinder salescan be redetermined. Flour, sauce cheese, and grindermeats are all used in the computation. In addition,the total amount of pizza boxes and grinder rolls canbe used to support the computation.

Some pizza restaurants may be difficult to audit.Almost all of the restaurants encountered by theproject group were closely held entities with basicallyno internal control over cash. The group also foundthe pizza restaurant owners to be a tight knitcommunity. Information such as what questions and whattechniques the Service is using in audits would bequickly communicated through out the community.

In addition, the books and records maintained by manyof these pizza restaurants are not detailed orcomplete. Cash receipts book often consists of a sheetof paper with a summary of 12 months sales. Manytimes, the preparer uses the sales reported on the 12sales tax returns, with no other backup. Therestaurant usually keeps the cash register tapes longenough to determine if the employees are stealing, thenthe tapes are destroyed.

Examinations have also revealed that several taxpayerstook cash out of the drawer without reporting theamount as income. There is virtually no audit trail todetermine the amount of funds spent for business andpersonal expenses. When it is time to make a deposit,some taxpayers would pocket some of the cash and

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deposit only that portion necessary to cover thoseexpenses to be paid by check. It was found in manycases that business expenses as well as personal livingexpenses were paid with cash taken from the cashdrawer. Audits in Providence have uncovered as much as$700 per week in cash being taken out of the cashdrawer.

Furthermore, the project group also found that manypizza restaurant owners are aware of the Government’sneed to establish certain facts to fully develop theunreported income issue. Most of the individualsencountered by the project group appeared to livemodestly with no apparent great accumulation of assets.Therefore, examiners should be alert to look beyondthis to develop the underreporting income issue.

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Chapter 2

SELECTION OF PIZZA RESTAURANTS FOR EXAMINATION

The starting point is to identify all pizza restaurantsin your area. This can be done by using the telephoneyellow pages. However, this can be a time consumingtask. If there are quite a few pizza establishments inthe area, it may be necessary to use a service thatprovides this type of information.

American Business Lists Inc ., is a company whichcompiles a list of all businesses by industry.American Business Lists will provide a list of allpizza restaurants in your specific area. The listingnot only indicates the restaurants by location, butmore importantly indicates the owner of the business.

A catalog can be obtained by calling or writing:

American Business Lists5711 South 86th CircleP.O. Box 27347Omaha, Nebraska 68127(402) 331-7169FAX (402) 331-1505

Once the pizza establishments and their owners havebeen determined, the next step is to use IDRS to securethe EIN of the businesses and the SSN for theindividual owners. Secure a transcript of the accountand whenever possible request a RTVUE for each return.This is the first attempt in eliminating those returnsthat reflect little or no audit potential. Obviously,you want to secure those returns which show thegreatest audit potential. The actual securing of theoriginal returns can be accomplished by working jointlywith the Planning and Special Programs Chief in theDistrict. When the list of returns is prepared, theChief-PSP can expeditiously requisition the returnsusing special project codes.

The original tax returns should be screened. In theProvidence District, the initial screening process wasundertaken by comparing gross receipts to purchases.Also considered were factors such as adjusted grossincome relative to taxpayer’s family size, largeincreases in interest income, very low or no netprofit, location of the pizza parlors, that is,neighborhood characteristics and seasonable variations,and any other classification techniques to identify the

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cases with the best audit potential. Additionally, itis important to secure and screen the shareholder’sreturns for each targeted corporation for potentialindications of unreported income.

Once the targeted cases were identified, these caseswere separated into several examination phases. Byusing several staggered phases, the project was moremanageable and easier to monitor.

Because the Providence District covers a smallgeographical area, canvas letters were sent to allknown pizza restaurant suppliers in the R.I. area. SeeExhibit 2-1. This information was very helpful in thescreening process. If the purchases amount per thethird party suppliers exceeded the purchases claimed onthe tax return, there was an apparent problem thatwarranted explanation. In addition, there weresituations where the owner destroyed all of thepurchase invoices for a particular supplier and did notclaim a deduction for purchases from that supplier. Bycanvassing all of the known suppliers in the area,these situations were discovered. This scheme probablywould not have been detected without contacting all ofthe suppliers.

Obviously, the geographical size of the district willdictate the feasibility of sending this letter. It maybe impossible to canvass all suppliers in the largerdistricts. Therefore it may be more practical toobtain a list of suppliers from each agent so onlythose suppliers will be contacted.

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Exhibit 2-1 (1 of 2)

Internal Revenue Service Department of TreasuryDistrict Director

Person to Contact

Telephone Number:

Refer Reply to:

Date:

The ___________District is now beginning Phase______of the Pizza Project. Wehave now identified approximately______pizza restaurants that we are interestedfor this phase of the project.

Information is requested relative to the total amount of sales made by you tothe attached list of establishments. Your help in connection with an officialinvestigation concerning these taxpayers would be appreciated.

Please enter on the attached worksheet the total sales made to eachestablishment for the years indicated. If no sales were made to theestablishment, please enter a "-0-" next to the name of this business.

A Self-addressed envelope is enclosed for your convenience. Please return theenclosed worksheet by______________. If you cannot meet this deadline, pleasenotify me as soon as possible and the necessary arrangements can be made.Failure to respond will result in the immediate issuance of a summons. Youshould direct any inquiry to Revenue Agent________________________.

We are making this request under the authority of Section 7602 and 7609 of theInternal Revenue Code. The information you furnish will be held in strictconfidence.

Thank you for your assistance in this inquiry and if you have any questions,please feel free to contact me.

Very truly yours,

REVENUE AGENT

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EstablishmentName and Address 1990 1991 1992 1993

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Chapter 3

PREAUDIT

Exhibit 3-1 is a copy of the suggested Initial Pizza RestaurantInformation Document Request. It is very important to requestthis information prior to the initial interview.

The Initial Pizza Restaurant IDR appears to be lengthy and canseem to be intimidating, but it is necessary that thisinformation be obtained early. Requesting this informationprior to your first visit will make for a faster and moreefficient audit. It is important that the books and recordsused to prepare the tax return are available at the firstmeeting. The purchase invoices should also be available so theycan be fully analyzed. Make sure that the taxpayer has a menuavailable at this meeting so that the menu prices can be clearlydetermined. These prices will prove to be important later inthe examination.

It is crucial to analyze the business and personal bankaccounts, tracing all the nontaxable sources of income. It isimportant that a detailed analysis be performed during theinitial stages of the examination. An accurate and completeinitial IDR will expedite the examination and provide for a morethorough initial interview.

The examining agent’s preaudit should consider the followingsteps:

1. Cash T at the owner/shareholder level.

2. Use of other available sources to verify income such asForms 8300, TECS inquiry, IRP’s, and CID information items.

3. Use of public record sources such as city and town halls,Registry of Motor Vehicles, Secretary of State, and BusinessCumulative Index (B.C.I.).

4. Emphasis should be on sales/income, cost of goods sold andinventory.

5. Payroll expense and only large and extraordinary expensesshould be identified.

6. Request copies of all related and subsequent returns notincluded in the package.

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7. When requesting IRP documents, request current andsubsequent years.

8. Whenever possible, contact the State Division of Taxationfor any state sales/income tax examination reports.

Obviously, it is very important to be as prepared aspossible for the initial interview.

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***************************************************************INITIAL PIZZA RESTAURANT

INFORMATION DOCUMENT REQUEST***************************************************************

DOCUMENTS REQUESTED

Please have the following documents ready for our initialappointment.

1. A copy of tax returns for the years 19__ and 19__.

2. A copy of related returns.

3. A copy of the payroll tax returns (four Forms 941 and oneForm 940) for the year 19__.

4. Current year Forms W-2 and Forms W-4. A copy of the Forms1099 issued for 19__.

5. Workpapers of schedules used in preparing the tax return.

6. Books and tax records relating to your income, expenses,and deductions.

-- A copy of the income portion of your books and recordsfor the year(s) under examination.

7. All purchase invoices.

a. Attempt to have the invoices separated by vendor.

b. Request a listing of all cash expenses.

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8. For business and personal bank accounts, brokerage and moneymarket accounts, provide statements, cancelled checks,deposit slips and check registers for the period December19__ through January 19__.

a. Please take the bank statements out of the envelopes, andarrange them in chronological order. Separate thestatements from the cancelled checks.

b. List transfers between bank, brokerage and money marketaccounts. Document all transfers.

9. Documents concerning loans and loan repayments if theyoccurred in the year(s) under examination.

10. Information on all nontaxable income (for example, gifts,interest on municipal bond, inheritance, etc.)

11. Documents concerning the purchase, sale or exchange of realestate or personal property for 19__.

12. Personal living expense statement completed for 19__.

a. Please distinguish between expenses paid by cash versuscheck.

b. Credit card statements for the year(s) under audit.

13. A list of business expenses paid by cash for the year(s)under audit.

14. Documentation concerning business capital expenditures,such as pizza ovens, equipment etc. made during the yearunder audit.

15. A menu showing all items sold at the pizza restaurant.(Copy of the current menu as well as the menu used duringthe year under audit.)

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Chapter 4

INITIAL INTERVIEW

The initial interview is very important in these casesbecause of the lack of an audit trail and the poorrecordkeeping. It should be stressed that accuratedocumentation of the initial interview is critical.

Use the Pizza Questionnaire to establish how the pizzarestaurant is operated. (See Exhibit 4-1.) Thesequestions are important and should be covered during theinitial interview or as early in the examination aspossible. These questions will give the examining agentan overview of the pizza restaurant’s day to dayactivities. When using the list of suggested questions,keep in mind that while the list is not all inclusive, atthe same time, not all questions would be appropriate toask in all cases. The examiner should only ask thosequestions that are relevant and necessary to properlydevelop his or her case.

A contemporaneous record of the questions and answersshould be made during the initial interview to establishthe facts. Therefore, during the initial interview, theagent should ask the taxpayer to verify the accuracy ofthe information and not wait until the audit is nearcompletion. The contemporaneous notes from the initialinterview can be relied on in the resolution phase of thecase, when the agent and the taxpayer are clarifying theincome issue and related factual discrepancies. Theanswers to many of these questions are critical later inthe examination, when the ingredients markup computationis prepared.

Request that the taxpayer (owner/operator) be present atthe initial interview. This is important because thereare questions that only the pizza restaurant owner cananswer. If there is a power of attorney filed, it shouldbe stressed that the taxpayer be present for the initialinterview because most questions can only be answered bythe person responsible for day-to-day operations.Experience shows that most representatives do not havefirst hand knowledge about the actual operation of therestaurant.

At the initial interview, obtain a copy of the menu andreview the prices of all menu items with the taxpayer.Identify the big selling items. If it is impossible toget a menu for the tax year under examination, review acurrent menu with the owner to determine price changesand fluctuations between current and old menus. Make

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the appropriate notes and clarify any discrepanciesbecause the selling prices are critical to the unit volumemarkup computation. When there are no old menusavailable, contact the company that printed the menu.Often, the printer keeps copies of the old menus.

Review the Statement of Annual Estimated Personal andFamily Expense (Form 4822) with the taxpayer at theinitial interview. Be sure that the taxpayer clearlyunderstands the form and completes it properly to avoidthe argument that the taxpayer did not fully understandthe form. Determine exactly what expenses were paid withcash and which were paid by check. Attempt to determineat this point exactly how much cash the owner takes fromthe cash drawer to pay personal expenses.

Prepare a detailed listing of purchase invoicesdetermining how they were paid, cash or check. Accountfor the possibility of missing invoices. Review supplierswith the pizza shop owner, and determine what products arepurchased from the various suppliers. This may appear tobe a time consuming task, but agents have discovered manygood issues through this technique. The followingscenarios illustrate this point:

1. The examiner questioned the owner about his suppliersand noted that there were no deductions for sodapurchases. The taxpayer stated he had nothing to dowith the soda machine. By contacting the sodasupplier, it was determined that taxpayer had madesoda purchases and had not reported income from thesoda sales.

2. The examiner noticed that certain ingredients were notreflected on the purchase invoices. In addition,there were missing invoices. From the originalinvoices received from the supplier, it was determinedthat the owner understated purchases by over $ 50,000.This was done to camouflage the skimming by keepingthe gross profit percentage in line.

The pizza boxes will be a factor in the unit volume markupcomputation. Establish where the owner is purchasingpizza boxes.Also, confirm where the taxpayer purchasesgrinder rolls. Ask the owner approximately how manygrinder rolls are delivered each day because therestaurants receive relatively standard orders daily.Some taxpayers have used the defense that they return dayold bread to the bakery. The bulk of the bakeries inProvidence area stated that this is not the case becausethe markup is so low on the rolls. (This should beverified in each district if grinder

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rolls are going to be used as a factor for incomereconstruction.) The bakers state that they would be outof business if this was the practice. Attempt to tie downthe amount of grinder rolls purchased during the earlystages of the examination. The grinder rolls purchaseswill be used to confirm the reconstructed grinder salescalculated using the ingredient markup method.

Another thing that should be done is to tie down exactlyhow many pizzas can be made out of 100 pounds of flour.Determine during the initial interview exactly what pizzaingredients the owner throws away due to spoilage. If theowner insists that there is a spoilage factor, questionhim/her about each ingredient during the early phase ofthe audit and agree on the amount of spoilage. Have theowner walk you through the complete pizza making process.If the owner makes dough balls, determine how many doughballs are made each day. Get the specifics as to exactlyhow much spoilage there actually is and why the productcould not be sold. The suppliers have indicated thatthere is very little spoilage with flour. Generally,flour deliveries are pretty much standard orders in thepizza business. The owner knows exactly how much flour isneeded to make the dough for the day-to-day pizza orders.Damaged bags of flour may be easily replaced by thesupplier.

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QUESTIONNAIRE

***************************************************************

THE FOLLOWING IS AN OUTLINE OF SUGGESTED QUESTIONS FOR THEINITIAL INTERVIEW OF PIZZA RESTAURANT OWNERS. (Note: Whilethe list is not all inclusive, at the same time, not allquestions listed are warranted in every case. Examiners shoulduse the following as a guide, and ask only those questions thatare appropriate for their specific case.)

***************************************************************

HISTORY:

1. Where is the taxpayer from?

2. How long has the taxpayer been in business?

3. How did the taxpayer get started in the business?

4. Where did taxpayer get capital to start business?

5. Who did the taxpayer purchase the business from?When? Cost?Obtain a copy of the sales agreement.

6. Exactly what assets were purchased? Goodwill?

7. Do relatives work in the restaurant?If yes, obtain names and relationship to taxpayer.

8. Does the taxpayer own or rent the restaurant space?

9. Does the restaurant owner own his/her own home?

10. How much are the rent/mortgage payments:

a. For the restaurant?

b. For the home?

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11. Does the taxpayer own any other businesses?

12. What type of records are available?

13. Are there separate bank accounts for business andpersonal?

- Identify all accounts.

14. Who keeps the books and records?

15. What information is sent to the accountant?

16. Does the taxpayer have control over any foreignbank accounts? If so, where?

17. Does the taxpayer own property outside the UnitedSates? If so, where?

BUSINESS ACTIVITIES

1. Ask the taxpayer to describe the business:

a. Number of days a week open?

b. Hours open?

c. Does the restaurant close for vacation?

d. Who works & how many employees?

e. What are the responsibilities of each employee?

f. Does the taxpayer pay the employees in cash?

g. Percentage of takeout versus eat in business?

h. Pizza sales versus grinder sales?

i. Are there good/bad times during the year? When?

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2. Are all receipts deposited and to which account?

3. Are cash register tapes used and maintained?

4. Does the taxpayer sell beer or wine?

5. Does the taxpayer sell soda in cans or throughmachines using syrup and water?

6. What are good and bad selling items on the menu?

7. By going down through the menu carefully, questionthe taxpayer about ingredients and the amounts usedin the preparation of each item on the menu?

a. Pizza

1) Ask about the sizes of the pizzas sold.

2) What type of cheese is used on the pizzas?

3) What pizza ingredients does the taxpayerthrow away due to spoilage? If spoilage isclaimed, what ingredients and how much?

4) Why couldn’t the product be sold?

5) Approximately how many pizzas can be madeout of 100 pounds of flour?

6) How many dough balls are made each day?

b. Grinders

1) Where does the taxpayer purchase grinderrolls?

2) How many grinder rolls are delivered eachday?

3) What are the sizes and types?

4) What ingredients are subject to spoilage andthe percentage?

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5) Which grinders sell the best?

6) What goes into the grinders? (Amounts/ozs.)

7) What sizes are used for rolls? (be sure toask if the taxpayer is buying larger rollsand cutting them down for sandwiches orbuying the small rolls.)

c. Drinks

1) Ask about the sizes of the drink cups.

2) Which size is sold the most? (Small,medium, large.)

8. Who are the suppliers of the ingredients?

9. Ask the taxpayer what products are purchased fromthe various suppliers?

10. Does the owner call suppliers or do they contacthim/her?

11. Where does the taxpayer purchase the pizza boxes?

12. Does the taxpayer make purchases in cash? If so,how are these accounted for?

13. Does the taxpayer take cash out from the register topay expenses?

- If so, what are those expenses and how are theyaccounted for?

14. Question taxpayer about their video vending machineincome:

a. Who does the taxpayer rent their machines from?

b. Does the taxpayer own any machines?

15. Are there any cigarette machines?

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Chapter 5

EXAMINATION TECHNIQUES

In general, the examination of a pizza restaurant taxreturn is not much different than other examinations.The examiner will often find little or no internalcontrol. Many times, there would be few recordsavailable, and sometimes no records at all. Before thealternative method is used, you first need to establishthe inadequacy of the taxpayer’s books and records.This would necessitate the issuance of an inadequaterecords notice.

It is not uncommon for the pizza restaurant owners toregularly pay expenses with cash. This often results inlittle or no paper trail. Invoices are often notretained requiring the need to obtain third partysupplier invoices. Some owners have indicated that theydo not deposit the daily gross receipts intact. Someowners even have acknowledged taking cash from the cashregister to pay personal expenses.

It is crucial that the agent perform a detailed analysisof gross income and purchases to show that the recordsare unreliable. It is important to show that a materialitem on the tax return is incorrect and therefore, anindirect method of proving income should be used. Thefollowing situations are indications of poor salesrecords.

1. Gross receipts on the tax return come from monthlysummary sheets. The amounts are all even, roundamounts with no further backup.

2. Gross receipts per return come from monthly salestax returns filed with the state. The sales taxreturns are the only records of gross receipts.

3. Taxpayer computed receipts based on deposits to thebank accounts, yet failed to report the depositsmade to personal accounts and cash payouts.

4. Taxpayer has absolutely no documentation to supportthe income reported on the tax return.

These are all examples of the poor records furnished toexamining agents. Document the reasons why the methodused by the taxpayer to determine income is unreliable,requiring the use of an alternative method. Aninadequate records notice should be considered in allcircumstances where the records are deemed inadequate.

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See the chapter on inadequate records notices.

In addition to gross receipts, agents should concentrateon the cost of sales section, identifying the suppliersof the pizza and grinder ingredients.

The project coordinator, or if there is no projectcoordinator, the agent can then contact the third partysuppliers and obtain the original invoices. Theoriginal invoices will then be used as the sourcedocuments for the unit volume markup computation.

More importantly, the agent should look for thefollowing:

1. Personal living expenses well above reported income

2. Assets acquired possibly with skimmed receipts

3. Accumulation of funds in various bank accounts withno reported income

4. A low gross profit percentage

5. Assets such as automobiles, personal residence,etc., could be indications of unreported income

6. Other lavish expenses with no nontaxable source ofincome.

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Chapter 6

CONFIRMATION OF PURCHASES

Each examiner is responsible for identifying theindividual suppliers for the purchases claimed on thetax return. Using a supplier feedback sheet similar toExhibit 6-1, the agent will summarize the purchasesclaimed on the tax return by the supplier. Thisinformation will then be compared with the actual thirdparty supplier confirmation amounts. The projectcoordinator or agent will be responsible for contactingthe vendors to confirm purchases.

The agent will either secure taxpayer copies of thepurchase invoices or photocopy them, but only if adetermination can be made that the invoices can berelied on. If there are no taxpayer invoices availableor a large portion of the invoices are missing, theproject coordinator or agent should secure the originalinvoices from each third party vendor.

To confirm purchases, a summons may be used. Onesummons can be issued to each supplier to cover allcases in the project. This is much more practical thanhaving several agents contacting the same supplier.

The original invoices are crucial in the preparation ofthe ingredient markup computation. The ingredients usedin the making of the pizzas and grinders will be inputfrom these original invoices. When the agent determinesthat the records are poor and the purchase deduction onthe tax return is incorrect, consideration should begiven to securing the third party invoices as soon aspossible for use in the unit volume markup computation.

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Exhibit 6-1

SUPPLIER FEEDBACK SHEET

PIZZA ESTABLISHMENT AGENT

19__* 19__*TOTAL PURCHASES PER RETURN

TOTAL GROSS RECEIPTS PER RETURN

INDIVIDUAL SUPPLIER AMOUNTS(SUPPLIER NAME)

TOTAL PURCHASES=========== ============

DOES THE TAXPAYER HAVE ANY PURCHASE INVOICES? YES ( ) NO ( )

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Chapter 7

OVERVIEW OF THE INGREDIENT MARKUP COMPUTATION

The ingredient markup computation is an indirect methodused to reconstruct the gross receipts of the pizzarestaurants. It is important to stress that this methodis not intended to be used on all cases but rathershould be considered once it has been determined thatthe taxpayer’s financial books and records cannot berelied on.

Treas. Reg. section 1.446 authorizes the IRS to computeincome in accordance with whatever method that clearlyreflects income, where the taxpayer keeps no records, orthe financial records are inadequate and unreliable.The percentage or unit volume method has been consideredan acceptable method of proving income in Tax Court. Inaddition, the Tax Court has allowed the use of thirdparty supplier records in ascertaining the cost of goodsand the gross profit resulting from business activitieswhere the records are inadequate.

In Maltese v. Commissioner , T.C. Memo. 1988-322, the TaxCourt ruled in favor of the Internal Revenue Service,where the taxpayer failed to keep adequate records forthe pizza restaurant’s sales, cost of sales, andexpenses. Not all of the restaurant’s receipts weredeposited and some of the expenses were paid in cash.The court held for the Service where the IRS usedsupplier information to reconstruct the income. The IRSdetermined corrected gross receipts from the estimatednumber of pizzas which could be made from the amount offlour purchased during the years in question.

Although the court held for the Service, it criticizedthe failure to compare the pizzas sold by the taxpayerwith those sold by retail chains that provided theinformation on which the reconstruction was based.Accordingly, use of this method must be supported bycareful documentation of the quantity of flour thetaxpayer would need to produce a given number of pizzas.

Using this theory, the supplier invoices were obtainedfor all pizza restaurant cases where the taxpayer’sfinancial records were poor or the records did notexist. The total amount of flour, sauce and cheesepurchases were determined and used in the computation.Also the supplier invoices were obtained for the

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grinder meats being purchased so that total grindersales could also be estimated.

An additional step was taken in the project group’singredient markup computation. A large and a smallpizza were purchased from the restaurant and sent to afood testing laboratory to be weighed and analyzed. Thelaboratory was able to establish the total weight of theflour, sauce and cheese that went into each pizza foreach restaurant. Various large and small grinderslisted on the menu were also purchased and analyzed atthe laboratory. The lab was also able to furnish thetotal weight of the meats in each grinder.

Gross receipts were reconstructed from the estimatednumber of pizzas and grinders which could be made fromthe ingredients purchased. The reconstruction of grossreceipts also included soda and beer sales. Based onthe information obtained from the beverage distributors,the total beer and soda sales could be calculated.

Remember, this computation considers grinders and pizzasales only. This calculation does not take intoconsideration other types of meals such as spaghettidinners, fish and chips, salads, and any other dinners.These additional dinners would only serve to increasethe reconstructed gross receipts. For this reason, theingredients markup computation is a very conservativeapproach in the reconstruction of the gross receipts.This point should be stressed in defending thiscomputation because gross receipts could be much higherif the dinners were considered.

The project group found these assumptions to be valid inthe Providence District, and believe they may be validin other districts as well. To properly develop yourcase, however, you will need to establish and documenttheir validity in your area and with the particularrestaurant under examination.

It is recommended that the examiner consider atraditional indirect method to further substantiate theingredient markup computation. Consideration should begiven to using the bank deposits, net worth or someother indirect method to prove that the taxpayer isskimming the cash and the disposition of these funds.This will be discussed further in Chapter 11.

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Chapter 8

PIZZA AND GRINDER LABORATORY TESTING

SHOPPING PHASE

The next step in the process is to actually purchase thepizzas and grinders and have the samples tested at thefood testing laboratory. Contact the food analysislaboratories listed in your local telephone yellowpages. These laboratories will actually do thenecessary testing to establish the actual weight of theingredients in each sample.

The "shopping phase" is quite simple. A large and asmall plain cheese pizza should be purchased. Fortesting purposes, the laboratory prefers that the pizzabe slightly cooked, therefore ask for the pizzapartially cooked. The laboratory will be able toseparate and weigh the flour, sauce and cheese for thatpizza. There is a heating test done on the crust of thepizza to determine the dry weight of the dough. This isthe actual weight of the flour used in the process.

A small and large plain cheese pizza must be purchasedand tested so that the "average weight" can be used inthe unit volume computation. The average weight is usedto avoid the argument that more large pizzas than smallor vice versa are sold.

The same should be done for each grinder listed on themenu. A small and large grinder should be purchased andsent to the laboratory for testing. The laboratory willdetermine the actual weight of all the meats in thegrinder.

Certain additional factors should be considered.

1. Purchase a large and small plain cheese pizza. Donot purchase any toppings on the pizza. This againis a conservative approach because toppings wouldonly increase the selling price of the pizza.

2. Purchase the grinders with no oils, mayonnaise,mustard, melted cheese or any other items whichcould affect the weight of the grinder meats.

3. Once the samples are purchased, they must bedelivered to the laboratory the same day .

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4. Maintain an accurate inventory of the samplestested.

5. The custody and control of the samples is critical.The Providence District used a custody control sheetfor all food samples delivered to the lab (SeeExhibit 8-1). Record on the control sheet thefollowing information:the type of sample purchased,the date and time of the purchase and the date andtime the sample was delivered to the laboratory.Have an official from the laboratory sign thecustody sheet.

LABORATORY TESTING

The laboratory will test each sample and determine theactual weight of the flour, sauce and cheese in eachpizza. The weight of each type of grinder ingredientwill also be calculated by the laboratory. TheProvidence District used Microbac Laboratories for theirtesting.

Microbac Laboratories can be contacted at:

Microbac Laboratories Inc.202 Bussey StreetDedham, Massachusetts 02026617 326-7117

The Microbac Laboratory listed above is the New Englandsubsidiary. (See Exhibit 8-2 for other MicrobacLaboratories located elsewhere in the country. Pleasenote that Microbac is just one of many laboratories thatcan provide food analysis services. Consult yourtelephone directory to locate the most convenient one.)

The laboratory will summarize the test results in areport form. The report will tell you the weight of eachof the main ingredients of the samples submitted. Forexample, for a pizza, the report will show the weightof the entire pizza, the weight of the cheese, theweight of the sauce, the weight of the crust, thepercentage of solids and the weight of dry ingredientssuch as flour. For each individual sandwich sample, thereport will show the size of the bun (in inches), weightof the bun, the weight of the meat, and the weight ofthe cheese.

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EXHIBIT 8-1

CUSTODY CONTROL SHEET

SAMPLE NUMBER:_____________________

ITEM PURCHASED:_____________________

DATE SAMPLE PURCHASED:______________

TIME SAMPLE PURCHASED:______________

LOCATION OF PURCHASE:_______________

AGENT PURCHASING THE SAMPLE:_________________

DATE TRANSPORTED TO____________ LABORATORIES:__________________

TIME DELIVERED TO LABORATORY:__________________

TEMPERATURE DURING TRANSPORTATION TO LAB:_________________

RECEIVED BY _________________ LABORATORIES:

DATE:

TIME:

SIGNATURE:

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3149-106 8-4

Exhibit 8-2

LISTING OF MICROBAC LABORATORIES

MICROBAC LABORATORIES, INC. SEAWAY LABORATORY DIVISIONHome Office & Laboratory 542-544 Conkey Street4580 McKnight Road Hammond, IN 46324Pittsburgh, PA 15237 (219) 932-1770(412) 931-5851

MICROBAC ENVIRONMENTAL LABORATORYSCHILLER LABORATORY DIVISION P. O. Box 49449 Rochester Road Fayetteville, NC 28301Pittsburgh, PA 15237 (919) 864-1920(412) 369-1830

MICROBAC MID-ATLANTIC INCERIE TESTING LABORATORY 12650 McManus Blvd.2411 West 26th Street Suite 4Erie, PA 16506 Newport News, VA 23602(814) 833-4790 (804) 874-4930

NEW CASTLE LABORATORY SENATE ANALYTICAL LABORATORY DIVISIONR.D. #3 U-ParcPulaski Road 545 William Pitt WayNew Castle, PA 16105 Pittsburgh, PA 15238(412) 654-4212 (412) 826-3700

KENTUCKY TESTING LABORATORY J-LABS Inc.1121 West Broadway P. O. Box 489Louisville, KY 40203 Bradford, PA 16701(502) 583-5256 (814) 368-6087

MASSACHUSETTS TESTING LABORATORY TAYLOR-MILK COMPANY202 Bussey Street 348 Merchant StreetDedham, MA 02026 P. O. Box D(617) 326-7117 Ambridge, PA 15003

(412) 266-9334MICROBAC HANOVER DIVISION701 Third Street MICROBAC INGOMAR DIVISIONHanover, PA 17331 P.O. Box 368(717) 633-6011 Harmony Drive

Ingomar, PA 15127JOHNSTOWN LABORATORY DIVISION (412) 364-4820P.O. BOX 1447JOHNSTOWN, PA 15907-0447(814) 266-9548

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3149-106 8-6

Chapter 9

COMPUTATION OF GRINDER AND PIZZA SALES

As discussed earlier, the total number of pizzas andgrinders sold can be determined from the amount ofingredients purchased, and the restaurants incomecan, therefore, be reconstructed.

The following explains the steps in thereconstruction of pizza and grinder income.

PIZZA

1. Determine the total number of pounds of flour andcheese purchased and the number of cans of pizzasauce purchased.

2. Multiply the total number of pounds of flour andcheese by 16 to calculate the total number of ouncesof flour and cheese, respectively.

3. Multiply the total number of cans of pizza sauce by105 ounces (the total number of ounces in a #10 sizecan).

4. Divide the total ounces of flour, sauce and cheesepurchased by the respective average weight of eachingredient per laboratory results.

5. The result is the total estimated number of pizzassold based on flour, cheese or sauce purchased. Thethree methods (flour, cheese or sauce) shouldclosely approximate pizza sales and should berelatively close. Attempt to use the lower, moreconservative number of pizzas sold. If there is alarge discrepancy between the three methods, thereis a chance that not all of the suppliers have beenidentified, or possibly some products were purchasedwith cash.

6. Multiply the units sold by the average menu price ofa large and small cheese pizza to arrive at pizzasales.

Example 1

Assume that the purchases for flour, cheese, andsauce were 12,000 lbs., 9,000 lbs., and 800cans (#10 size), respectively. Also,

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laboratory testing of one large and one smallpizza found the average weight of the flour,cheese and sauce were 9.5, 7, and 4 ouncesrespectively. The average menu price for pizzais $6.

Flour Cheese SaucePurchases 12,000 9,000 800Converted to

ounces x 16 x 16 x 105

Total Ounces 192,000 144,000 84,000

Divide byAverage Weight 9.5 7 4

Total Units Sold 20,210 20,571 21,000

Since the discrepancy here is not substantial,continue with steps 5 and 6.

Take the lowest of the three results, in this casethe amount is 20,210 units, and multiply thetotal units sold by the average menu price forpizza.

Total Estimated Pizza Sales =

20,210 units x $6 = $121,260========

GRINDER

The following steps should be performed on each type ofgrinder.

1. Determine the total amount of the grinder meatpurchased.

2. Meat purchases are normally stated in pounds.Convert to ounces by multiplying the number ofpounds by 16.

3. Obtain the average weight of the large and smallgrinder determined by the food testing laboratory.Divide the total ounces of meat purchased by theaverage calculated weight of each sample to arriveat the number of grinders sold.

4. Multiply the total number of grinders sold by theaverage menu price. The average menu price is theaverage price of the small size and the large sizegrinders.

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5. The result is the estimated amount of income forthat type grinder.

Example 2

Assume 500 pounds of roast beef was purchased.Laboratory testing show the average weight ofthe meat in a grinder is 5 ounces. The averagemenu price for a roast beef grinder is $4.

Meat Purchased 500 lbs.

Convert to ounces x 16----------

Meat in ounces 8,000

Divide by Average weight 5----------

Grinder sold in units 1,600

Average menu price x 4----------

Roast Beef Grinder Sales $ 6,400===========

ADDITIONAL CONSIDERATIONS

1. If a supplier accepts cash for the purchases and theslip is made out to cash, there is no way the thirdparty can identify who made the purchase. Thoseingredients may have an impact on the computation.It is very common in this industry that if you paywith cash, then you get a better price. If thetaxpayer does purchase items with cash, keep this inmind. Secure the taxpayers copies of the cashinvoices so that these ingredients can be consideredin the computation.

2. SPOILAGE - Generally, a reasonable spoilage factorshould be allowed (a 10 percent spoilage factor wasallowed by Providence). Attempt to determine aspoilage factor during your discussions with theowner.

3. PRICING - Use the menu price for the year underexamination. Compute the average price of a largeand a small item. In the event that an old menu cannot be obtained, use a current menu. Discuss theprice fluctuations between the old and new priceswith the restaurant owner to come up with aninflation factor to back into the old menu prices(Providence had allowe d a 6 percent price

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adjustment in their project). For pizza prices, usethe lowest priced plain cheese pizza in thecomputation. The toppings on the pizzas are notconsidered. If the taxpayer argues that thetoppings should be considered, this will only serveto increase the income computation. There is lessmeat used as a topping on the pizza than if the meatis used in the grinder. Some pizza restaurantscharge as much as a dollar more for each pizzatopping added. Therefore, the more conservativeapproach is to consider the meat as used in thegrinders as opposed to a pizza topping. (Each pizzarestaurant should be asked which produces the highermark-up meat pizzas or grinders.)

4. Use the box computation and compare the number ofboxes purchased to the number of pizzas sold. Thepizza boxes purchased should support the recomputedpizza sales. The eat in versus takeout ratiodetermined in the initial interview should also beconsidered.

5. Use the grinder rolls calculation to support therecomputed total grinder sales.

Remember, the raw ingredient markup calculation may notbe warranted in every case. Evaluate the internalcontrol of the restaurant. Evaluate the books andrecords used in the preparation of the tax return.Evaluate the taxpayer’s financial status in relation tothe reported income. Consideration should be given touse of this method where there is a strong possibilityof skimmed income, or if the taxpayer maintains norecords and the purchase invoices are not available orif no tax returns were filed. Most of all, use thismethod in conjunction with the more conventionalindirect methods to determine the amount of the skimmedincome and the disposition of the skimmed income.

3149-106 9-4

Chapter 10

BEVERAGE COMPUTATION

CANS/BOTTLES OF SODA AND BEER

The beverage suppliers will confirm the total units ofsoda and beer purchased. Generally, the products arepurchased by the case, 24 units per case. Determine theselling price of the soda and beer. Next, project thetotal sales of soda and beer by multiplying the numberof cans purchased by the unit selling price.

PREMIX SODA

Premix soda is purchased by the tank. Each tankcontains 5 gallons of syrup. The ratio of soda water tosyrup is 5 to 1.

The following computation is necessary to establish thenumber of servings per tank of syrup.

1. 1 tank = 5 gallons of syrup5 tanks = 25 gallons of soda water

30 gallons of product

2. 128 oz. / gal x 30 gallons = 3,840 ounces

3. If the establishment’s average cup size is 12ounces, the quantity actually dispensed will be 10ounces per serving. (The examining agent must becareful to document the basis for this assumption.)

3,840 ounces divided by 10 ounces = 384 servingsper tank

When considering this computation, remember toconsider ice and waste using a conservative approachin the calculation.

DRAFT BEER - CALCULATION FOR KEGS

Draft beer is sold by the one quarter keg and one halfkeg. A one quarter keg contains 992 ounces of beer. Aone half keg contains 1,984 ounces of beer. The beerdistributors calculate that there are approximately 190glass servings per one half keg and 93 servings from aone quarter keg. This accounts for the foam andspillage which is common with draft beer. (This may

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depend on local practice and needs to be documented bythe examining agent.)

Remember, only beer and soda sales are considered in thebeverage computation. If the establishment sells wine,liquor, juices or coffee, this would only serve toincrease the beverage sales.

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Chapter 11

SECOND METHOD OF DETERMINING INCOME/PROOF OF SKIM

Although the unit volume computation indicates thepossibility of skimmed income, the use of anothertraditional indirect method would help to confirm thefact that the owner is skimming. Consider the use of anaccepted indirect method of proof such as a bankdeposits analysis, source and application, net worth orany other method to support the unit volume calculation.Attempt to look beyond the books and records. Considerfactors such as the purchase of assets, the taxpayer’sfinancial status, the lack of a salary or draw from thebusiness, to determine which method should be used. Thenegligence and/or substantial understatement penaltyshould be considered based on the facts andcircumstances of each case. Coordinate with the FraudCoordinator if the unit volume computation showssubstantial amounts of unreported income and thedisposition of the skimmed income can be documented.

A third party source told the Providence project groupthat it is not uncommon for pizza owners to take moneyout of the country. However, to prove that the owner orhis or her nominees are taking the unreported income outof the United States is not an easy task. If there is apossibility that money is being taken out of thecountry, consult with International to develop theissue. This issue should be addressed on a case by casebasis.

Consideration should also be given to whether additionalinformation can be gotten by contacting formeremployees. Usually, these individuals know exactly howthe business was operated and may be helpful inidentifying schemes used by the owner. The formeremployees can also confirm allegations to solidify thecase.

If appropriate, the examiner can also go to a bank orbanks near the taxpayer and ask the head teller if thetaxpayer comes in and makes cash conversions. (Smallbills into large denominations.)

It may be difficult to prove income underreporting orskimming without more specific information, therefore,the agent must continue to look beyond the books andrecords and pursue other leads.

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3149-106 11-2

Chapter 12

RELATED EMPLOYMENT TAX ISSUES

The most common problem identified during theexamination of the pizza restaurants is the cash wagespaid "off the books." This appears to be a commonpractice in the restaurant business. Many times,employees are paid with cash taken from the cashregister and there are no payroll or time recordsmaintained.

The obvious problem here is the avoidance of taxes. Theowner avoids the payroll taxes, but in addition, theemployee avoids paying tax on the wages. During theinitial interview, the agent should pursue thepossibility of cash payroll. Attempt to confirm thehours of operation and who performs specific functionsat various times of day. It is nearly impossible to runa restaurant alone.

One agent used the purchase invoices to identifyemployees who were not on the payroll but were signingthe daily purchase delivery slips. When the taxpayerwas confronted with this information, he agreed thatcertain amounts of income was skimmed to pay theseemployees and he did in fact avoid the payroll taxes onthese wages. Check to see if employees identified havefiled tax returns using the IMFOLT command code on IDRS.

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Chapter 13

INADEQUATE RECORDS NOTICE

An inadequate records notice should be considered in allcases where the examiner determines that the taxpayer’srecords are inadequate. This is one effective tool thatcan be used to enforce compliance with the tax laws.

In those situations where the taxpayer does not keep theproper records to determine income and expenses, thecase agent should refer to IRM 4271.21 for theguidelines for inadequate records notices. This willput the taxpayer on notice that the proper records mustbe maintained. This will also provide for a follow-upexamination to confirm if the taxpayer has improved hisrecordkeeping.

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