Posted August 7, 2001

Do you get tips for doing your job? Do you own a business in which your employees get tipped?

Especially if you are the latter, you should be aware of an arcane battle between the restaurant industry and the Internal Revenue Service that is now playing out in the courts, and could conceivably reach the U.S. Supreme Court.

The outcome could affect any business with employees who receive "tips," or gratuities — everything from restaurants and taverns to hotels and resorts to cab drivers and hairdressers.

If the restaurateurs win, the IRS could be denied use of a strategy in which it forces businesses to pay taxes on employees' underreported income, rather than directly auditing or penalizing the employees themselves.

First, some background

Contrary to what many people believe, tips are considered wages. So like all wages, they are subject to a federal income tax, as well as to Social Security and Medicare taxes (7.65% for the employee and 7.65% for the employer on the first $80,400 of income; 1.45% for both on amounts above that ceiling).

But the IRS believes that less than half of all tip income is actually reported. So the government has come up with several programs to increase the amount of tip income that is reported. The programs appear to have made a difference: The IRS notes that restaurants in 1999 reported $8.3 billion in tips, up from $3.9 billion in 1993. In that same period, tips reported by all businesses increased to about $14 billion from about $8 billion.

Under some of these IRS programs, the agency can look at the amount of tip income reported on credit-card receipts, compare that with an establishment's total receipts and total reported tip income, and, if necessary, allocate or adjust the tip income reported to various employees. That income then would be subject to additional income and employment taxes.

Skip the employee, bill the employer

No problem so far. The controversies — and the court battles — have been triggered by another program that, in essence, skips over the employees and focuses on the employer. Under this program, the IRS determines that there were unreported tips, estimates how much was unreported and then makes an assessment against the employer for Federal Insurance Contributions Act (FICA) taxes on that unreported income.

By the way, it's not all that difficult for the IRS to figure out that large amounts of tip income are not being reported. In many cases, the total tips (including cash tips) reported by employees of an establishment are less than the amount of tips appearing on the business's credit-card charge slips.

So under the program in question, the employer gets hit with a tax of 7.65% on additional tip income that employees are deemed by the IRS to have received. This action against the employer is what has landed the case in court.

Note that the IRS could also then go after all the employees of the business for additional income and employment taxes as well. But it generally doesn't. Why not? Well, the agency has only so many resources. It probably makes a lot more bottom-line sense to focus on just getting additional employment taxes from one business that employs 100 people than to put the time and resources into auditing every employee.

(One other thing about these "aggregate" assessments. Because the IRS is not assigning additional income to any particular taxpayer, the additional FICA taxes are not credited to any individual's account for future Social Security benefits.)

Employers need to become 'tip police'?

Critical observers say what is at issue here is to what degree an employer can be held responsible for the income reporting of employees. "A business owner could say that the IRS should audit his employees if the IRS thinks they're not telling the truth. But the IRS can say, 'No, we're going to audit you,' " says Vern Hoven, a certified public accountant in Missoula, Mont.

"The question is, can the IRS assess an employer for FICA and unemployment taxes without auditing the employee first? Put another way, does the IRS have the authority to penalize an employer for potential employee malfeasance?"

Representatives of the restaurant industry, which accuses the IRS of trying to make restaurateurs into "tip police," say that they would rather see the IRS go after individual employees than simply assess an aggregate amount to the employers.

"We are not arguing against the overall tax, but our point is that if there is going to be a tax assessed, there should be some certainty as to the figures on which it is based," says Peter Kilgore, general counsel for the National Restaurant Association. "The IRS could do individual employee tax examinations rather than this aggregate assessment."

Supreme Court review next?

As I write this, various federal appellate courts have issued different rulings on the legitimacy of these so-called "employer-only" audits. Cases that have gone before the Courts of Appeals for the Seventh and 11th Circuits have been decided in favor of the IRS. But in March 2001, the Court of Appeals for the Ninth Circuit sided with restaurant owners in Fior D'Italia Inc. v. United States.

"So as it stands right now, the IRS approach is legal in Atlanta, for example, but in California it is not legal," notes Kilgore.

An issue is often ripe for consideration by the U.S. Supreme Court when the appellate courts produce differing opinions. The government must request that the Supreme Court review the Ninth Circuit case. If the Supreme Court accepts, the whole issue could be debated during the court's next term.