Court limits Service's ability to assess FICA tax on unreported tips.

• Author: Friedman, Steven M.

Procedure & Administration

In a case of first impression, a district court recently held that the IRS did not have statutory authority to assess the employer's share of FICA taxes on tip income without first determining whether the individual employees accurately and completely reported their tips (Morrison Restaurants, Inc., DC Ala., 2/29/96). In addition, the court faulted the Service for making no attempt to determine the amount o f additional tip income, if any, that individual employees earned, and for failing to credit the employer-paid FICA taxes to the benefit of individual employees (as required by the Social Security Act).

Morrison Restaurants operates a chain of 290 restaurants in which customers generally tip the servers. The company receives and records tip reports from individual employees. On the basis of these reports, the company withholds and remits employment taxes, including both the employees' and the employer's shares of FICA taxes in accordance with Secs. 3102 and 3111, respectively. The company's stated policy is to report fully and accurately all tips received and the company stresses this policy to employees when they are hired.

In March 1993, the IRS selected a single Morrison's restaurant to participate in a compliance check of tip reporting. For 1990 and 1991, the company had timely filed Form 8027, Employer's Annual Information Return of Tip Income and Allocated Tips, for that particular restaurant. The forms reflected a 16% charged tip rate and a cash tip rate of just under 8%. In May 1993, the Service served notice and demand on the company for the employer's share of FICA taxes on the amount of employee tips it estimated were underreported, pursuant to Sec. 3121 (q).

The IRS used the "Restaurant McQuatters Formula Total Tip Received/FICA Computation" to indirectly estimate the aggregate amount of cash tips properly subject to FICA. Applying this formula, the Service determined that the company owed an additional $5,314 for 1990 and $4,810 for 1991 in unpaid FICA taxes.

The IRS did not investigate any individual employee to determine whether individual reports of tip income provided to the company by its employees were inaccurate or incomplete. The Service also made no attempt to credit additional tip income to individual employees in light of the results of the investigation, and furthermore, did not attempt to credit...