In recent years, the restaurant industry has undergone a significant transformation, driven by changing consumer behaviors, the growth of delivery platforms, and increased reliance on third-party food preparation models. Alongside these changes, state and local tax authorities have intensified sales and use tax audit efforts, particularly in areas where third-party food preparers are involved. These audits reveal gaps in tax compliance that many restaurant operators may not even realize exist.
Let’s examine the trends, risks, and best practices emerging from recent sales and use tax audits, with a focus on the growing involvement of third-party food preparers in today’s restaurant operations.
Understanding Third-Party Food Preparation Models
What Are Third-Party Food Preparers?
Third-party food preparers refer to external entities that assist restaurants with food production. These include:
- Ghost kitchens: Facilities that cook meals for delivery or pickup under one or more virtual restaurant brands.
- Commissary kitchens: Shared kitchen spaces used by multiple businesses to prepare food products.
- Co-packers and contract kitchens: Companies that produce food products on behalf of a restaurant or food brand, often for distribution or resale.
These models offer significant operational benefits, such as cost savings, scalability, and flexibility. However, they also introduce complex sales and use tax implications.
Sales and Use Tax Issues in Third-Party Food Preparation
Taxability of Prepared Food and Services
One of the primary challenges with third-party preparers lies in determining which services and products are taxable. Depending on the jurisdiction, the following items may be subject to sales or use tax:
- Prepared meals delivered to customers,
- Food preparation services rendered by ghost or commissary kitchens,
- Packaging, utensils, and non-food items provided with meals, and
- Transfers of tangible personal property between preparers and restaurant operators.
The taxability of these items varies from state to state. For instance, in some jurisdictions, if a third-party preparer merely provides a service (e.g., preparing meals for a brand’s customers), their charges may be subject to taxation. In other cases, if the preparer acts as a subcontractor selling a finished product to the restaurant, the transaction might be exempt if a resale certificate is executed properly.
Resale Certificates and Audit Exposure
Resale certificates are often used to exempt purchases from sales tax when the item will be resold to an end consumer. However, misuse or poor documentation of resale certificates is a common issue identified under audits.
When restaurants engage third-party kitchens or co-packers, they may assume that their purchases are exempt from tax under a resale exemption. However, tax authorities frequently scrutinize these transactions to determine whether:
- The correct documentation exists,
- The transaction truly qualifies for resale,
- The preparer is acting as a vendor versus a service provider.
Failure to correctly apply or validate resale exemptions can lead to significant tax assessments, including penalties and interest.
Audit Trends in the Restaurant Industry
Why Tax Authorities Are Paying Attention
Sales and use tax auditors have become increasingly focused on:
- Underreported taxable purchases from third-party preparers.
- Uncollected taxes on delivery, packaging, or service fees.
- Misclassified transactions between restaurants and preparers.
- Marketplace facilitator gaps, particularly where delivery platforms, ghost kitchens, or contract preparers are involved.
For example, some restaurants operating virtual brands may not realize that if a ghost kitchen prepares and delivers food directly to consumers under the restaurant’s name, they might be viewed as the actual seller for tax purposes, shifting the obligation to collect and remit sales tax.
Common Audit Findings
In audits where third-party preparers are involved, some common issues include:
- Improper or missing resale certificates,
- Non-taxed charges for preparation or packaging,
- Unreported use tax on untaxed purchases, and
- Discrepancies between point-of-sale records and actual operations.
These findings often lead to substantial assessments when documentation is lacking or misunderstood.
Best Practices for Navigating Compliance
Clarify the Nature of Third-Party Relationships
Restaurants should clearly understand whether their third-party preparers are:
- Selling a product (i.e., taxable goods),
- Providing a service (i.e., food preparation),
- Or acting as a hybrid (e.g., ghost kitchens selling under a license or brand).
This distinction is critical in determining tax responsibility.
Obtain and Maintain Proper Documentation
Maintain up-to-date, properly executed resale certificates when claiming exemptions. Ensure that:
- The certificate is correctly filled out,
- The vendor is registered in the state,
- The transaction aligns with the exemption claimed.
Review Contracts and Invoices for Tax Implications
Scrutinize agreements with third-party preparers to ensure tax responsibilities are clearly defined. Invoices should indicate what is being charged (e.g., prepared food, labor, packaging) and whether sales tax is charged appropriately.
Conduct Internal Reviews and Seek Advisory Support
Engaging in periodic internal reviews of your sales and use tax treatment for third-party preparers can reveal potential exposures before an audit. Consider consulting a sales tax advisor with expertise in the restaurant industry to review your documentation, contracts, and reporting processes.
What This Means for You
As restaurant operations become increasingly outsourced, decentralized, and digitally driven, the role of third-party food preparers continues to grow. With this evolution comes increased attention from tax authorities eager to ensure proper sales and use tax compliance.
Restaurant operators must stay ahead of the curve by understanding how these relationships impact their tax obligations. By implementing strong documentation practices, reviewing third-party agreements, and conducting regular compliance checks, restaurants can minimize audit risk and focus on what they do best… serving their customers.
If your restaurant uses ghost kitchens, commissaries, or contract food preparers, now is the time to assess your sales and use tax exposure. A proactive approach can save your business time, money, and stress when the auditors come knocking.
Contact Thompson Tax today for expert guidance on your sales and use tax needs. We’re just a phone call away!