Battle over employer FICA tax.

The controversy over the IRS'S ability to assess employer FICA tax on employee tips continues. The Service is adamant in its attempt to assess an employer (without also auditing each employee) to determine each employee's unreported tip income. In a recent case, Quietwater Entertainment, Inc., DC Fla (6/25/99), a district court once again decided in favor of an employer. If appealed, this decision would go to the Eleventh Circuit, which previously ruled in rawer of the IRS on the same issue.

Tips are considered part of an employee's wages for FICA tax purposes under Sec. 3121(q). Several courts have held that the Service does not have the authority under Sec. 3121(q) to assess an employer's share of FICA taxes on its employees' unreported tip income on an aggregate basis, without first determining the underreporting by the individual employees and crediting their wage history accounts. Employers must apply and collect both the employer portion and the employee portion of FICA taxes on employees' reported tip income. The employer collects FICA tax until the employee's combined wages and reported tips exceed the taxable wage base for that particular year; withholding for income tax purposes continues for the year, regardless of whether the Social Security wage base limits have been reached. The employer is not liable for its portion of the FICA taxes on tips an employee failed to report to the employer until notice is received by and demand for taxes are made to the employer by the IRS.

In Bubble Room, Inc., 159 F3d 553 (Fed. Cir. 1998), the Court of Appeals confirmed Congress's intent to impose an employer-only FICA tax on employees who do not accurately report their tips. The court concluded that Sec. 3121(q) expressly contemplates that an employer may be liable for its share of FICA taxes, even if the records supplied by its employees are missing, inaccurate or incomplete. In this case, the reported figures reflected a tip rate of 16.4% on charge receipts and only 1.4% on cash receipts. Under these circumstances, it was reasonable for the Service to determine that the employer's accounting method did not accurately reflect the amount of tips received by its employees. The court granted the IRS flexibility to base its assessments on formulas when it was evident the taxpayer understated wages received and when it was impossible or impractical to determine the exact amount of wages actually received. This left the Service with no choice; it felt there would be an incentive to employers to discourage accurate reporting or, conversely, to ignore clearly inaccurate reporting by its employees. At the same time, the Service knew it was impractical to make an assessment against each employer for employee FICA taxes.

In Morrison Restaurants, Inc., 118 F 1526 (11th Cir. 1997), the IRS assess an employer additional FICA tax the basis of unreported tips. After the employer filed for a refund, the district court granted summary judgment favor of the taxpayer, determining that the Service lacked authority to assess employer FICA taxes on unreported tips in the aggregate without first determining the individual employee's underreporting and first crediting the employees for the employer's share of the assessed taxes. The Eleventh Circuit reversed, holding that, because the IRS's interpretation of Sec. 3121(q) was reasonable, it would defer to the Service's interpretation that it had the authority.

In Morrison, the Eleventh Circuit did not consider the issue of shared tips, as the restaurant owner in that case stipulated that the IRS's aggregate estimate of unreported tips was reasonable. In Quietwater, the district court stated that, if Morrison was not controlling on the issue, it would have reached a different conclusion; according to the court, the applicable statutes and regulations indicate the Service is not authorized to assess the employer's share of FICA tax on the unreported tips of employees on an aggregate basis.

Under Sec. 6053(c)(3), restaurants are to determine if the total amount of their employees' reported tip income is less than 8% of the restaurant's gross receipts. If reported tip income is less than 8%, the restaurant is required to allocate an amount of tip income necessary to equal 8% among employees receiving tip income. The allocation may be made in one of three ways: hours worked, gross receipts or good faith agreement. In Quietwater, the employer performed the allocation as required by law. However, because Morrison failed to consider Sec. 6053(c)(3), that decision was not a controlling precedent to Quietwater.

As a result, the district court granted summary judgment in favor of Quietwater. The Service assessed a 12% tip rate for cash tips (16% for credit-card tips), which the court considered well in excess of the 8% determined by law, accusing it of choosing "to disregard the law and go beyond what the law specifies." According to the court, Congress has made changes to the FICA tax since 1977 and "given no indication that it intended to alter the direct correspondence between employee and employer FICA contributions and the individualized employee Social Security benefit. In light of the symmetrical scheme established by Congress as to FICA benefits, it does not appear that Congress ever intended that FICA taxes be assessed against an employer in excess of the amount contributed by its individual employees when such taxes will never be credited to the individual employees' accounts." A tax without individual employee credit would operate as a revenue generator, which is not the purpose of the FICA tax.

When Sec. 3121(q) is read with other sections of the FICA statute, as well as other Code sections, it appears that Congress intended to determine an employer's share of FICA taxes based on individual assessments of each employee's wages. The IRS'S interpretation of computing FICA on an aggregate basis directly conflicts with this intent. The structure and purpose of the Social Security Act was intended to place a tax on employers that would be credited to individual employees' accounts. The aggregate method would not enhance the employee's Social Security benefits. While the jury is still out on this matter, the lower courts have established a pattern of ruling in the taxpayer's favor. If tip income is allocated on a reasonable basis (per Quietwater, 8%), taxpayers should be able to withstand challenges from the Service.

FROM DAVID W. APPEL, CPA, SHAREHOLDER, AIDMAN, PISER, & COMPANY, P.A., TAMPA, FL

Philip E. Moore, CPA, MBA Brown, Dakes & Wannall, P.C. DFK International Fairfax, VA