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Challenge to tax assessment based on IRS aggregate-tip reporting.

Under Sec. 45B, an employer for a food and beverage establishment may take a tax credit for FICA tax paid on reported tips in excess of those treated as wages for the purposes of satisfying the minimum wage. The credit applies to tips received from customers in connection with the delivery or serving of food or beverages, regardless of whether the food or beverages are for consumption on the establishment's premises.


Last year, the Ninth Circuit, in Fior D'Italia, Inc., 3/7/01, held that the IRS could not assess employer FICA taxes based on the aggregate-tip reporting method. The Supreme Court granted certiorari on Jan. 11, 2002, because Fior conflicts with 330 West Hubbard Restaurant Corp., 203 F3d 990 (7th Cir. 2000), Bubble Room Inc., 159 F3d (Fed Cir. 1998), and Morrison Restaurants Inc., 118 F3d 1526 (11th Cir. 1997). The issue was whether an assessment can be made based on a reasonable estimate of the aggregate tip amounts received by employees or whether it must be based on the accumulated results of individual employee audits.


Fior operated a restaurant that employed waiters, bartenders and others whose earnings came in part from tips. It computed and paid its share of FICA taxes for each employee, based on each employee's salary and tip reports. Each year Fior filed Form 8027, Employer's Annual Information Return of Tip Income and Allocated Tips.

In 1994, the Service sent Fior a notice to pay its share of FICA taxes due on tips not reported by its employees for 1991 and 1992. The IRS computed the amount by first using the information on Forms 8027 that Fior had submitted. Second, it determined the percentage of tips on the food and services charged on credit cards, by dividing the total amount of tips charged on credit cards by the total credit card charges. It then estimated the total tips received by all employees, by multiplying that percentage by Fior's total receipts. The tips reported to the Service on Forms 8027 were then subtracted from that amount to determine the estimate of total unreported tips. That figure was then multiplied by the employer's 7.65% FICA tax rate to determine what the IRS said Fior should have owed. The Service did not attempt to identify the amount of each employee's unreported tips. Instead, it used a formula for all of Fior's employees in the aggregate. Fior's position is that the aggregate-tip reporting method employed by the IRS does not identify the individuals who received wages; therefore, it had no way of disputing the calculation of the tax assessment.

The IRS determined that Fior owed additional FICA taxes on the aggregate unreported tips of all employees of $11,976 in 1991 and of $11,286 in 1992. Fior paid a small part of those taxes under protest, and then brought suit for a refund in district court, where it prevailed after challenging the Service's use of the aggregate method. The government's position is that the assessment of tax based on the aggregate-tip reporting method is the only way to account for the disparity between amounts reported on credit card purchases and amounts that the employers report as tip income paid by employees.

Ninth Circuit's Position

The Ninth Circuit stated that not all tips are treated as taxable wages for FICA purposes. Only tips and salary up to the wage base are subject to FICA under Sec. 3121(a)(1). Also, under Sec. 3121(a)(12)(B), cash tips received by an employee would not be FICA wages if they are under $20 in a given month.

The court pointed out that for the IRS's aggregate method to precisely equal the tips on which the employer's FICA tax is calculated, the cash-tipping rate must be exactly the same as the tipping rate on credit card charges, and total tips received must be distributed among employees so that none fall outside the wages band. The court said that none of these conditions would hold true in most cases. First, it felt that charged tips generally exceed cash tips. Second, Fior's employees engaged in tip sharing. Third, looking only at the aggregate tips collected does not indicate how many employees made less than $20 in tips per month for some or all of the periods in question. Lastly, there was no way of knowing how many employees received salaries plus tips exceeding the Social Security wage base.

The court held that there was no way to determine the employer's FICA liability without making an employee-by-employee determination of the taxable tips each earned. Also, the court felt that the Service was not authorized by the Code to use the aggregate method. However, the court conceded that Sec. 6205(a)(1) authorized the IRS to make FICA assessments based on aggregate estimates by promulgating regulations to that effect. However, no such regulations have ever been released. Further, the Ninth Circuit also held that even though Sec. 3121(q) allows the Service to serve a demand on employers for the FICA taxes on unreported tip amounts without also serving a demand on the employees, the provision does not say that the IRS may determine the employer's share through aggregation.

Under Sec. 446(a), taxable income can be computed under the accounting method under which a taxpayer regularly keeps its books. If the method regularly used is not a clear reflection of income, Sec. 446(b) would allow the Service to compute taxable income under a method that does. The IRS has interpreted this to permit it to use estimates to determine unreported tip income subject to income tax. However, the Ninth Circuit held that Sec. 446 does not apply to the collection of FICA taxes.

Supreme Court

On June 17, 2002, the Supreme Court issued a decision in Fior D'italia, Inc. (Doc. 2002-14448). In a divided opinion, the Court upheld the Service, ruling that the IRS may use the aggregate-estimation method (see News Notes, p. 484, this issue).

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Article Details
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Author:Bakale, Anthony
Publication:The Tax Adviser
Geographic Code:1USA
Date:Aug 1, 2002
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