Unreported Tips and FICA

TAX CASE

Food service employees generally rely on tips to earn a reasonable wage; they and their employers have special withholding and reporting requirements. IRC section 3121(q) requires that “tips received by an employee in the course of his employment shall be considered remuneration” and “deemed to have been paid by the employer” for purposes of FICA withholding and reporting. Under IRC section 6053 each employee is required to report tip income to his or her employer on a monthly basis. Under Treasury regulations section 31.3402(h)-1 the employer may withhold on the basis of average estimated tips.

In 1991 and 1992, San Francisco’s Fior D’Italia restaurant reported tip income of $247,181 and $220,845 respectively. These amounts were supported by reports from the restaurant’s employees. However, customer credit card slips listed larger tip totals than the amounts the employees reported. Consequently, the IRS calculated and assessed additional FICA taxes.

The IRS used an “aggregate estimation method” to calculate the additional taxes. It computed an average of the tips found on the credit card slips: 14.49% for 1991 and 14.29% for 1992. The IRS multiplied the restaurant’s total receipts by these percentages and subtracted the amounts already reported. It assessed FICA taxes on the difference between the computed and reported amounts.

Fior D’Italia paid part of the taxes and brought a refund suit, arguing that section 3121(q) required that each employee’s tips be determined and individual deficiencies aggregated to determine any underreported amounts. Under that interpretation the IRS would not be allowed to use its aggregate estimation method. The district court ruled for Fior D’Italia, and the Ninth Circuit Court of Appeals affirmed (see “ Tax ‘Tips’ ,” JofA , Feb.02, page 68). The IRS petitioned the U.S. Supreme Court for certiorari . The Court granted it due to differing opinions in the Ninth, Eleventh and federal circuits.

Result. For the IRS. The tax authorities may use aggregate estimation methods to determine the required withholding and reporting amounts. The Supreme Court decided that IRC section 6201, which requires the IRS to make inquiries, determinations and assessments of the tax, allows it to use reasonable methods to estimate taxes due. The Court also ruled the definitional section that used the singular term “employee” does not explicitly require the IRS to make the computations on an individual basis. In addition, IRC sections 446(b) and 6205(a)(1) do not imply an aggregate estimation method could not be used, as the lower courts had argued.

The Court went on to discuss the reasonableness of the aggregate method. It suggested that assessing taxes individually would not have resulted in a better tax computation. Fior D’Italia stipulated it would not challenge the particular IRS calculation as inaccurate, preventing it from presenting evidence that any assessment was inaccurate.

Businesses that must comply with the tip withholding and reporting requirements can take steps to minimize any overstatement of liabilities that might arise from the IRS’s aggregate estimation methods. A restaurant should document

Short-term employees who earn less than $20 in tips.

Employees whose total earnings, including tips, exceed the wage base.

Cash given back to patrons paying with a credit card.

A lower tip percentage paid by cash patrons.

Credit card fees paid out of tips, resulting in lesser net tips to employees.

Although the recordkeeping requirements to support a lower assessment might be substantial, the tax savings could also be quite large.

United States v. Fior D’Italia Inc., Sup. Ct., 89 AFTR2d 2002-2883.

Prepared by Sharon Burnett, CPA, PhD, assistant professor of accounting and Darlene Pulliam Smith, CPA, PhD, professor of accounting, both of the T. Boone Pickens College of Business, West Texas A&M University, Canyon.