Tip Income: A Taxing Issue
John Robertson, Tina Quinn, and Rebecca C. Carr
2006 - The U.S. restaurant industry consists of thousands
of establishments employing millions of workers. Many of these
workers rely upon tips as part of their compensation; however,
part or all of these tips may be in the form of cash paid
directly to the worker by customers. These tips are subject
to both income taxes and FICA taxes. A worker who receives
more than $20 per month in tips must report these tips to
the employer at least once a month. Employers must withhold
federal income tax and FICA tax on wages and reported tips
and match the FICA amount. An establishment that meets certain
criteria must file Form 8027 with the IRS reporting annual
sales, charge-card sales, and employee-reported tips. If reported
tips are less than 8% of total sales, an employer must allocate
tips on the employee’s W-2 form.
to 1998 IRS estimates, however, fewer than 40% of all tips
received were reported, an estimated $9–$12 billion
in unreported income. The issue of unreported tip income
is inherently troublesome because tips are often in cash
and subject to self-reporting. The IRS has established several
initiatives to increase the reporting of tips, including
the Tip Rate Determination/Education Program, designed to
encourage employees to report the correct amount of tip
income to their employer.
the case of Fior D’Italia [536 U.S. 238 (2002)],
the restaurant met all reporting requirements, yet was assessed
additional FICA taxes for 1991 and 1992. On its Form 8027,
the amount of tips reported by the workers was less than
the amount of tips reported on charge sales alone. The IRS
used an aggregate estimation method to reach the assessment.
The restaurant paid part of the assessment, then filed a
refund suit. The district court held that the IRS lacked
the authority to estimate tip income using an aggregate
estimation method, and this ruling was affirmed by the Ninth
Circuit Court of Appeals. The Supreme Court reversed the
opinion and held that the IRS does have authority to assess
a restaurant’s FICA taxes on unreported tip income
using an aggregate estimation method.
this resolved a conflict between circuits over the aggregated
estimation issue, other issues remain, such as the estimation
methodology, the asymmetry created by an employer paying
FICA tax with no credit to an employee’s earnings
record, and the potential for coercion to a tip reporting
employees often receive the majority of their income from
their tips. Because tips are often received in cash, it
may be difficult for an employer to know exactly how much
tip income an employee receives. The IRS has always suspected
that a great deal of tip income went unreported.
to 1965, employers had no reporting or withholding responsibilities
for their employees’ tip income. In 1965, the law
was amended to require employers to withhold Federal Insurance
Contribution Act (FICA) tax on tips from the employees’
pay, but, unlike regular wages, employers did not have to
pay a matching amount. The Social Security Administration
would credit the employees’ Social Security account
for the employees’ share. In 1977, the law was changed
to require the employer to pay its share of FICA tax, but
only up to the minimum wage [see The Bubble Room, Inc.
v. U.S., 159 F.3d (Fed. Cir., 1998)]. During this period,
neither employer nor employee had a strong incentive to
report tip income to the government.
1982, the Tax Equity and Fiscal Responsibility Act (TEFRA)
added IRC section 6053(c), which required employers whose
employees failed to report at least 8% of gross sales as
tips to allocate tips equal to 8% of revenue among employees
(See PL 100-203). This gave employers an incentive to make
sure that employees reported tips equal to at least 8% of
their sales. Unfortunately, this rule often led employees
to think that they would be safe from audit if they reported
at least 8% of sales as tips.
to 1987, employers were assessed FICA taxes on tips only
up to the minimum wage. The employee, however, was taxed
on all wages and tips, including the portion that exceeded
the minimum wage. In 1987, Congress amended IRC section
3121(q) by removing the minimum wage ceiling and taxing
all tips to both employers and employees. Employees still
had no incentive to report all tips.
restaurant industry wanted some concessions to compensate
for the additional tax burden caused by paying FICA on all
employee tips, so Congress added IRC section 45B, which
provides employers with a dollar-for-dollar tax credit for
FICA taxes paid on tips above minimum wage. Because section
45B is a nonrefundable credit, an employer must owe federal
income taxes to take advantage of the credit. The credit
cannot be used to offset employment taxes. The section 45B
credit causes taxable income to increase, because any amount
used to calculate the credit cannot be treated as a deductible
expense. The usefulness of the credit may also be reduced
because it is combined with all other general business credits.
Any unused credit can be carried back one year and carried
forward 20 years (previously, any unused credit could be
carried back three years and carried forward 15 years).
If an employer is subject to alternative minimum tax, however,
it may not be able to use the entire credit.
An employee who receives more than $20 per month in tips
must report these tips to the employer at least once a month
(this marks the start of the “wage band” discussed
below). The employee must make this report by the 10th day
of the next month or be subject to a penalty [Revenue Ruling
95-7, 1995-1 C.B. 185 (1995)]. The employee may use Form
4070, Employee’s Daily Record of Tips, to do so. Alternatively,
the tips may be reported on a time card or even electronically,
as long as a record is kept (Reporting Tip Income, IRS Publication
Employers must withhold federal income tax
and FICA on wages and reported tips. Employers must match
FICA. IRC section 3121(q) states that tips received by an
employee in the course of employment should be considered
remuneration. Employers of large food or beverage establishments
must report sales to the IRS each calendar year. An employer
must file Form 8027 with the IRS if the following conditions
Tipping is customary in their establishment.
Food and drink are provided for consumption on premises.
The business employs more than 10 employees or the equivalent
(more than 80 employee hours per day) on a typical day
[IRC section 6053(c)(4)].
is important to note that all 10 employees do not have to
be waitstaff or other directly tipped employees. The figure
should include all employees who provide services in connection
with food and beverages.
Form 8027, employers must report annual sales, charge-card
sales, charge-card tips, and employee-reported tips. If
reported tips are less than 8% of total sales, the employer
must allocate tips on the employee’s W-2 form to employees
who reported tips less than 8% of their sales. Tip allocations
have no effect on withholding income or FICA taxes.
IRS allows three methods of allocating tips among employees.
The hours-worked method allocates tips on the basis of hours
worked. This method is allowed for establishments that employ
less than 25 full-time employees (both tipped and nontipped).
The gross-receipts method allocates tips based on an employee’s
actual gross receipts, as compared to the restaurant, irrespective
of hours worked. The third method is a good-faith agreement
between the restaurant and at least two-thirds of the employees
in each tipped occupational category. This agreement specifies
an allocation of tips of less than 8% of gross sales that
will approximate the actual distribution of tip income among
employees. An employer is not liable to any person for incorrect
allocations under IRC section 6053(c)(3)(B) if the allocation
was done in accordance with the prescribed regulations.
employer-only audit occurs when the IRS levies FICA tax
on the employer without first auditing the employees of
the restaurant. When this occurs, the business is required
to pay the employer’s share of FICA on what the IRS
believes to be unreported or underreported tips. In these
cases, the determination is made through an observation
that the overall rate of tips for a restaurant is not high
enough. Because it is done without regard to whether particular
employees declared sufficient tip income, no employee Social
Security account is credited with the withheld FICA taxes.
1993, the IRS introduced the Tip Rate Determination/Education
Program (TRDEP) to encourage employees to report the correct
amount of tip income to their employer. [See Tips on Tips,
IRS Publication 1875 (Rev. 5-99).] Originally there were
two types of agreements: the Tip Rate Determination Agreement
(TRDA) and the Tip Reporting Alternative Commitment (TRAC)
agreement; the EmTRAC was later added. The TRDA requires
the determination of tip rates, while the TRAC emphasizes
education and tip reporting procedures. The agreements,
which are voluntary, provide that companies that comply
with the terms of the agreement will not be subject to employer-only
audits. The IRS recently introduced a new tip-reporting
procedure called the Attributed Tip Income Program (ATIP).
An employer who enters into a TRAC agreement must establish
a quarterly education program for existing employees and
educate newly hired employees about their tip-reporting
responsibilities. The employer must establish tip-reporting
procedures and advise all employees of their legal requirement
to report all cash and charged tips to their employer. Under
a TRAC agreement, an employer must file all appropriate
returns and make timely tax deposits to be in compliance.
A large establishment with a TRAC agreement must file Form
8027, Employer’s Annual Information Return of Tip
Income and Allocated Tips, showing gross receipts subject
to tips and charge receipts showing charged tips. Adequate
records must be maintained and made available to the IRS.
In return for compliance, the IRS agrees that the employer
will not be subject to employer-only audits. According to
congressional testimony by William F. Conlon, IRS director,
reporting compliance, the IRS had secured 12,871 restaurant
TRACs covering 37,788 establishments by July 2004.
The TRDA agreement requires the IRS to work with an establishment
to arrive at a tip rate for the various restaurant occupations.
The employees must enter into a Tipped Employee Participation
Agreement (TEPA) with the employer. At least 75% of the
employees must sign a TEPA and report at or above the determined
rate. If an employee fails to report at or above the determined
rate, the employer provides the IRS with the employee’s
name, Social Security number, job classification, sales,
hours worked, and reported tips. The TRDA has no specific
education requirements. TRDA participation protects the
employer against prior period audits as long as the participants
comply. According to Conlon, the IRS had secured 1,176 restaurant
TRDAs covering 1,440 establishments by July 2004.
Another option for employers is the Employer-Designed TRAC
Agreement (EmTRAC). An EmTRAC is a substitute for a TRAC
and retains many of the provisions of the TRAC agreement.
An employer must establish an educational program on tip-reporting
requirements. Education must be provided to new employees
and provided quarterly for existing employees. The employer
must establish tip-reporting procedures that reflect all
tips for services attributable to each employee. An EmTRAC
also protects against employer-only audits, but it is more
flexible than a TRAC. Employers develop and submit for IRS
approval a tip education and reporting program for their
employees. The employer agrees to comply with tax reporting,
filing, and payment requirements set forth under the regular
TRAC as well as maintain the applicable records. A restaurant
that has a TRAC agreement with the IRS will be terminated
from that agreement when the EmTRAC goes into effect [IRS
Notice 2001-1, TECH-MIS Number OGI-114882-00]. According
to Conlon, the IRS had approved all seven of the EmTRAC
applications received as of July 2004.
The IRS unveiled a new tip-reporting procedure
under TRDEP in Revenue Procedure 2006-30 called the Attributed
Tip Income Program (ATIP). ATIP provides benefits similar
to the existing TRAC, EmTRAC, and TRDA programs but has
simpler paperwork requirements.
ATIP program is available for an initial three-year period
from January 1, 2007, through December 31, 2009. Eligible
employers elect to participate in ATIP by individual establishment
and must file a new election for each establishment each
year. Notice of participation is made by checking a box
on Form 8027 and sending the ATIP coordinator a copy of
last year’s Form 8027. An employer that would not
otherwise file Form 8027, such as an employer with less
than 10 employees, must check the box and complete only
the first five lines of Form 8027 to show participation.
establishment must meet two requirements to participate
in ATIP: At least 20% of the preceding year’s food
and beverage sales must have been charge-card sales showing
a charged tip and at least 75% of tipped employees must
agree to participate in ATIP for the current year.
ATIP, tips are attributed to employees based on a percentage
of food and beverage sales. The percentage used is the charge
tip rate from the prior year’s Form 8027, less 2%.
The employer must devise a method to allocate tips among
employees. Tips are attributed to both participating and
nonparticipating employees, but attributed tips are not
considered taxable income to nonparticipating employees.
employees must still maintain tip logs and report tips to
TRDA, TRAC, and EmTRAC programs were scheduled to end after
December 31, 2005, but they have been extended indefinitely
by the IRS (IR-2004-117, September 16, 2004). Employers
with existing plans do not need to reapply. The IRS considers
the TRDEP very successful: In 1995, tip wages reported amounted
to $9.45 billion. In 2003 the amount reported exceeded $18
IRC section 3121(q) notice and demand issued to an employer
related to any period a TRAC agreement is in effect can
be based on either: 1) a Form 4137, Social Security and
Medicare Tax on Unreported Income, filed by an employee,
or 2) a Form 885-T, Adjustment of Social Security Tax on
Tip Income Not Reported to Employer, prepared at the end
of an employee tip examination (IRS Notice 2001-1, TECH-MIS
TRAC, EmTRAC, and ATIP agreements are voluntary. The IRS
is forbidden by section 3414 of the IRS Restructuring and
Reform Act of 1998 from coercing a restaurant into signing
a TRAC by threatening to audit it. The Internal Revenue
Manual outlines allowable procedures to get tip agreements.
Interpretation of a Statutory Problem
Treasury Department, through the IRS, reacted to the changes
in the tax laws discussed above by auditing restaurant industry
employers in an attempt to find unreported tip income. These
audits were designed not to collect unpaid income taxes,
but to collect the employer’s share of FICA taxes.
IRS took the position that it was entitled to collect the
employer’s share of FICA taxes without first determining
the amount of unreported tips by individual employees. In
recent years, the IRS has generally limited its attempts
to collect income taxes or the employee’s share of
FICA taxes from employees. This approach is not specifically
authorized in the law, rather, it is the Treasury Department’s
Resolution of the Problem
restaurant industry wanted the IRS to audit individual employees
before attempting to collect the employer’s share
of FICA taxes. In a series of four employer-only audit cases,
the restaurants raised a number of arguments against the
McQuatters decision [McQuatters v. Comm’r, T.C.
Memo 1973-240] is important to understand the taxation of
tip income because a variation of the indirect method used
in this case has become the IRS’s standard method
of estimating tip income, even though it was not the first
case to allow the use of an indirect method [see Mendelson
v. Comm’r, 305 F.2d 519 (7th Cir., 1962)]. McQuatters
differs from later cases because it predates the 1977 changes
to the Social Security Act—the IRS did not yet have
the authority to collect the employer’s share of Social
Security taxes on tip income.
case involved an income tax audit of the waitstaff at the
Space Needle restaurant in Seattle for 1967 and 1968. The
waitstaff reported tips to the restaurant. The restaurant
maintained records of each employee’s hours worked,
reported tips, and wages. Reported tips were less than the
amount of wages paid to each employee.
none of the employees had maintained records, the IRS applied
an indirect estimate. Its formula had several steps:
Total annual food and beverage sales for the Space Needle
were reduced by 10% to account for patrons who did not
tip, tip sharing among staff, and low-tipping activities
such as banquets. The result was sales subject to tips.
Sales subject to tips were then divided by the total hours
worked by the waitstaff to arrive at average sales per
Average sales per hour were multiplied by the number of
hours worked by each individual to arrive at annual sales
subject to tipping for each employee.
employee’s annual sales subject to tipping were
then multiplied by 12% to arrive at total tips for the
IRS made no distinction between the tip rate on cash sales
and charged sales. The IRS examined the total charged tips
for March (14.10%) and September (14.42%) 1967. Charged
sales for the year were 27.17% of total sales.
employees challenged the IRS’s determination in court.
The employees argued that the 12% tip rate was too high
and asked the court to reduce the amount to 7%. The court
held that the IRS was justified in estimating the taxpayers’
income through an indirect method because they had not maintained
adequate books and records and the IRS’s method “was
logically and factually sufficient” [citing Mendelson
and Carroll F. Schroeder, 40 T.C. 30 (1963)]. The court
did, however, reduce the tip rate to 10% to account for
tip sharing and other factors that the taxpayers had raised.
case [Morrison Restaurants, Inc. v. U.S., 918 F.Supp.
1506 (S. Dist. AL, 1996), Morrison Restaurants, Inc.
v. U.S., 118 F.3d 1526 (11th Cir., 1997)] involved
a 1993 employer-only FICA tax audit of Ruby Tuesday Unit
2607 for 1990 and 1991. Unit 2607 filed Form 8027 for each
of the tax years in question. It reported tips of 16.15%
of charged sales in 1990 and 16.32% of charged sales in
1991. Reported cash tips were only 7.7% of cash sales in
1990 and 7.8% of cash sales in 1991.
Morrison Restaurants, the IRS agent reduced the charged
tip rate by 4% to obtain a cash tip rate that accounted
for a lower rate of tipping on cash sales. The cash tip
rate was then multiplied by the cash sales. Reported cash
tips were subtracted from this estimate of total cash tips
to obtain an estimate of unreported cash tips. The restaurant
was then issued a notice of deficiency for the employer’s
share of the FICA tax on the unreported tips.
case was eventually heard by the U.S. Court of Appeals for
the 11th Circuit. The government contended that it had the
authority to investigate and assess all taxes imposed by
the IRS under IRC section 6201(a), and that the employer’s
share of the Social Security and Medicare FICA taxes were
taxes authorized by IRC sections 3111(a) and (b). The court
of appeals found that the IRS’s interpretation of
the statute was reasonable, and it reversed the district
Bubble Room, Inc., operated two restaurants in Maitland
and Captiva, Florida. The case [The Bubble Room, Inc.
v. U.S., 36 Fed.Cl. 659 (1996) and The Bubble Room,
Inc. v. U.S., 159 F.3d. 553 (Fed. Cir., 1998); petition
for rehearing denied, Bubble Room Inc. v. U.S.,
unpublished decision, 199 U.S. App. Lexis 1759 (1999)] involved
a 1989 FICA tax audit. The IRS assessed an employer-level
tax on Bubble Room after calculating an aggregate estimate
of underreported tips by the service staff. Bubble Room
challenged the assessment in the Court of Federal Claims
and won on summary judgment. The government appealed to
the Court of Appeals for the Federal Circuit, which reversed
the lower court’s decision.
main issue in this case was the interpretation of IRC section
3121(q). The appeals court concluded that the aggregate
estimate method was allowable, as were employer-only audits.
that the aggregate estimate does clearly reflect income,
the imposition of the employer’s share of FICA tax
through an aggregate estimate or through individual audits
of the employees should not make any difference to Bubble
Room. The appeals court considered the Bubble Room’s
argument on the “wage band” (which spans from
the taxable minimum of $20 per month in tip income to the
ceiling on wages subject to FICA taxation), subjecting all
estimated tips to FICA tax, as well as problems the Court
of Federal Claims had noted with the IRS’s methodology.
It found that even though the formula used in the audit
of the Bubble Room might not be accurate, this was an issue
of fact to be considered in a trial.
West Hubbard Restaurant Corporation
case [330 West Hubbard Restaurant Corporation v. U.S.,
37 F.Supp.2d 1050 (N. Dist. IL, 1998) and 330 West Hubbard
Restaurant Corporation v. U.S., 203 F.3d 990 (7th Cir.,
2000)] also involved an employer audit of FICA taxes. This
case is factually different from the other three cases because
the employer maintained a mandatory “tip pool.”
In tip pooling, the employer collects all tips and distributes
them among specified groups of employees. A tip pool might
include otherwise nontipped employees (e.g., table bussers),
and it might allow for a more level distribution of tips
between highly tipped employees, such as table waitstaff,
and less highly tipped employees, such as bartenders and
cocktail waitstaff. Assuming all cash tips are turned in
to management, a restaurant that maintains a tip pool knows
how much each employee actually receives in tips.
330 West Hubbard Restaurant Corporation operated Coco Pazzo,
a restaurant in Chicago. An audit of Coco Pazzo’s
1993, 1994, and 1995 returns indicated that the tips reported
by employees were $450,837.70 while charged tips were $1,412,786.29.
The tip pool was divided weekly among the staff. The company’s
own records indicated that it had collected and divided
$1,556,301.15 in tips for the three years. The IRS compared
tips reported on Form 941, Employer’s Quarterly Federal
Tax Return, to the company’s records of the tip pool.
The IRS determined that $1,112,453.92 of tips had not been
reported, and assessed additional employer-only FICA taxes
of $85,104. Coco Pazzo paid $1.53 and sued for a refund
in the District Court for the Northern District of Illinois.
The government countersued for the balance of the assessment.
The court found in favor of the government.
Pazzo appealed to the U.S. Court of Appeals for the Seventh
Circuit. The appeals court affirmed the trial court. The
Seventh Circuit required Coco Pazzo to show that the Treasury’s
interpretation of IRC section 3121(q) was unlawful. The
court required only that the government apply a rational
interpretation of the statute. The court did not find the
restaurant’s reliance on the statutory term “employee”
to be sufficient. As the 11th Circuit and the Federal Circuit
had previously noted, the use of the singular “employee”
is not determinative.
D’Italia, Inc., operated an upscale restaurant. The
case [Fior D’Italia, Inc. v. U.S., 21 F.Supp.2d
1097 (N.D. Cal., 1998); Fior D’Italia, Inc. v.
U.S., 242 F.3d 844 (9th Cir., 2001); and Fior D’Italia,
Inc. v. U.S., 536 U.S. 238 (2002)] involved an employer-only
FICA tax audit of 1991 and 1992. Fior D’Italia’s
Forms 8027 showed that employees underreported tips. Charge
tips were $364,786 in 1991 and $338,161 in 1992. Tips reported
by employees were $247,181 and $220,845 for those same years.
In response to this, the IRS audited the restaurant. The
IRS calculated the tip percentage by dividing charged tips
by charged sales. This was 14.49% in 1991 and 14.29% in
1992. The tip percentage was then multiplied by total sales.
Based upon this result, unreported tips were calculated
to be $156,545 in 1991 and $147,529 in 1992. The IRS then
assessed the employer’s share of FICA taxes on the
unreported tips. Fior D’Italia paid part of the assessment
and sued for a refund in the Northern District of California.
Neither party disputed the calculation of the unreported
court found that IRC section 3121(q) neither forbade nor
authorized the use of an aggregate estimate of unreported
tips for purposes of collecting the employer’s share
of FICA taxes. It found that this section was only about
the timing of assessments and interest charges.
court reviewed the legislative history of FICA taxes and
IRC section 3121(q) to determine that Congress never intended
to impose a tax on restaurant employers that was not credited
to individual employees.
court found nothing in the IRC or the legislative history
that supported an argument that IRC section 3121(q) was
intended to provide the IRS with a mechanism to deal with
any incentive for employers to encourage underreporting
of tips by employees. The court found that administrative
convenience could not support an administrative agency’s
interpretation of a statute without clear support from Congress.
For these reasons, the court granted the restaurant’s
motion for summary judgment.
government appealed the decision to the U.S. Court of Appeals
for the Ninth Circuit. The Ninth Circuit had several criticisms
of the IRS’s methodology, but ultimately held that
it had no statutory authority for the use of aggregate estimates.
The court held that IRC section 446 did not provide the
IRS with the requisite authority because it does not apply
to FICA. The court also found that IRC section 3121(q) does
not provide authority for the use of an aggregate estimate
because it deals with the collection of tax, not the assessment.
majority held that the decision did not require the government
to assess additional taxes against each individual employee
before moving against the employer. Once the IRS has audited
the employees and calculated the amount of underreported
tips, it is free, according to the Ninth Circuit, to assess
taxes against the employer without making an assessment
against the employees.
Ninth Circuit explained that the IRS had options if it could
not audit every member of every restaurant’s waitstaff.
For example, it could ask Congress to expand the provisions
of IRC section 446 to FICA taxes. In the alternative, the
IRS could promulgate a regulation allowing the use of aggregate
estimates. The Ninth Circuit was willing to give a regulation
more weight than the administrative interpretation used
in employer-only audits.
Ninth Circuit was the first, and ultimately the only, circuit
to agree with the restaurant industry. The Ninth Circuit
reviewed the holdings by the Eleventh and Seventh Circuits
and concluded that they were based on the question of whether
the IRS must first assess FICA taxes against employees.
The Ninth Circuit stated that it was ruling on a different
question, whether the IRS may use an aggregate estimate.
In the Ninth Circuit’s view, its holding was consistent
with those in Morrison Restaurants and 330 West Hubbard,
but not Bubble Room.
Ninth Circuit’s opinion was not unanimous. The dissenting
judge was not convinced that the majority had successfully
reconciled its opinion to those of the other circuits. The
dissent thought that the other circuits had authorized the
use of aggregate estimates.
government appealed the decision of the Ninth Circuit to
the Supreme Court, which granted certiorari to resolve the
split among the circuits [536 U.S. 238 (2002)]. Although
the government brought the appeal, the Supreme Court based
its discussion on Fior D’Italia’s arguments.
Supreme Court addressed five arguments. The first was that
aggregate estimates used to estimate employer-only liability
were inappropriate because of the use of the singular “employee”
in various parts of the FICA tax provisions of the IRC.
The second argument was the lack of statutory authority
for aggregate estimates that the Ninth Circuit found in
the IRC. The third argument was Fior D’Italia’s
position that aggregate estimates are unreasonable because:
1) they do not take into consideration wage brackets, 2)
the estimate is based on charged tipping percentages that
may not properly reflect actual tipping patterns, and 3)
the IRS does not consider the financial burden that such
an estimate places on the restaurant. Fior D’Italia
argued that the taxes assessed amounted to two years’
profits. Under the IRC, estimates must be reasonable. The
fourth argument was a fairness argument based on an interpretation
of Treasury Regulations section 31.6011(a)-(1) (a). This
regulation requires an employer to consider FICA taxes based
on tips to the extent reported by the employees to the employer.
The fifth and final argument before the Supreme Court was
Fior D’Italia’s argument that the use of the
aggregate estimate was an improper use of administrative
authority. Fior D’Italia argued that the only reason
the IRS used an aggregate estimate was to coerce employers
into the TRAC program. The restaurant argued that this was
the case because the IRC section 45B credit often meant
that the IRS would not generate any additional revenue from
an employer-only audit. Fior D’Italia went on to argue
that the coercion was illegal under section 3414 of the
IRS Restructuring and Reform Act of 1998. Section 3414 was
enacted specifically to prevent the IRS from threatening
audits to force employers into the TRAC program.
Supreme Court found no support for Fior D’Italia’s
argument that the use of the singular “employee”
in the IRC prevented the use of an aggregate estimate. The
Court pointed out that IRC section 3111, the section that
imposes the employer-level FICA tax, does not contain the
reference to “employee” upon which the taxpayer
relied. Instead, it is found in IRC section 3121(q), which
the Supreme Court referred to as a “definitional”
Supreme Court then moved to the statutory arguments the
Ninth Circuit used. The Court concluded that the Ninth Circuit
had found “negative implications” in both IRC
section 446 and section 6205(a)(1). The Court was unable
to find these same negative implications in the statutes.
It found that IRC section 446 does not prevent the use of
an aggregate estimate and section 6205(a)(1) did not restrict
the IRS’s authority to assess taxes.
D’Italia argued that all the potential errors go against
the taxpayer and result in overstated tax liabilities, thus
the aggregate estimate method was unreasonable. The Supreme
Court did not find the aggregate estimate method unreasonable.
Restaurants could challenge the accuracy of the estimates;
however, Fior D’Italia had not done so. Furthermore,
as in Mendelson and McQuatters, audits of individual
tipped employees will also require the use of estimates
that include the potential for similar errors. Thus, there
is no guarantee that individual audits will result in a
more “reasonable” assessment of the tax due.
responding to the restaurant’s fairness argument,
the Supreme Court found that allowing the IRS to assess
employer FICA taxes at a later date might create “bookkeeping
awkwardness.” This was not the same as finding the
IRS’s methodology impermissible. Although the IRC
and the regulations contemplate basing an employer’s
original payroll tax liability on reported tips, the Court
found no reason to prohibit the use of the aggregate estimate
method in a later audit. It found that the IRC contemplates
a later assessment of taxes on an employer that does not
police its employees’ tip reporting.
Supreme Court analyzed the restaurant’s argument that
the aggregate estimate was actually an attempt to coerce
the restaurant into policing its employees in violation
of section 3414 of the IRS Restructuring and Reform Act
of 1998. There had been no threat of an audit to convince
the restaurant to enter the TRAC program. The potential
for illegal abuse may have existed, but it did not make
the IRS’s method impermissible.
Souter was joined by Justice Scalia and Justice Thomas in
the dissent. Justice Souter said that the broad interpretation
of the IRC envisioned by the majority was not what Congress
had intended. Justice Souter stated that the aggregate estimate
method “raises anomaly after anomaly,” and these
problems with the method require a narrow reading of IRC
section 3121(q) to bar aggregate estimates on the employer.
Justice Souter stated that Congress’s decision to
tie Social Security benefits to earnings indicated a “general
intent to create a rough parity between taxes paid and benefits
Souter pointed out that several errors can be found in the
McQuatters formula. The formula assumes that cash
tips are equal to charge tips, it assumes that charge tips
are not used by customers as a way to receive cash back
from the restaurant, it assumes that all customers tip (that
a blank tip line on a charge slip suggests a cash tip left
on the table rather than no tip), and the formula simply
does not take into consideration the wage band.
Souter found that the taxpayer’s general duty to keep
records is excused in the case of tipped employees by IRC
section 6001. This section excuses an employer from keeping
records based on charged tips. Justice Souter stated that
the IRS had not claimed that employers have a recordkeeping
duty for cash tips; furthermore, it would not make sense
to place a recordkeeping burden upon them for information
that is difficult to obtain when they have a statutory exclusion
from such a burden for information that is easy to gather.
Justice Souter found that the aggregate estimate method
eliminated the IRC section 6001 exclusion.
Souter looked at the technical requirements of the IRC in
detail. The employer’s obligation to pay FICA taxes
on tips arises under IRC section 6053(c) when the employer
reports tips. The employer may have knowledge or suspicion
that tips are underreported, as in Fior D’Italia,
but the employer has no obligation to keep records of, or
pay taxes on, anything other than reported tips. Justice
Souter stated that the majority looked to IRC section 3121(q)
as a statute allowing the collection of unpaid FICA taxes
without charging interest. Justice Souter found this section
to be much more important. For the IRS to assess tax there
must be a liability to collect. He found the IRS’s
support for the liability in IRC section 3121(q). Usually
the IRS assesses a tax liability, and then issues a notice
and demand. In the employer-only FICA tax audits, the process
was reversed. The IRS made a preassessment estimate of the
tax liability, issued the notice and demand under IRC section
3121(q), and then issued the assessment under IRC section
6201. Justice Souter had two problems with this method.
First, the statute basing an employer’s liability
on employee reports has a built-in safeguard in that employees
are unlikely to overreport tips. There was no such safeguard
in the IRS’s method. Second, the preassessment estimate
the IRS relied upon had no statutory authorization.
Justice Souter looked to the IRS’s motives. What benefit
does the government obtain from an employer-only audit?
For a profitable restaurant, the IRC section 45B credit
will offset most or all of the additional taxes. The government
argued that the process allows a more accurate allocation
of revenues between the Social Security trust fund and the
general fund. Justice Souter believed that the only real
reason for these audits was to compel policing of tipped
employees by employers. The IRS is forbidden from using
the threat of an audit to force a taxpayer into the TRAC
program. The IRS might argue that beginning an audit, then
raising the possibility of an aggregate estimate, does not
violate the statutory language of section 3414 of the IRS
Restructuring and Reform Act of 1998; however, Justice Souter
suggested that the method violates Congressional intent.
Fior D’Italia, the Supreme Court settled
the issue of the use of an aggregate estimation method to
determine FICA tax on unreported tip income, thus resolving
conflicts among the circuits. Several other issues, however,
estimation method. The aggregate estimation
method used by the IRS in Fior D’Italia strayed
from the McQuatters formula in several ways. In
the original McQuatters formula, total sales were
reduced by 10% to allow for nontippers and for tip sharing,
and the resulting figure was divided by the total number
of waitstaff hours for the year. This resulted in a sale-per-hour
figure, which was then multiplied by the number of hours
worked by each member of the waitstaff to determine the
annual sales of each member of the waitstaff. This figure
was then multiplied by 12% to determine the annual tip income
of each member of the waitstaff. In response to complaints
by the petitioners that their tips did not average close
to 12%, the court then reduced the amount of tip income
by one-sixth, making the effective tip rate 10%.
computing the tip rate based on charge-card sales and applying
that rate to all sales, the IRS method in Fior D’Italia
ignored the fact that customers who pay by cash tend
to leave a smaller tip and some customers do not tip at
all. The IRS’s method made no allowance for low tippers,
nontippers, tip sharing, or other factors. The IRS’s
method also ignored the wage band, subjecting all estimated
tips to FICA taxation.
Fior D’Italia’s mistake was not challenging
the accuracy of the estimate. If the restaurant had the
information necessary to challenge the estimate, however,
it probably would have had the information necessary to
compute the correct amount of tips.
of employer-only audits. Employer-only audits
may result in additional FICA taxes paid by the employer,
yet there is no corresponding credit to any employee’s
Social Security account. In Quietwater Entertainment,
Inc. v. U.S. [80 F.Supp 2d 1323 (N.D. FL. 1999)], Judge
Roger Vinson discussed the asymmetry created by the IRS’s
use of the aggregate estimation method: “The structure
and purpose of the Social Security Act is inconsistent with
an assessment of an employer’s share of FICA taxes
on an aggregate estimation of reported tips.” The
Social Security benefits paid to a retiree are dependent
upon the individual’s earnings record.
of coercion. What is the purpose of an employer-only
audit if no new tax revenue is generated? Assuming the employer
can take advantage of the tax credit for FICA tax paid on
unreported tip income credit, the result merely shifts the
money from income tax revenue to the Social Security Trust
Fund. Even though IRS employees are forbidden from threatening
to audit a taxpayer in an attempt to coerce the taxpayer
into entering into a tip agreement, employer-only audits
shift the burden to employers, pitting them against their
own employees and effectively turning them into the “tip
that the Supreme Court has ruled in favor of aggregate estimation,
it will take an act of Congress to change things. Two bills
were introduced in Congress subsequent to the Fior D’Italia
decision. The Tip Tax Fairness Act of 2002 (H.R. 5445),
introduced in the House of Representatives on September
24, 2002, by Representative Wally Herger, would make employers
liable for Social Security taxes on unreported tips only
after the IRS established the amount of tips received by
the employees, effectively prohibiting employer-only audits.
(The bill was reintroduced in May 2003 as H.R. 2034, Tip
Tax Fairness Act of 2003.) In his speech to the House, Herger
stated that the IRS’s use of the aggregate estimation
method violated the intent of Congress: “Congress
did not intend FICA taxes to be paid on an aggregate basis,
because earnings subject to FICA taxes are intended to be
credited to an employee’s Social Security wage history.”
118 was introduced in the House on January 7, 2003, by Representative
Joel Hefley. The bill was short and sweet, requiring only
that “the Internal Revenue Code of 1986 shall be applied
without regard to United States v. Fior D’Italia,
decided by the Supreme Court of the United States on June
17, 2002.” The bill received no action.
Congress provides a remedy for employers, the only protection
against an employer-only audit is to enter into a tip agreement
with the IRS. Participation in such agreements is voluntary
but does not come without cost. Under a TRAC or EmTRAC,
the employer must provide education to employees regarding
tip reporting requirements and must file all appropriate
returns. The TRDA agreement has no specific education requirements,
but requires that at least 75% of employees sign a TEPA
with the employer and report tips at or above the predetermined
rate. All the agreements require additional recordkeeping
by employers. The new ATIP program provides benefits similar
to the other programs, but with less paperwork. If an employer
is not in compliance with the terms of an established tip
agreement, it will not be protected from employer-only audits.
Robertson, JD, LLM, CPA, is an assistant professor
of accountancy; Tina Quinn, PhD, CPA, is
an associate professor of accountancy; and Rebecca
C. Carr, MS, CPA, is an instructor in accountancy,
all at Arkansas State University, State University, Ark.