Tax “Tips.”

Finally, no employer FICA liability on unreported gratuities.

oes the IRS have the authority to assess restaurateurs for employer FICA taxes related to workers’ unreported tip income? In a recent ruling the Ninth Circuit Court of Appeals called this authority into question, parting ways with earlier decisions in the Seventh, Eleventh and Federal circuit courts.

In the 2001 case Fior D’Italia Inc. v. United States, the IRS computed a 14.49% tip rate on the restaurant’s 1991 credit card sales and a 14.29% rate for 1992. It applied these rates to the restaurant’s noncredit-card sales and estimated $156,545 of unreported tip income in 1991 and $147,529 in 1992. The IRS then assessed the restaurant for employer FICA at 7.65% on the estimated unreported tip income. It made no effort to allocate these assessments to the individual workers’ Social Security wage histories.


IRC sections 3101, 3102, 3111, 3121(a) and 3121(q) put restaurants and other employers with tipped employees in an awkward position. For purposes of the FICA tax, tips employees receive are deemed paid by the employer. While large sums may be involved, for obvious reasons the employer cannot determine the exact amounts. Still, section 3102 requires employers to withhold and pay matching FICA taxes on these tips as they would on regular hourly wages.

Section 3121, however, provides two exceptions to this withhold-and-match requirement:

Amounts in excess of the annual Social Security wage base.

Tips of $20 or less received by individual employees in any one month.

These two exceptions are often referred to as the “wages band.”


In Fior D’Italia, the Ninth Circuit sharply criticized the IRS’s aggregate approach of using the tip rate on credit sales to estimate tips on cash sales. Saying the tip rate on cash sales is generally lower, the court reasoned

It’s much easier for patrons to spend credit than cash.

People with business expense accounts frequently use credit cards and tipping with company credit is even easier than paying with one’s own card.

People tipping with cash feel limited to the currency in their pockets.

The Ninth Circuit also said the IRS was unrealistic to effectively assume none of its estimated amounts of unreported tip income would have been collected by tipped employees individually making less than $20 per month in tips or tipped employees over the annual Social Security wage base. (Fior D’Italia was an upscale restaurant.) The IRS made no effort to estimate tip amounts outside the wages band, which, the court said, could have accounted for a large portion of the estimated unreported tips.

The court was equally emphatic that the only accurate way to determine the restaurant’s FICA liability would be to audit all of the individual employees. Applicable FICA taxes assessed could then be attributed to these employees and their Social Security wage histories appropriately updated. Since the entire statutory scheme surrounding Social Security centers on the individual, it seems logical that all amounts paid into the program (by employee and employer) should accrue to the employee.


The Ninth Circuit flatly rejected the IRS’s claim that IRC section 446 empowered it to assess the estimated employer FICA tax. While section 446 gives the IRS broad and sweeping powers in the income tax arena, the court said it did not apply to FICA taxes. The IRS also pointed to section 3121(q) as the basis of its authority to assess based on an aggregate estimate. That code section does not, however, directly grant the IRS authority to use an aggregate method (as in Fior D’Italia ) although the dissenting opinion says such authority is implied.

Even in matters where section 446 applies, the Ninth Circuit said it should be used only in cases of incomplete, inaccurate or no records. Fior D’Italia had fulfilled all the duties the law imposed by compiling and making accessible to the IRS (on form 8027) its records of all tips employees reported on their forms 4027. Lacking audit power or any other means to bring about better tip reporting, Fior D’Italia had done as good a job as possible in reporting tip income. Accordingly, the IRS failed in its attempt to impose the employer FICA tax on its liberally estimated amount of unreported tip income.

Despite its protaxpayer stance, the Ninth Circuit acknowledged underreporting of tip income as a problem. But rather than going after employers, the court advised the IRS to proceed either by getting explicit authority from Congress to extend its section 446 authority or by issuing new regulations. According to the court, both of these options would involve appropriate political checks on IRS discretion.


The Fior D’Italia decision marks the first major defeat for the IRS in its ongoing campaign to collect more employer FICA taxes on unreported tip income. Even though the Seventh, Eleventh and Federal circuits rendered pro-IRS decisions, taxpayers in other circuits now have credible, judicial support to vigorously resist such assessments.

CPAs who advise or work for restaurants should stay tuned to this issue for several reasons. First, four appellate decisions in less than four years indicate a growing level of conflict. Second, it is unclear what the Fior D’Italia court would have concluded had the IRS adjusted its aggregate estimation method to take into account the wages band and the reasonable assumption that cash tips are generally less than charge tips. Third, it will be interesting to see how sensitive the IRS is to these concerns in conducting future audits and whether it will attempt to strengthen its position by issuing regulations under section 3121(q).

R. DAN FESLER, CPA, DBA, CIA, is professor of accounting at Tennessee Technological University in Cookeville. His e-mail address is . LARRY MAPLES, CPA, DBA, is COBAF Professor of Accounting at Tennessee Technological University. His e-mail address is . NORBERTO GACHO is an MBA student at Tennessee Technological University. His e-mail address is nag .


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