Tracking and reporting employee tip income has long been a headache for restaurants and other businesses with tipped employees. The IRS recently won a closely watched tip-reporting case that went all the way to the U.S. Supreme Court. At issue was the IRS’s use of an "aggregate estimation" method to determine the amount of tips a restaurant’s employees had received.

In 1991 and 1992, the restaurant calculated and paid FICA (Social Security) payroll tax based on the tips reported by its employees. The reports that were transmitted to the IRS also showed the tips customers had listed on their credit card slips — an amount far in excess of the total tip income employees had reported. This discrepancy prompted the IRS to conduct a compliance check.

The IRS examined the credit card slips and found that the restaurant’s customers had tipped an average of 14.49% of their bills in 1991 and 14.29% in 1992. The IRS then multiplied the charged tip rates by the restaurant’s total receipts for the two years to arrive at an estimate of the total tips employees had received — both cash and charged. Since these amounts were significantly higher than the reported amounts, the IRS issued an assessment against the restaurant for additional FICA tax owed.

The restaurant argued that the IRS’s method of estimating tip income was unreasonable for several reasons. For one, the method may include tips that shouldn’t be counted in calculating the FICA tax an employer owes — for example, tips of up to $20 a month which aren’t counted in the FICA wage base. Moreover, the restaurant argued that using credit card slips to estimate tips might overstate the amounts actually received because:

• Customers who pay cash tend to leave a lower percentage of the bill as a tip;
• Some customers don’t leave a tip;
• Employees sometimes receive a lower amount than what’s written on the slip because the customer asked for cash back; and,
• Credit card fees are sometimes deducted from the tip, leaving the employee with a lower amount.

In the restaurant’s view, situations like these could lead to overpayments of FICA tax that hurt a restaurant’s profitability. Customers, not the restaurant, determine the level of tips. Thus, it’s unfair to base an assessment of tax on an estimate of aggregate tip income rather than using individual calculations of employee tip earnings.

The Court held that the tax law authorizes the IRS to use the aggregate estimation method. The Court noted that a business is free to present evidence that the assessment is inaccurate in a particular case. The fact that the law may put an employer in the awkward position of having to pay FICA tax only on the tips its employees report — even if the employer knows tips are being underreported — doesn’t make the aggregate estimation method illegal. Penalties will not attach and interest will not accrue unless the IRS actually demands the money and the business refuses to pay the assessment.

The IRS has been handed a significant victory in this case. The decision may prompt more employers to participate in one of the IRS’s voluntary compliance programs — TRDA (Tip Rate Determination Agreement) or TRAC (Tip Reporting Alternative Commitment). At the least, employers with tipped employees should review their tip-reporting procedures. If we can be of assistance, please contact us.

The information provided in the newsletter has been obtained from sources believed to be reliable but its accuracy is not guaranteed.