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

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 the FICA taxes assessed to the benefit of individual employees.

In court, Morrison argued that the IRS did not have the statutory authority under Sec. 3121 (q) to assess FICA taxes in this manner. As its chief argument, the Service asserted that the language of the statute authorizes the IRS to assess FICA employer tax against Morrison Restaurants without regard to whether inaccuracies existed in the individual employee tip reports. The Service further asserted that if Congress intended the IRS to investigate at the individual employee level, before assessing against the employer, Congress would have so stated.

The court disagreed with the Service's analysis, holding that if Congress had absolved the IRS of any duty to investigate individual employees before assessing the employer, it would have provided for this specifically. The court stated further that the result the Service sought would contravene the intent and purpose of the FICA tip provisions, which focus on the individual employee, not on employees in the aggregate. In addition, the court concluded that the statutory history of Sec. 3121(q) demonstrates that Congress intended employers and employees to contribute equally to FICA with respect to all income, including tips. This intent is reflected in the legislative history, wherein Congress stated that "in order to apportion the cost of social security benefits more accurately, employers should be subject to tax on all tips which are credited for benefit purposes." (Emphasis added.)

In sum, the court held that the IRS's assessment of additional employer FICA taxes for the years 1990 and 1991 against Morrison Restaurants was illegal, and thus granted the company summary judgment.

This decision adds weight to the restaurant industry's long-held belief that a restaurant may rely on the tips reported by its employees in determining its FICA tax liability. In all likelihood, however, the Service will refuse to acquiesce and will appeal.

FROM STEVEN M. FRIEDMAN, CPA, J.D., WASHINGTON, D.C.