How a State Estimates Your Cash Sales (The Mark-Up Tactic)
If your business accepts cash, and you file sales tax returns, this article is for you.
This article applies in all states that estimate your cash sales when conducting audits for sales taxes. However, this borrows the law relied upon by the Illinois Department of Revenue’s (IDOR) tactics in Sales tax audits.
The Basic Law
All states with a sales tax have a base law that allows it to make estimates in an audit. For example, under the Illinois Retailers’ Occupation Tax Act (35 ILCS 120/1 and following) and related administrative regulations, the state is allowed to determine a business’s correct sales tax liability.
That same body of law gives authority to estimate unreported cash receipts during sales tax audits. This “estimate” procedure is to determine the correct amount of sales tax owed by businesses, in cases where complete, accurate records are unavailable.
Basically:
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Businesses are required to maintain detailed and accurate records of their sales transactions to substantiate the sales tax they report and remit. These records typically include receipts, invoices, ledgers, and other documentation of taxable and non-taxable sales.
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When a business fails to maintain adequate records, or when discrepancies suggest underreporting, the state is authorized to use indirect methods to estimate unreported sales, including cash receipts.
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Some of those indirect methods include analyzing bank deposits, examining the business’s overall inventory purchases, or applying “industry-standard markup” percentages. These methods aim to reconstruct a reasonable estimate of the business’s actual sales activity.
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At least once a year in many states, retailers are required to conduct an inventory of their stock on hand. For example, the Illinois law is 86 Ill. Adm. Code 130.805(a)(3).
Audit Magic – How States Estimate Your Cash Sales
State Sales Cash Sales, IRS Tax Attorney (Naperville IL)
Industry-Standard “Markup” Percentages?
Supposedly, this method is only be used in cases where there are no 1099-K statements available. Realistically, it is used when the Form 1099-K’s do not show the full amount of sales made.
In other words, states use this method if the business has sales that were not conducted through a merchant account (ie: with a debit or credit card), or some other outside processor (ie: CashApp, Venmo, PayPal, etc.).
When the business accepts cash, the percentage mark-up method can be used to estimate sales. This tactic assumes an average mark-up for the different categories of items sold. (For example, liquor, food items, used auto parts, books, etc.). Then, this mark-up is applied to the business’s cost of goods sold to arrive at expected sales.
Here are a few industry-standard mark-up rates:
Retail. The average retail markup ranges between 50% to 60%, according to Chron.com. Obviously, this range varies by geographic location, product and industry. Also, by time of year (ie: holidays, summer, etc.).
Restaurants. Food is usually marked up 60%, also according to Chron.com. However, we have seen markups range from 50% to 300%. Beverages may be marked up as much as 500%.
General Contractors. The average markup on tangible materials can be as high as 50%, according to Buildern.
Manufacturers. Used sometimes as an industry standard, PROS writes that manufacturers will typically mark up their products by 15% to 20%.
Distributors. The average wholesale or distributor markup is 20%, but some can be as high as 40%, also according to PROS. We have seen markup for modified items as much as 400% to 500%, but this range is not considered an industry standard.
The percentage mark-up method is favorable for states, considered to be effective when applied to businesses like taverns and liquor stores, or family-owned restaurants. The inventory purchases of these businesses can be easily broken down into a small number of categories, or into groups that use approximately the same percentage of mark-up.
How the Percentage Mark-Up Tactic Works
Some businesses that handle a lot of cash might fail to keep a record of all cash sales. Those sales are not easy to track, because there is no “independently verifiable” documentation of the sale. Consequently, some of those businesses might not report 100% of their cash sales on the sales tax returns.
However, states assume that all purchases are 100% reported on the business’s income tax returns.
Generally, here is the process. The state will:
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Identify the reported amount of inventory Purchases, including changes in levels of inventory.
Example:
If food has a 60% markup, then the Mark-Up Rate =
100% (of food cost) + 60% (mark-up) =
160% (the Mark-Up Factor)
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Multiply the number of Purchases by the chosen industry Mark-Up Factor. This estimates what were the Estimated Total Sales (which includes the cash sales).
Example:
If food purchases were $200,000, then Estimated Total Sales =
$200,000 (the Purchases) X 160% (the Mark-up Factor) =
$320,000 (Estimated Total Sales)
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Then from the Estimated Total Sales, subtract the total sales per the sales tax returns. This calculation results in Estimated Under-Reported Sales (unreported cash sales).
Example:
If Sales Per Tax Return was $150,000, then Estimated Under-Reported Sales =
$320,000 (Estimated Total Sales) – $150,000 (Sales Per Tax Return) =
$170,000 (Estimated Under-Reported Sales)
Then, the sales tax rate is applied to the Estimated Under-Reported Sales. Remember that penalties and interest may also apply.
Do You Need a Lawyer?
We always caution any business owner to find representation if the business has not correctly reported its cash sales, and is now under audit. In our opinion, you should let a lawyer represent you in the audit, and speak for you in all audit-related communication.
Here is why:
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Knowingly failing to correctly collect, report, and pay over sales taxes is a state crime.
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Communicating to a state auditor in a sales tax audit that you knowingly under-reported cash sales is an admission to a different state tax crime.
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Communicating to a state auditor in a sales tax audit that you correctly reported cash sales, when you know that is untrue, is a commission of yet another state tax crime.