Restaurateurs, count your tips!

• Author: Ely, Mark H.

In a highly controversial and closely watched case, the Supreme Court decided that the IRS can use an aggregate-estimation method in assessing a restaurant's portion of FICA tax owed, based on total receipts. As a result, employers of employees who receive tips must now develop procedures that will reasonably estimate total tip income, suitable to their situation. Unfortunately, tip employees tend to give employers an inaccurate accounting. As a result, the IRS faces a challenge in determining or estimating correct tip amounts.

The circuits have been in conflict over the scope of the Service's authority to use the aggregate-estimation method for tips; see Fior D'Italia, 242 F3d 844 (9th Cir. 2001); 330 West Hubbard Restaurant Corp., 203 F3d 990 (7th Cir. 2000); Bubble Room, Inc., 159 F3d 553 (Fed. Cir. 1998) and Morrison Restaurants, Inc., 118 F3d 1526 (11th Cir. 1997). The issue before the Supreme Court was whether, in the absence of a reasonably accurate estimate, a statute or another procedure authorizes the IRS to assess an employer's FICA taxes on tips, based on estimates made under the Service's examination guidelines.

In Fior D'Italia, Inc., 122 S. Ct. 2117 (2002), the Supreme Court, in reversing the Ninth Circuit, held that the IRS was authorized by law (Secs. 3101, 3111 and 3121(q)) to base an assessment of employer FICA taxes on tips, using an aggregate estimate of all tips that employees may have received, but did not report.

Fior D'Italia reported tips for FICA tax purposes based on employees' tips reported to it. This amount was far less than the total tips charged on credit cards. Due to the discrepancy, the Service computed total tips received by employees on credit card sales to determine the average tip rate (14.49% and 14.29%, in 1991 and 1992, respectively), then applied that rate to cash sales as well, resulting in an aggregate estimate.

Sec. 45B provides employers with an income tax credit that equals the FICA taxes paid on each employee's tips to the extent that the amount paid exceeds the tax due on each employee's Federal minimum wage. Thus, the only advantage the IRS seems to have achieved in Fior D'Italia is forcing employers to monitor their employees' tips more closely. However, in 330 West Hubbard, in which the issue and decision were similar, the taxpayer argued that without individual assessments, the Service cannot determine the amount of Sec. 45B credit entitlement. The Seventh Circuit flatly rejected this...