ou’ve just eaten an exquisite meal in a fine restaurant. Feeling satiated and generous, you decide to leave the superb wait staff a rather large gratuity. Hours after you’ve left the restaurant, that tip is pooled with others and divided among the staff. Who pays taxes on tips? Employers, employees or both?
CPAs with restaurant clients know that a restaurant is responsible for paying Federal Insurance Contributions Act (FICA) taxes (at 7.65%) on its employees’ wages, including tips. Employees also pay a 7.65% share via withholding. These contributions are used to fund Social Security. Because restaurants typically do not know how much tip income employees actually collect, employees are required to report tips to the IRS on Form 4070, Employee’s Report of Tips to Employer. Therefore, when employees underreport their tips, restaurants underwithhold the employee share due under IRC section 3101 and also underpay the employer share due under IRC section 3111.
Under regulations section 31.3111-3, an employer is obligated to pay employer FICA taxes based only on the amount of income their employees actually report when employees fail to furnish tip reports or their reports are inaccurate. However, under IRC section 3121(q), once the IRS determines that employee tip income is greater than that reported by the employee and sends the restaurant owner notice and demand, the restaurant owner must pay employer FICA tax on those wages.
In assessing unreported tip income, the IRS audits the restaurant (not individual employees, as that would be administratively burdensome) and assesses the employer share of FICA based on the aggregate amount of unreported tips from all the restaurant’s tipped employees. This is known as use of an aggregate method.
One such aggregate method is based on A. J. McQuatters (TC Memo 1973-197). The McQuatters formula works as follows: The IRS reduces the restaurant’s total sales by a percentage to account for sharing tips and customers who leave little or no tip. The result is divided by the total number of hours worked by all servers during the year to determine a sales-per-hour average. That average is multiplied by the number of hours worked by each server to determine the server’s yearly sales. Each server’s annual sales are multiplied by the average tip rate to determine each one’s annual tip income. The formula uses the charged tip rate (the tip rate computed on bills charged on credit cards) as a reference point for the average tip rate.
While the Seventh, Eleventh and Federal Circuit Courts of Appeal have agreed with the IRS’s use of such indirect methods, some district courts have disagreed. The controversy over the validity of the methods warrants an examination of the cases and guidelines by tax advisers to avoid or contest an assessment.
In 330 West Hubbard Restaurant Corp., 203 F3d 990 (7th Cir. 2000), aff’g 37 F. Supp.2d 1050 (1999), Coco Pazzo, a Chicago restaurant, declared both its total charged tips and cash tips reported by employees on Form 8027, Employer’s Annual Information Return of Tip Income and Allocated Tips, for 1993–95, the years at issue. By comparing the amounts Coco Pazzo reported on its Form 941, Employer’s Quarterly Federal Tax Return, with the amounts it reported collected on form 8027, the IRS determined that the restaurant’s employees had underreported $1,112,454 in tips for the three years at issue. The IRS thus demanded an additional $85,104 in FICA taxes from the restaurant.
The only issue for the appeals court was whether the IRS could use the aggregate method to assess the employer’s share of FICA taxes. The taxpayer contended that the IRS first had to individually determine the tips each employee had underreported.
Coco Pazzo’s initial argument was that section 3121(q) refers to wages subject to FICA as “tips received by an employee,” requiring a prior assessment of individual employees. The Seventh Circuit rejected this, stating that use “of the singular is not meaningful in federal statutes” and that nothing could be inferred from such use.
Second, the taxpayer contended that individual employee determinations of underreporting were needed to properly credit their Social Security earnings records for the FICA tax paid. The IRS’s aggregate assessment forced the taxpayer to pay FICA taxes on tip income, but such tax would not be credited to the employees who had earned it. The court easily dismissed this argument, concluding that because the employees had failed to report their tips correctly, they had waived their right to a credit.
Third, the taxpayer argued that using the aggregate method precluded a determination of whether the “wage band” applied (the upper and lower limits on individual employee income for which employers must pay FICA taxes). Employers are not required to pay FICA taxes if an employee’s tips are less than $20 per month or if wages exceed the FICA annual wage base. The court rejected this contention, holding that the wage band does not impede the IRS’s authority to use the aggregate method; rather, it may affect the actual calculation of the FICA tax. Because the taxpayer did not initially raise the calculation argument, the court refused to address the issue.
Finally, the taxpayer argued that use of an aggregate method prevented proper application of the IRC section 45B tax credit. That credit equals the amount of employer FICA taxes paid on each employee’s tips to the extent that amount exceeds the tax due on the federal minimum wage for each employee. The court held that Coco Pazzo failed to demonstrate its entitlement to the credit. The restaurant has petitioned for a rehearing.
In Morrison Restaurants, Inc., 118 F3d 1526 (11th Cir. 1997), vact’g and rem’g 918 F. Supp. 1506 (1996), the IRS used the McQuatters formula to assess $10,124 in additional employer FICA taxes for 1990 and 1991.
Morrison Restaurants’ main argument was that the IRS had no specific statutory authority to assess FICA tax without making individual employee determinations and crediting employees with the employer’s share of the tax. According to the taxpayer, an aggregate assessment, without crediting to employee accounts, was contrary to the legislative intent of the Social Security Act.
According to the court, section 3121(q) suggests the employer can be assessed its share of FICA taxes even when individual employees’ shares are not determined. Further, segregating the employee’s share in section 3101 from the employer’s share in section 3111 suggests that Congress contemplated that the shares could be imposed separately. Moreover, an employee who incorrectly reports tips waives his or her right to be credited; the FICA tax collected from that employer goes to aid Social Security recipients in general.
In The Bubble Room, Inc., 159 F3d 553 (Fed. Cir. 1997), vact’g and rem’g 36 FedCl 659 (1996), the Court of Appeals for the Federal Circuit held valid the IRS’s use of the McQuatters formula. The IRS calculated the charged tip rate to be 14.6% of the cost of a meal, assumed the cash tip rate was similar, determined unreported tips to be $423,290 and assessed the restaurant $31,790 of additional FICA taxes for 1989 (at the then-prevailing 7.51% FICA rate).
Like the Seventh Circuit, the Federal Circuit rejected the taxpayer’s argument that section 3121(q) refers to wages subject to FICA as “tips received by an employee,” requiring a prior assessment of individual employees. The appellate court held that citing that phrase alone does not resolve the issue. Rather, the language merely provides that tips are considered wages received by the employee and paid by the employer; it neither grants nor denies the IRS power to assess employer-only FICA taxes without first assessing the FICA tax liability of each tipped employee.
The taxpayer also argued that individual employee determinations of underreporting were needed to properly credit their Social Security earnings records for the FICA tax paid. The IRS’s aggregate assessment forced the taxpayer to pay FICA taxes on tip income, but such tax would not be credited to the employees who had earned it. The court had no trouble dismissing this argument, concluding that because the employees had failed to report their tips correctly, they had waived their right to a credit.
The taxpayer further contended that the IRS’s use of the McQuatters formula was punitive and illegal. However, the court found that under IRC sections 3121, 6201 and 446(b), the IRS was authorized to use an indirect method to calculate taxable income, because the employees had understated the amount of tips received and it was impractical to determine the exact wages they had actually received. Although the restaurant argued that its FICA tax obligation should be based solely on its employees’ reports, the court found that situation would discourage accurate tip reporting.
The court likewise rejected the taxpayer’s wage band argument, concluding that it speaks to the accuracy of the assessment rather than to the authority of the IRS to use an indirect method.
In Fior D’Italia, Inc., 21 F. Supp.2d 1097 (1998), a California district court held that using an aggregate method was inappropriate. The IRS had estimated 1991 and 1992 tips by dividing the total amount of tips charged on credit cards by the total charges. It then had estimated the total tips received by all employees by multiplying that percentage by the restaurant’s total receipts and subtracting reported tips. Finally, the IRS had multiplied the unreported tip amount computed by 7.65%.
Both the taxpayer and the government had sought summary judgment. The district court concluded that, although section 3121(q) allows the IRS to demand FICA taxes from employers on unreported tips, it does not provide that the IRS may determine the employer’s share through aggregation (that is, it does not impose the employer’s obligation based on the estimated tips of all the employees as a group).
Turning to the legislative history of FICA taxes, the court agreed with the taxpayer that individual employee determinations of underreporting were needed to properly credit their earnings for the FICA tax paid. Rather than concluding that, because the employees had failed to report their tips correctly, they had waived their right to a credit, the court held that an employer tax, without an individual employee credit, amounted to a general revenue tax beyond the purpose of FICA taxes.
In addition, the court held that the IRS’s use of the aggregate method was invalid, because it precluded a determination of whether the $20 de minimis rule applied. The court agreed with the taxpayer that use of the aggregate method prevented proper application of the section 45B tax credit.
In Quietwater Entertainment, Inc., 80 F. Supp.2d 1323 (1999), the IRS used the McQuatters formula to assess a 12% tip rate, resulting in FICA taxes on $20,100 in unreported tips for 1990 and 1991. Quietwater is appealable to the Eleventh Circuit, which had upheld use of the McQuatters formula in Morrison.
Reviewing all of the above decisions, a Florida district court noted that 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 estimate of unreported tips.” Further, the IRS’s adaptation of the McQuatters formula does not take into account the $20 de minimis rule. The Florida court declined to follow Morrison on the grounds that the case failed to consider IRC section 6053(c)(3), which says restaurant employers are to determine whether the total amount of employee-reported tip income is less than 8% of the restaurant’s gross receipts and, if so, to allocate an amount of tip income necessary to equal that 8% among the employees customarily receiving that income. The allocation may be made in one of three ways: based on (1) hours worked, (2) gross receipts or (3) good-faith agreement. Because Quietwater had made this 8% allocation for the years in issue, the IRS had no right to mandate a 12% tip rate. The restaurant was granted summary judgment.
What’s a Restaurateur to Do?
What do these decisions mean for restaurant owners and their tax advisers? How can they protect themselves?
—Lesli S. Laffie, JD, LLM,