Unreported Tip Income: A Taxing Issue

By John Robertson, Tina Quinn, and Rebecca C. Carr

E-mail Story
Print Story
DECEMBER 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.

According 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.

In 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.

Although 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 program.

Background

Tipped 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.

Prior 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.

In 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.

Prior 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.

The 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.

Reporting Requirements

Employees. 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 531, 2004).

Employers. 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 are met:

  • 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)].

It 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.

On 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.

The 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.

An 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.

Tip Agreements

In 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).

TRAC. 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.

TRDA. 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.

EmTRAC. 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.

ATIP. 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.

The 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.

An 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.

Under 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. Nonparticipating employees must still maintain tip logs and report tips to their employers.

The 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 billion.

Any 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 Number OGI-114882-00).

TRDA, 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.

IRS Interpretation of a Statutory Problem

The 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.

The 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 interpretation.

Judicial Resolution of the Problem

The 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 IRS’s position.

McQuatters

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.

The 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.

Because 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 hour.
  • 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.
  • Each employee’s annual sales subject to tipping were then multiplied by 12% to arrive at total tips for the year.

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.

The 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.

Morrison Restaurants

Another 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.

In 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.

The 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 court’s decision.

Bubble Room

The 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.

The 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.

Assuming 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.

330 West Hubbard Restaurant Corporation

Another 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.

The 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.

Coco 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.

Fior D’Italia, Inc.

Fior 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 tips.

The 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.

The 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.

The 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.

The 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.

The 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.

The 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.

The 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.

The 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.

The 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.

The 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.

The 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” section.

The 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.

Fior 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.

In 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.

The 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.

Justice 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 received.”

Justice 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.

Justice 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.

Justice 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.

Finally, 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.

Unresolved Issues

In 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, remain troublesome.

Aggregate 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%.

By 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.

Perhaps 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.

Asymmetry 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.

Possibility 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 police.”

A Legislative Solution?

Now 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.”

H.R. 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.

Until 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.


John 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.


 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.

©2009 The New York State Society of CPAs. Legal Notices