IRS to stop employer-only assessments for underreporting of tips.

• Author: Michelman, Marvin

The IRS has long believed that underreporting of tips by service employees is rampant in the food and beverage industry. To combat this underreporting, the Service began assessing restaurants for the employer share of employment taxes based on IRS-estimated amounts of unreported tips. In what has become known as the McQuatters formula, the Service used an indirect method for reconstructing the income of an individual employee who had failed to keep adequate records. However, the IRS has agreed to stop employer-only assessments after two recent adverse decisions.

In these cases, the courts objected to the method, since the tax assessments were based on estimated unreported tips of employees collectively and there were no attempts to determine the actual tip income of individual employees. Moreover, there were no attempts to credit the FICA taxes to individual employees' Social Security wage accounts. The Service is appealing one of the rulings, but for now will discontinue its employer-only audits.

Discussion

The IRS has attempted several ways to accurately determine wage income. In McQuatters, TC Memo 1973-240, the Service selected waitresses at the Space Needle Restaurant for an audit of their wage income. Using Sec. 446, the IRS determined that the taxpayers were underreporting their tip income, and used an alternative method to compute wages. The Service determined their tip income indirectly under the following method: (1) total sales of food and beverages for the restaurant were reduced by 10% to account for low or nontippers and for sharing tips with captains md banquets; (2) the resultant figure was divided by the total number of hours worked by all waitresses during the year to determine a sales-per-waitress-hour average; (3) this average was multiplied by the number of hours in each year that each waitress worked to determine the yearly sales of each waitress; and (4) the yearly sales of each waitress were multiplied by 12% to determine the yearly tip income of each waitress. (No distinction was made between tips on cash and charge sales.) The IRS determined a 12% rate based on the fact that charge customers of the restaurant who also charged their tips gave tips equaling slightly more than 14% of the cost of their food and beverages. These customers accounted for one-fifth of the restaurant's total sales for two months in the year at issue. The Service had lowered it to 12%, since many cash customers leave smaller tips than charge customers, the taxpayers shared their tip income with captains, and low-tip work such as...