Tips received by employees in the scope of their duties is considered taxable wages and compensation under the Internal Revenue Code. It does not matter if the tips are in cash, made by credit card or not reported to the employer. The Internal Revenue Service places the burden on the employee to report all tips to ensure that the proper FICA taxes are paid. In addition, the employer has the responsibility to ensure that its employees are reporting tips or else it may be personally liable for the unpaid Social Security and Medicare taxes on the deficient amounts. Failure to follow these rules can lead to the IRS assessing additional taxes on employees and employers alike with penalties and interests.
Every employee who receives $20.00 or more in tips must report them to his or her employer on or before the 10th day following the month that they were earned. 26 U.S.C. §6053(a). This is accomplished by completing Form 4070 (Employee’s Report of Tips to Employer) within the statutory deadline. Employees may even opt to use Form 4070-A (Employee’s Daily Record of Tips) as a convenient format to document tips daily so that the required report is an accurate one. Tip income for the year will be reported by your employer in Box 7 of your Form W-2. Employees who do not report their tips still have a duty to pay taxes on the income by completing Form 4137 (Social Security and Medicare Tax on Unreported Tip Income) and submitting it with the employee’s annual federal tax return to the IRS.
Employers have an interest in accurate tip reporting because they have a duty to pay FICA taxes to the IRS. They must withhold from the employee 7.65% of wages, which consist of the Social Security Tax (6.2%) and the Medicare Tax (1.45%). If the employee earns over $200,000.00 in wages for the tax year, then an additional 0.9% Medicare tax is withheld. Employers must also contribute their portion of these two taxes, which also consist of the Social Security Tax (6.2%) and the Medicare Tax (1.45%). The total FICA tax to be remitted to the IRS is 15.3% (7.65% from the employee’s income and 7.65% from the employee’s share. The final responsibility to collect FICA taxes rest on the employer under the Internal Revenue Code. 26 U.S.C. §3111, 3121(q). If the employees are not claiming tips, then the employer is not forwarding accurate payroll taxes and this can lead to audits and additional assessments.
It is no secret that employees tend to underreport tips to the employer, and the Internal Revenue Service has taken notice. The Internal Revenue Code assumes a tip rate of 8% and that amount at least should be allocated among the employees of “a large food or beverage establishment”. 26 U.S.C. §6053(c)(3). Of course, it would require an incredible amount of resources for the IRS to go after every single waiter, waitress and busboy to assess a few dollars each. Instead, the IRS has turned to the restaurant operators to assess these taxes instead. They provide the most cost-effective target for tax collection. Since bars and restaurants are well-known for employee compensation through tips, the IRS has developed specialized methods for audits of these entities to ensure the appropriate tax dollars are captured. As such, the IRS has developed an “aggregate estimation” method to calculate how much tip dollars the restaurant should be reporting based on its gross revenues and average tipping percentages. Using this simple math formula, the Internal Revenue Service determines and assesses what FICA taxes are supposed to be paid whether the employees reported all of their tips or not.
The U.S. Supreme Court gave its blessing to the Internal Revenue Service in using the aggregate methodology to collect unpaid taxes on tips from employers. In United States v Fior D’Italia, Inc., 536 U.S. 238, 122 S.Ct. 2117 (2002), the IRS conducted a compliance check against San Francisco’s Fior D’Italia restaurant after discrepancies were reported. In 1991 and 1992, the total tip income reported by employees to the restaurant (and ultimately to the IRS) was $468,026.00. However, those same reports showed that customers listed tips on their credit card slips amounting to $702,947.00 in the same period. To figure out the unreported tips, the IRS first examined the credit card slips and found that customers tipped an average of 14.49% on their bills in 1991 and 14.29% on their bills in 1992. It then multiplied the tip rates against the restaurant’s total receipts for reach year, then subtracted tips already reported and applied FICA taxes to the remainder. The Internal Revenue Service ultimately determined that the total unreported tips were $156,545.00 for 1991 and $147,529.00 in 1992. Applying the employer’s 7.65% FICA tax rate to each year, the IRS determined that Fior D’Italia owed $11,976.00 in taxes for 1991 and $11,286 in taxes for 1992 ($23,262 total).
The restaurant filed suit against the IRS, alleging that the tax statutes did not authorize it to use an aggregate estimation but rather it must determine the tips received by each individual employee. The U.S. District Court ruled in the restaurant’s favor and the Ninth Circuit Court of Appeals upheld this verdict in a 2-1 ruling, both courts having concluded that the Internal Revenue Service lacked statutory authority to employ this method. This result differed from a Seventh Circuit ruling on a similar tip issue that favored the IRS. The U.S. Supreme Court granted certiorari to settle the difference among the appellate courts.
Many restaurants had a stake in the determination that the high court would make. These businesses already have to cope with low profit margins and now face a huge potential for a tax assessment that can’t be met with their meager resources. The National Restaurant Association even filed an amicus curiae brief to the U.S. Supreme Court and provided $100,000.00 to help pay for the Fior D’Italia’s legal fees to cover the fight.
Case law established by this point have consistently held that an IRS’s assessment of tax is entitled to a presumption of correctness that the taxpayer must overcome. See United States v. Janis, 428 U.S. 433, 440 (1976). In addition, the courts have consistently held that the IRS does not exceed its limits when it uses a “reasonable” method to estimate an individual’s tax liability. For example, the Seventh Circuit Court of Appeals upheld an estimate of a waitress’s tip income based on restaurant’s gross receipts and average tips earned by all waitresses employed by the restaurant. Mendelson v. Commissioner, 305 F.2d 519, 521-522 (CA7 1962). Fior D’Italia conceded that the Internal Revenue Code permitted estimations by the IRS to make assessments, but argued that this was limited to determining income tax liability and not FICA tax liability. Therefore, they argued, it was not the intent of Congress for the Internal Revenue Service to make estimated assessments out of this scope.
The U.S. Supreme Court disagreed with these arguments and found that “these considerations do not show that the IRS’ aggregate estimating method falls outside the bounds of what is reasonable.” Id at 247.
- “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%, 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.” Id at 247-248.
Since Fior D’Italia only challenged the IRS statutory authority for aggregate estimation but did not challenge the accuracy of the tax assessment, the suit was defeated and the U.S. Supreme Court ruled in favored of the Internal Revenue Service. The result of the Fior D’Italia decision is a rule that now compels employers to act as the “tip police” in monitoring, administering and reporting tips or else face an assessment based on aggregate estimations for any perceived shortfalls. This leaves many bars, restaurants and other tip-intensive businesses to either create reserve accounts to cover FICA assessments or enter into alternative arrangements with the IRS to cover themselves (e.g. Tip Reporting Alternative Commitment). If this rule is to be overturned, it would have to be done through an act of Congress.
As tempting as it is to cheat the IRS by not reporting tips, it is increasingly difficult to get away with it in a world where cash is used in less frequency and credit cards are leaving a paper trail. Sooner or later, the Internal Revenue Service will target that employer and use an estimation method to determine what taxes should have been paid based on gross receipts. The outcome may be that both employer and employees alike are found to be underreporting and a large tax deficiency is assessed with penalties and interests. This merely compounds the problem and it simply isn’t worth it.
If you have any questions about the taxation of tips or any other aspect of federal taxation, then do not hesitate to contact the attorneys at Kershaw, Vititoe & Jedinak PLC for assistance today.