The Supreme Court: Taxes on Employee's Tip Income

Taxes on Employee's Tip Income

A controversy over collecting taxes for Social Security and Medicare sent shockwaves through the restaurant industry after the Supreme Court ruled in favor of the Internal Revenue Service's (IRS) position in Fior D'Italia, Inc. v. United States on June 17, 2002. The case started when the IRS billed Fior d'Italia, a restaurant based in San Francisco, for $23,262 in unpaid Social Security and Medicare payroll taxes for tips that its employees allegedly failed to report in 1991 and 1992. The IRS based its case on the restaurant's own records.

Supreme Sayings

“For more than five years, Fior d'Italia has single-handedly fought the IRS through the judicial system. Small businesses like this are the cornerstone of the restaurant industry …. To have the IRS continue to exert pressure on a single operator, and casually extract funds without performing a thorough audit of employees' records, is unconscionable.”

—Bill Hyde, chairman of the NRA's Save American Free Enterprise (SAFE) Fund in the trade publication Restaurants USA in January 2002

The restaurant sued the IRS, claiming it had no legal authority to bill the restaurant for these taxes until the IRS had first determined which employees had actually under-reported tips. Both a federal court and a federal appeals court ruled in the restaurant's favor, so the government took the case to the Supreme Court, which accepted it on January 11, 2002. While the 9th Circuit Court of Appeals ruled in Fior d'Italia's favor, four other Circuit Courts sided with the IRS in similar restaurant cases. Circuit courts siding with the IRS were the 7th Circuit (Illinois), 11th Circuit (Florida and Alabama), and Federal Circuit (Washington, D.C.).

The National Restaurant Association (NRA) contributed $100,000 to Fior d'Italia's legal battle and filed a friend-of-the-court brief to help the restaurant take the case all the way to the Supreme Court. If the restaurant lost the case, NRA vowed to take the fight to Congress because it does not believe restaurants should be forced into the role of “tip police.” This battle is now at Congress' doorstep.

Let's look at how the IRS calculated the tax bill in question. The IRS used the restaurant's charge card data and calculated that credit card customers tipped at the rate of 14.49 percent in 1991 and 14.29 percent in 1992. The IRS then used these averages to estimate tips generated by cash sales received by the restaurant's employees. Using those assumptions the IRS concluded that the restaurant should have reported total tips of $772,100 over the two year period rather than the $468,026 that was reported.

The difference of $304,000 was used to calculate the $23,262 based on the tax of 7.65 percent due for Social Security and Medicare.

Living Laws

The Internal Revenue Service can use aggregate estimates based on credit card receipts to determine the total tips at a restaurant. If tips are underreported, the IRS can bill the restaurant for Social Security and Medicare taxes based on its aggregate estimates.

The restaurant claimed this was not an accurate calculation because the tips on cash sales did not average the same amount as on credit sales. In most cases cash tips are lower than credit card tips, the restaurant stated in its brief. In addition, the restaurant claimed that many of the tips on credit card sales also included cash back to customers, which is done as a service to their customers if requested.

Justice Steven Breyer wrote the 6-3 opinion for the Supreme Court. He was joined by Chief Justice William Rehnquist and Associate Justices John Paul Stevens, Sandra Day O'Connor, Anthony M. Kennedy and Ruth Bader Ginsburg. In his opinion, Breyer comments directly on the restaurant's claim that the IRS method of calculating tips is unreasonable:

  • “Fior D'Italia adds that these potential errors can make an enormous difference to a restaurant, for restaurant profits are often low, while the tax is high …. Indeed, the restaurant must pay this tax on the basis of amounts that the restaurant itself cannot control, for the restaurant's customers, not the restaurant itself, determine the level of tips. Fior D'Italia concludes that the IRS should avoid these problems by resting its assessment upon individual calculations of employee tip earnings, and argues that the IRS' failure to do so will always result in an overstatement of tax liability, rendering any assessment that results from aggregate estimates unreasonable and outside the limits of any delegated IRS authority.
  • “In our view, these considerations do not show that the IRS' aggregate estimating method falls outside the bounds of what is reasonable. It bears repeating that in this litigation, Fior D'Italia stipulated that it would not challenge the particular IRS calculation as inaccurate. Absent such a stipulation, a taxpayer would remain free to present evidence that an assessment is inaccurate in a particular case. And we do not accept Fior D'Italia's claim that restaurants are unable to do so—that they “simply do not have the information to dispute” the IRS assessment. Why does a restaurant owner not know, or why is that owner unable to find out: how many busboys or other personnel work for only a day or two—thereby likely earning less than $20 in tips; how many employees were likely to have earned more than $55,000 or so in 1992; how much less cash-paying customers tip; how often they “stiff” waiters or ask for a cash refund; and whether the restaurant owner deducts a credit card charge of, say 3 percent, from employee tips? After all, the restaurant need not prove these matters with precision. It need only demonstrate that use of the aggregate method in the particular case has likely produced an inaccurate result. And in doing so, it may well be able to convince a judge to insist upon a more accurate formula.
  • “Nor has Fior D'Italia convinced us that individualized employee assessments will inevitably lead to a more “reasonable” assessment of employer liability than an aggregate estimate. After all, individual audits will be plagued by some of the same inaccuracies Fior D'Italia attributes to the aggregate estimation method, because they are, of course, based on estimates themselves …. Consequently, we cannot find that the aggregate method is, as a general matter, so unreasonable as to violate the law.”

Associate Justice Souter wrote the dissenting opinion and was joined by Associate Justices Scalia and Thomas. He believes the majority erred in its opinion and does not think the IRS is carrying out the intent of Congress. Souter states:

  • “In fact, the only real advantage to the IRS seems to be that the threat of audit, litigation, and immediate liability may well force employers to assume the job of monitoring their employees' tips to ensure accurate reporting. But if that explanation for the Government's practice makes sense of it, it also flips the Government from the frying pan into the fire. Congress has previously stymied every attempt the IRS has made to impose such a burden on employers. In the days when employers were responsible only for withholding the employee's share of the FICA tax, the IRS attempted to force employers to include tip income on W-2 forms; this effort was blocked when Congress modified [tax code] to exclude tip income expressly from the W-2 requirements …. Finally, when the IRS developed its Tip Reporting Alternative Commitment (TRAC) program …. Congress forbade the IRS from “threaten[ing] to audit any taxpayer in an attempt to coerce the taxpayer” into participating …. And although the use of a threatened aggregate estimate (after an audit) to induce monitoring of employee tips may not technically run afoul of that statute, it is difficult to imagine that Congress would allow the aggregation practice as a lever on employers, when it forbade the use of an audit for the same purpose.”

For the time being the majority opinion stands and the IRS can use the aggregate method questioned in the Fior d'Italia case until Congress passes a law to stop it. Legal experts for the restaurant industry believe this ruling has the potential to devastate small restaurants because the IRS can go back as far as 1988, which is the first year employers were liable for Social Security and Medicare taxes on all employee tips. “With restaurant profit margins around 3 to 5 percent, this could potentially put a number of restaurants out of business,” according to Peter Kilgore, senior vice president and general counsel for the NRA.

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Excerpted from The Complete Idiot's Guide to The Supreme Court © 2004 by Lita Epstein, J.D.. All rights reserved including the right of reproduction in whole or in part in any form. Used by arrangement with Alpha Books, a member of Penguin Group (USA) Inc.