by George G. Jones and Mark A. Luscombe
The IRS has scored a victory in its long-running battle to get a better handle on the taxation of tip income. The Supreme Court has overturned the Ninth Circuit and ruled that the IRS may estimate the FICA taxes due from an employer from tip income without first auditing the tip income of the individual employees.
Tip income has long been a problem for the IRS because of the lack of an audit trail. Although tip income is a significant factor in many businesses, the restaurant industry represents the largest dollar amount of tip income. The IRS has focused on determining the proper amount of tip income not only for income tax purposes but also FICA withholding purposes. For income tax purposes, the employer often will not have a withholding obligation because tips received by an employee are not required to be included as W-2 wages. For FICA purposes, the employer does have an obligation to contribute the employer portion of the FICA taxes as long as the workers are classified as employees rather than independent contractors, as is usually the case in the restaurant industry.
Cash tips are often left by individuals for personal meals. These tips are income to the recipient but are not deductible by the diner. Even where cash tips are left for business meals for which a business deduction is claimed, the audit trail back from the business deduction to employees of particular restaurants is often difficult, if not impossible.
The growing use of credit cards and reporting tips on credit cards has provided the IRS with a more direct audit trail for that portion of tip income. Many less expensive restaurants, however, still primarily operate with cash rather than credit card sales, and many diners still leave cash tips even when the underlying food bill is put on a credit card.
The IRS has specific statutory authority to use estimation methods to determine income tax liability. The statutory language with respect to FICA taxes is less specific, however, with Code Sec. 6205(a)(1) authorizing regulations to be adopted prescribing mechanisms for employers to adjust FICA tax liability.
U.S. v. Fior D’Italia Inc.
In U.S. v. Fior D’Italia Inc. (Sup Ct June 17, 2002), the restaurant had determined its employer FICA liability based on the tips reported to the employer by its employees. The IRS noticed that the total tips reported by the employees, however, were less than the tips shown on credit card slips for credit card sales alone. With obvious underreporting by the employees going on, the IRS chose not to audit individual employees but rather to employ aggregate estimation techniques for the employer’s FICA obligation.
The IRS determined the percentage that tips represented of total credit card sales for the two years at issue and applied those same percentages to the total receipts of the restaurant for those years to estimate total tips. The IRS then assessed the employer’s FICA obligation based on that amount. The restaurant paid part of the assessment and filed a claim for refund, challenging the right of the IRS to apply aggregate estimation techniques at the employer level rather than determining the proper amount of tips at the employee level. The restaurant also stipulated that the estimation made by the IRS in this case was accepted as accurate.
The Ninth Circuit had decided in favor of the taxpayer on the basis that Congress had given statutory authority to the IRS to use estimation techniques only for income tax withholding, not FICA tax. The Ninth Circuit further held that the statutory authority in the FICA area was for the IRS to adopt regulations, and the IRS had not adopted any regulations authorizing the use of estimation techniques.
The Supreme Court held, however, that reasonable estimation techniques were a necessary part of the IRS’s obligation to determine tax liabilities and that the IRS’s techniques seemed reasonable to the Court. Although a taxpayer in general could seek to show that the IRS’s estimation was not accurate in a particular case, the taxpayer in this case had waived its right to challenge the accuracy of the IRS’s estimation, having stipulated as to its accuracy.
Planning for FICA reporting
Although the restaurant industry is warning about the burdens imposed on the industry by this decision, its impact is far from clear. If restaurants continue to follow the practice of basing their FICA reporting on the tips reported to them by their employees, they face the possibility of audit and additional FICA tax obligations being imposed on the employer. By statute, however, no interest or penalties will be imposed if the employer pays the assessment when received. Further, by statute, the employer is entitled to an income tax credit for the FICA taxes paid. Therefore, aside from the increased audit risk and associated costs and distractions, a restaurant would endure no direct financial hardship by continuing to follow the practices used by the taxpayer in the Fior D’Italia case.
A restaurant that seeks to avoid an audit situation, however, does have a more difficult task. It must basically ignore the information being reported to it by its employees and do its own estimation techniques. It need not follow the estimation technique used by the IRS in Fior D’Italia because the Supreme Court specifically pointed out some possible problems with the accuracy of that technique (e.g., cash customers do not necessarily tip at the same rate as credit card customers). It appears that the IRS is willing to be flexible in working with taxpayers who use their own estimation techniques as long as they have a reasonable basis.
The IRS does offer a Tip Reporting Alternative Commitment (TRAC) program for restaurants to establish accurate tip reporting procedures in return for a promise that the IRS will accept the reported tips for FICA tax purposes. The IRS is prohibited by statute from coercing restaurants into the TRAC program with audit threats. Although this does help the IRS, it also may be a good solution for the employer looking to avoid any unexpected FICA tax liability that an audit can bring while, at the same time, looking not to offend employees by submitting a FICA report different from the tip reports that they submit.
One anomaly of the Fior D’Italia case is that the additional FICA taxes withheld from the employer may end up never benefiting the Social Security of the restaurant employees. If the IRS never audits the employees nor increases their reported income, the income credited to them for Social Security purposes will never be increased to correspond to the additional FICA taxes being paid by the employer and may eventually qualify for refunding. As pointed out by the dissent in Fior D’Italia, it is hard to imagine how the IRS benefits in the long run from this case unless employers start taking action to encourage more accurate reporting by their employees, either through signing up for the TRAC program or through other efforts.
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