Supreme Court Approves IRS Method for Employer FICA on Tips

By Larry Maples and R. Dan Fesler

May the IRS use an aggregate estimation method to determine unreported tips and then assess employer FICA taxes on the estimated unreported amounts? According to a recent Supreme Court decision in U.S. v. Fior D’Italia [536 U.S. _ (2002), 2002-1 USTC 50,459], the answer is yes. The decision settles the dispute among the circuit courts by approving an expansive IRS estimation procedure.

Law and IRS Policy

IRC section 6053(a) requires employees to report taxable tips to their employers each month. Food or beverage establishments with more than 10 employees on a normal business day disclose the amount of total tips reported to them on Form 8027. Nevertheless, Form 8027 specifies tips as 8% of total receipts no matter what the employees report. The employer then allocates among the employees the difference between the tips computed using the 8% rate and the amount of tips actually reported by the employees.

A dispute arose among the courts when the IRS went above the 8% used on Form 8027. More specifically, the IRS multiplied total restaurant receipts by the credit card tip rate (computed from other information provided on Form 8027) to estimate total tips. A deficiency, for employer FICA taxes, was then assessed on the difference between this assumed amount of total tips and tips reported by employees. The instructions to Form 8027 warn that an employer can be liable for additional FICA taxes, and provide a worksheet that illustrates this computation. The instructions clearly indicate however, that the worksheet is only for the employer’s information (it is not sent to the IRS).

The IRS has been encouraging employers to enter into tip rate determination agreements (TRDA) or tip reporting alternative commitment (TRAC) agreements. In a TRDA, the IRS and the employer negotiate a percentage that employees should report. In a TRAC, an employer agrees to train its employees to correctly report tips and to comply with IRS filing and recordkeeping requirements. In return, the IRS agrees to base the employer FICA tax solely on reported tips and any unreported tips discovered during an audit. The IRS does not intend to perform many audits in TRDA/TRAC situations. The IRS strategy of vigorously pursuing unreported tips appears to be an effort to encourage employers to enter into these agreements.

Fior D’Italia

In 1991 (the case also involved 1992), employees of Fior D’Italia restaurant reported tips of $247,181 and the restaurant reported this amount to the IRS on Form 8027. The same Form 8027, however, reported tips on credit card slips alone of $346,786. The IRS applied the credit card tip rate, 14.49%, to cash sales. The result under this “aggregate estimation method” was a total tip amount of $403,726. The IRS assessed additional employer FICA on the difference between the two.

The restaurant’s primary argument was that the IRC assesses employer FICA on the wages “received by an employee” and thus an aggregate method is not sanctioned. Fior argued the IRS had to audit each employee and sum the total amount of unreported tips for the group. Then, FICA tax could be assessed on each employee and an appropriate assessment made on the restaurant for matching FICA. In the minority’s dissenting opinion, the justices indicated strong support for this argument, going so far as to say the basic design of the Social Security system involves updating individual contribution records for the employee and employer contributions. Under the aggregate approach condoned by the majority, there is no updating of individual records for the FICA paid by the employer on unreported tips. To quote the minority opinion, “aggregate assessment fits poorly with the design of the system.”

The Supreme Court majority considered Fior’s position as a mere linguistic argument that bypassed the intent of the law. Siding with the IRS, the court cited IRC section 6201(a), which says the IRS “is authorized and required to make the inquiries, determinations, and assessments of all taxes … which have not been duly paid.” The opinion then cited a long line of income tax cases authorizing IRS use of reasonable estimation methods. In the employment tax arena, it pointed out the Tax Court’s approval of estimating an employee’s FICA based on the average tips of other waitresses in the same restaurant [McQuatters, 32 TCM 1122 (1973)]. The majority said Fior failed to “show that the IRS’ aggregate estimation method [falls] outside the bounds of what is reasonable.”

The majority in this 6–3 opinion, while approving IRS use of an estimation method, explicitly indicated that an employer may challenge the accuracy of the method. For example, an employer may keep records and provide evidence as to amounts of tips that are outside the “wage band” and thus not subject to FICA taxes. The two situations where tips fall outside the wage band are when a tipped employee receives less than $20 in tips during a given month, and when tips received by employees are above the FICA ceiling amount. The dissenting opinion by Justice Souter (who was joined by Scalia and Thomas) pointed out that the law excuses employers from keeping such records, but the majority opinion nevertheless suggests that these unrequired records could be useful in challenging the accuracy of an IRS estimate.

IRS Commissioner Charles O. Rossetti issued a statement shortly after the June 2002 IRS victory saying the Court’s decision upheld the IRS’ ability to see that all Americans pay a fair share of taxes. The IRS will continue to work cooperatively with restaurants and other affected industries to create a fair and accurate system for tip reporting.

Implications

The Supreme Court has removed the uncertainty about whether the IRS has the authority to use an aggregate method to estimate employer FICA taxes on unreported tips. The Supreme Court’s decision may make the IRS less flexible in arriving at the terms of TRDA and TRAC agreements. On the surface, it is strange that the IRS would push the issue of employer FICA, because an income tax credit under IRC 45B is available as an offset. But backed by this decision, the IRS can insist on tighter TRDA and TRAC agreements with the objective of improving employee tip reporting.

The statute of limitations on an employer’s FICA liability for unreported tips does not start to run until the IRS attaches the liability, and there is no time limit to issue the notice that triggers the liability. If employers had prevailed in their contention that employer liability should rest on the foundation of employee liability, the employee three-year statute would have effectively limited the employer’s exposure.

Finally, the majority opinion invites employers to present documentation to counter the reasonableness of the IRS estimate.

Larry Maples, DBA, CPA, is the COBAF Professor of Accounting, and
R. Dan Fesler is a professor, both at Tennessee Technological University, Cookeville, Tenn. income Tax Liabilities in Bankruptcy