Restaurant owners walk into audits ready to defend their expenses. Receipts for food costs, invoices for equipment, the lease. That is the wrong preparation. In a restaurant audit, the question the examiner cares about most is not what you spent. It is what you took in.
Here is how the IRS tests a restaurant's sales, using its own manuals, and what you can do to make the answer boring.
Income comes first in every business audit
The Internal Revenue Manual section on examining income, IRM 4.10.4 (revised August 29, 2025), requires minimum income probes on business returns. For an individual business return, such as a sole proprietor's Schedule C, the IRM lists the steps:
- A financial status analysis to see whether reported income could support the owner's lifestyle.
- An initial interview about how the business operates and handles cash.
- A tour of the business site.
- An evaluation of internal controls.
- A reconciliation of income on the books to income on the return.
- Testing gross receipts.
- Bank account analysis.
- Business ratio analysis.
Corporations, partnerships and S corporations get a parallel set of probes, including balance sheet analysis and a review of Schedules M-1, M-2 and M-3.
None of this means the examiner suspects you of anything. It is the minimum. But in a business that handles cash, each step has teeth.
The interview and the tour
The interview is where most restaurant cases are won or lost, and owners rarely prepare for it. Expect questions about how sales are rung, who closes out the register, how cash is counted and deposited, whether cash is used to pay vendors or staff, how much cash the owner keeps on hand, and what happens to tips.
Answer accurately and only what is asked. A casual "we pay some of the kitchen guys in cash" in the first meeting can open an employment tax issue that was not on the table.
The tour is not a formality either. The IRS's Retail Industry Audit Technique Guide (revised March 5, 2021) gives the example of an examiner touring a liquor store, seeing lottery tickets sold at the counter and then expecting to find lottery revenue on the books. The same logic applies to your dining room. Catering signage, a retail case, a delivery tablet or a private event room each implies an income stream that should appear somewhere.
Testing gross receipts
IRM 4.10.4.2.3.6 tells examiners to trace entries in the books back to original sales documents, such as cash register receipts, and to trace original documents forward into the books. If sales documents are numbered or sequenced, the examiner is to identify and account for missing ones.
For a restaurant, the original sales documents are your POS records. Expect requests for daily sales reports, end-of-day "Z" reports, voids and comps, discounts, item mix reports and the payment-type breakdown of cash, card and third-party delivery. The Retail Industry ATG also flags point-of-sale software manipulation, which it calls ZAPPER, and editable electronic accounting records as issues examiners must watch for.
Voids and comps deserve your attention before the examiner's. A restaurant with a high void rate after the check prints, concentrated on cash tickets, has a story to tell, and you want to know what it is.
Card data the IRS already has
Card sales are the easiest part of your revenue for the IRS to verify, because someone else reports them. Under IRC 6050W, payment settlement entities report payments in settlement of payment card transactions on Form 1099-K. Notice 2025-62 confirms that all payments in settlement of payment card transactions must be reported, while the $20,000 and 200-transaction threshold applies only to third party network transactions. Delivery apps and other platforms can also generate information returns.
If your reported gross receipts are close to your card volume, the examiner will ask an obvious question: where are the cash sales? We cover Form 1099-K mismatches in detail in our guide to 1099-K income mismatches.
When the IRS reconstructs your income
If the books are unreliable, the examiner can move to a formal indirect method. The authority traces to IRC 446(b), which lets the IRS compute taxable income under a method that clearly reflects income when a taxpayer's method does not. There is a statutory limit: IRC 7602(e) says the IRS may not use financial status or economic reality examination techniques to determine the existence of unreported income unless it has a reasonable indication that there is a likelihood of unreported income.
IRM 4.10.4.5 describes the formal methods. Two matter most to restaurants.
The markup method
IRM 4.10.4.5.5.2 recommends the markup method when inventory is a principal income-producing factor and records are unreliable, and specifically says it is effective for industries such as liquor stores, taverns and restaurants. The examiner starts with your purchases from food and beverage vendors, which can be confirmed with those vendors, and applies a markup to estimate sales. The IRM directs examiners to use your own records and testimony to establish markups and to accept plausible explanations for why your markups differ from national averages.
For a bar, this is often a pour-cost analysis. Bottles purchased, drinks per bottle, price per drink. Spillage, comps, breakage and staff drinks matter. The IRM's discussion of defenses notes that markup computations can be attacked for failing to give adequate consideration to spillage, breakage or theft, and that these issues should be addressed and quantified in the initial interview. So quantify them.
The bank deposits method
IRM 4.10.4.5.4.2 says the bank deposits and cash expenditures method should not be the automatic choice, and that cash intensive businesses, where significant receipts are not deposited and there are numerous cash outlays, do not lend themselves to it. When it is used, the IRM requires the complete analysis, including business and personal cash expenditures. We explain that method in our guide to bank deposit audits.
Your defenses
IRM 4.10.4.5.8 groups the defenses to indirect methods into three categories:
- The computation is inaccurate or flawed.
- The unexplained difference comes from a nontaxable source, such as loans, gifts, inheritances or transfers between accounts.
- The unexplained difference comes from cash on hand or funds accumulated in earlier years.
Each one needs proof. A claim of cash savings with no bank withdrawals, no prior returns showing the income to build it and no documentation is not a defense. It is a story. Gather loan documents, transfer records and prior-year statements before the examiner asks.
Tips are part of the picture
An income examination of a restaurant often leads straight into tip compliance. Your POS shows charged tips on every card ticket. Under IRC 6001, the only records an employer is required to keep in connection with charged tips are the charge receipts, records needed to comply with section 6053(c) and copies of employee tip statements. Keep those three things well. If charged tips are far above reported tips, expect the employer FICA question discussed in our guide to aggregate tip assessments.
Making the audit boring
- Deposit all cash receipts intact, and pay vendors and staff from the bank, not the drawer.
- Reconcile POS sales to deposits and card settlements every month.
- Keep voids and comps under manager approval with reasons in the system.
- Track pour costs and food costs so you can explain your markup before anyone else computes it.
- Keep tip reports, card receipts and payroll in one place.
If an examination is already underway, see how the firm handles IRS audits before your next meeting with the examiner.
The examiner will count your sales one way or another. Better that your records do the counting.