Tip reporting: what you need to know

In March 2001, the Court of Appeals for the 9th Circuit handed down its decision in the case of Fior d'Italia v. United States, striking down employer-only audits.

The history
The ruling marked the first court of appeals victory for the restaurant industry on the issue – after three previous rulings siding with the IRS – and opened the way for a review by the U.S. Supreme Court.

The issue in the case was whether the IRS has the right to assess employers for their share of FICA taxes on tips the IRS says employees earned but failed to report – without ever determining the exact amount of tips not reported or which employees failed to report their tips and without crediting employer FICA payments to those employees' Social Security accounts.

The case is significant as it affects the tip practices of more than 200,000 restaurants and their employees as well as every other business that has tipped employees.

Since 1966, tips received by employees and reported to their employers have been considered wages paid by the employer for withholding and FICA tax purposes. In 1988, the employers' share of FICA was expanded to cover not only tips reported by employees but also the tips employees received and failed to report. (IRS code section 3121(q)) It has consistently been an industry practice to encourage employees to report tips, but where employees reported at or above eight percent of restaurant sales, many within the industry did not further challenge employees as to the reasonableness of their reporting. This was due in large part to the misinterpretation of the tip reporting rules whereby many businesses thought that the reporting of tip income at eight percent of restaurant sales was an implied "Safe-Harbor" reporting level.

For more than thirty years the IRS has repeatedly attempted to shift the responsibility for tip income reporting to the employer. However, Congress has intervened and clarified that it is the job of the IRS to police the accurate reporting of income by employees. This has all changed with the amendment of section 3121(q). Stated in the regulations of 3121, Congress tied the employer's liability to a specific enforcement procedure — the issuance of a notice and demand — which by long standing agency custom and practice entailed the determination and adjustment of individual wage earnings of specific employees.

The results
To the dismay of the restaurant industry the IRS decided to use information obtained from annual reporting of gross sales, total charged sales, total charged tips and total tips reported by employees to assess employer's FICA tax liability on unreported tips in the aggregate rather than the timely task of first determining the employee obligation and using this information to assess the employer. The aggregate assessment was a significant financial obligation on businesses due to the size of the employer's potential liability for employer FICA tax on unreported tips as determined by the IRS. The IRS used the annual reporting by restaurants to imply that tips received on charged sales is representative of true tip income of employees and assessed employers for the employer share of FICA taxes on the difference in total tips reported by employees and the calculated amount.

The IRS commenced an enforcement program using the threat of the employer liability for FICA taxes on unreported tip income to coerce participation by employers in Tip Reporting Determination Agreements (TRDA) which required employees to prospectively report tips at an IRS prescribed rate of sales and burdened the employer with responsibility of assuring employee sign-up in the program and monitoring full reporting.

Federal law requires employees to report tip income, in excess of $20 per month, to their employers on a monthly basis. Generally, Form 4070, Employee's Daily Record of Tips, can be used for this purpose. However, employers may allow the use of any other regularly used form, such as a time card. Electronic submission is also permissible, as long as adequate documentation is maintained.

Although much effort has been exerted by many interested and concerned taxpayers as to the legality and equity of actions taken by the IRS in aggregate employer only assessments of FICA tax, the decision by the U.S. Supreme Court in the Fior d'Italia case has tipped the scales in favor of the IRS. The Court on June 17 ruled that the Internal Revenue Service can use "aggregate estimates" of total tip income as a basis to assess employers for alleged underreporting by employees. The estimation method used by the IRS in the Fior d'Italia case was based on extending the tip percentage paid by credit card customers to the restaurant's total sales. The restaurant was then assessed the employer's share of the FICA tax on the difference between this "estimated" amount and the amount previously reported by the employees. The Supreme Court, in essence, stated that the use of this method is not inherently wrong, and therefore opened the door for its use. However, it also encouraged the industry to appeal to its representatives for a statutory change, if the desire was to prohibit the use of this method.

This ruling focuses on large food or beverage businesses with dine-in facilities. However the entire restaurant industry should exercise caution as should any business where employees normally and customarily receive tips from customers. This ruling may encourage the IRS to increase their audit activity of businesses with tipped employees and to apply this estimation technique. More and more fast-food operations have implemented credit card sales procedures that include the same tip income reporting that caught the full-service restaurant segment.

While the National Restaurant Association and other groups have vowed to lobby Congress to call for a change in the tax code, there is no guarantee that any legislation will pass.

Tips on tips
Meanwhile, in order to protect yourself and your business you should reinforce the importance of reporting tip income. You should post tip reporting posters in your restaurant, as required. You should affirm that your employees understand their responsibility and obligation to report tips is not only the law, it also makes good business sense.

We also encourage you to write to your local congressional representative and let him or her know that holding employers accountable for the failure of their employees to report tip income is unfair, unreasonable and goes beyond the intent of the statute. This decision by the Supreme Court has the potential to give the IRS too much power to make judgments against employers without having to prove any wrongdoing, and it turns the employer into the enforcer.

This is an extremely important issue and you should take the appropriate steps now to protect your business. The IRS has also asserted that the provisions of 3121(q) afford assessment all the way back to 1988. This is undoubtedly an obligation that would put most restaurants out of business. There is little doubt that the IRS will use this victory to coerce participation in Tip Reporting Alternative Contracts (TRAC) which are the current version of agreements between the IRS and industry but don't expect the IRS to be as accommodating as prior to the court ruling.

Can there be a silver lining? Employer FICA tax on tip income reporting above the minimum wage tip offset entitles employers to a tax credit equal to the Employer FICA tax paid. The IRS asserts that an assessment for employer FICA tax based on aggregate assessments are not allowed for the tax credit provisions. It appears that there is sufficient statutory authority for this outcome for closed tax years, generally those covering tax reporting years more than three years old. So to avail yourself of the tax credit provisions for employer FICA tax paid on tip income reporting, you must pay the tax on a current basis. It is also reasonable to infer that there are other benefits to tip reporting by employees. In a tight labor market, having accurate tip earnings compliments management's ability to hire and manage customer service. Having tip earnings records enables management with information that can be monitored to identify weaknesses in tipped employee performance whereby low tip to sales reporting may imply service or customer issues. This information could prove to be valuable for recruiting experienced employees by enabling management to review average hourly earnings including tip earnings with prospective employees.