Topics at a Glance:

Fior case Review
Employer Tip Options
Proposed Tip Legislation

Fior D’Italia Review :

● Allows IRS to estimate tip income by using the “aggregate method.”

● "the taxpayer remains free to challenge the accuracy of the calculation

Employer Options:

●To avoid audits, employers may be forced to enter into a Tip Reporting Alternative Commitment (TRAC)

Editors:
Robert H. Wilson, Esq.
rwilson@ht.umass.edu
Web Site

Linda K. Enghagen, Esq.
lke@ht.umass.edu
Web Site

203 Flint
Hospitality and Tourism Management

Isenberg School of Management
University of Massachusetts
Amherst, MA 01003

Useful Links:

Department of Hospitality & Tourism Management

Isenberg School of Management

The Business of Hospitality Focus on Law, Volume 1 Issue 2

Supreme Court forces Restaurants to change Tip Reporting

The Internal Revenue Service has long believed that restaurant employees have not reported their tip income accurately, with one study finding that tipped employees report about one-half of the tips they actually receive. The IRS has spent decades attempting make employees and employers take steps to accurately report tip income. The Supreme Court Case, U.S. v. Fior D’Italia, Inc. (2002), gives the IRS broad tools to make employers responsible for the accurate reporting of tip income by employees.

Tipped employees are responsible for maintaining accurate records on the amount of tip income that they earn. They must report the tip income to their employer and on their personal income tax returns. Employers are responsible for paying withholding taxes and FICA taxes based upon the amount of the employee wages earned and tips received. Employers are required to collect employee tip reports, withhold employee income taxes and withhold the employee share of FICA taxes based upon wages and tip income received, and then report this information to the IRS. In addition, employers are required to pay the employer share of FICA taxes based on the total wages paid as well as the tip income declared in the employee tip reports.

Employers must file Form 8027 which lists gross sales, total credit card receipts, total credit card tips, and the total of all reported tips.

Even though the IRS continues to believe that employees are underreporting their tip income, they are reluctant to audit all of the tipped employees in a restaurant in order to determine whether the correct amount of tips are being reported. The IRS has been employing a method of estimating tips, called the “aggregate method,” where the IRS does not attempt to identify the amount of unreported tips of each employee, but it instead uses a formula to estimate the total amount of the tips received by all employees.

Review of Fior Case

Fior reported total restaurant revenue, total tips received from credit card sales, (as calculated from credit card slips), and the amount of tips received, as reported by the employees on the required Form 8027. The restaurant then paid FICA taxes to the Internal Revenue Service based upon the amount of wages paid by the employer and tips received, as reported by the employees. What caused the IRS to question Fior on the accuracy of the tip income reported was that the amount of just the credit card tips received (as shown from the credit card slips) was greater than the total amount of tips that the employees reported. The amount of tips shown on credit card transactions for 1991 was $364,786 and in 1992, $338, 161. The employees of Fior reported tip income from all sources (credit cards and cash) to their employer in the amounts of $247,181 in 1991 and $220,845 in 1992.

As a result of the obvious discrepancy between the total tips reported by the employees and the credit card tips, the IRS conducted a compliance check and issued an assessment against Fior for the additional FICA tax due using the aggregate method. The court stated:

The IRS examined the restaurant's credit card slips for the years in question, finding that customers had tipped, on average, 14.49% of their bills in 1991 and 14.29% in 1992. Assuming that cash-paying customer on average tipped at those rates also, the IRS calculated total tips by multiplying the tip rates by the restaurant's total receipts. It then subtracted tips already reported and applied the FICA tax rate to the remainder. The results for 1991 showed total tips amounting to $ 403,726 and unreported tips amounting to $ 156,545. The same figures for 1992 showed $368,374 and $ 147,529.

The court threw aside the arguments made by the restaurant that the IRS had no authority to use the aggregate method, that the process was abusive, and that the IRS had an obligation to audit each employee before auditing the employer. While The Supreme Court agreed that it might be possible that the method used by the IRS to calculate the total tips could be inaccurate in some cases, it rejected this argument as it related to the Fior case, stating "the taxpayer remains free to challenge the accuracy of the calculation. Fior had chosen not to challenge the results that the IRS calculated using the aggregate method and, in fact, had waived its right to challenge the accuracy of the assessment.

Summary of Supreme Court decision

1.  The IRS "is authorized and required to make the inquiries, determinations, and assessments of all taxes… which have not been duly paid."

2.  The IRS may determine reasonable methods to assess FICA and other taxes;

3.  The IRS use of the "aggregate method" to estimate total tip income is reasonable;

4.  The IRS may ignore the amounts of tip income reported by the employees and instead use the "aggregate method" to determine a more precise and accurate amount of tips received when conducting a compliance check and assessment;

5.  An employer may challenge the IRS if it feels that the IRS is using a method that is being applied in an unfair or unreasonable manner.

Ways and Means.

Employer Options after Fior

With the authority given to the IRS from the Fior decision, a restaurant owner currently has several alternatives available in trying to decide what to do about employee tips and the payment of FICA taxes.

1. Pay FICA taxes on the amount of reported employee tips. This is what Fior D'Italia did and they were subjected to an IRS audit and assessment, and years of litigation. Most employers should avoid putting themselves at risk to the type of “employer-first” audit that was forced upon Fior D'Italia.

2. Sign tip agreement contracts with the IRS. The Tip Reporting Alternative Commitment (called TRAC) approved by the IRS requires the owner to educate employees regarding their obligations to report tips and to set up IRS approved procedures to ensure that employees accurately report their tip income.

3. Sign a customized tip reporting contract with the IRS called an EmTrac. This method is similar to the TRAC agreement but allows the employer to customize the procedure appropriate to their business, subject to IRS approval

Proposed Legislation

A bill was filed by U.S. Representative Wally Herger of California, The Tip Fairness Act, during the 2003 legislative session that targets the IRS and its use of the aggregated method to determine total tip income. The bill requires the IRS to obtain tip information first from the employees directly by audit or other means. Only after each employee has been audited would the IRS be able to assess the restaurant owner for additional taxes as a result of under-reporting of tip income. The proposed Tip Fairness Act has received strong support from the National Restaurant Association and its membership. The bill, originally filed in 2002 and then re-filed in May, 2003, has been referred to the House Committee on Ways and Means.