Does the IRS have the authority to assess restaurateurs for employer FICA taxes related to workers' unreported tip income? In a recent ruling the Ninth Circuit Court of Appeals called this authority into question, parting ways with earlier decisions in the Seventh, Eleventh and Federal circuit courts.
In the 2001 case Fior D'Italia Inc. v. United States, the IRS computed a 14.49% tip rate on the restaurant's 1991 credit card sales and a 14.29% rate for 1992. It applied these rates to the restaurant's noncredit-card sales and estimated $156,545 of unreported tip income in 1991 and $147,529 in 1992. The IRS then assessed the restaurant for employer FICA at 7.65% on the estimated unreported tip income. It made no effort to allocate these assessments to the individual workers' Social Security wage histories.
IRC sections 3101, 3102, 3111, 3121(a) and 3121(q) put restaurants and other employers with tipped employees in an awkward position. For purposes of the FICA tax, tips employees receive are deemed paid by the employer. While large sums may be involved, for obvious reasons the employer cannot determine the exact amounts. Still, section 3102 requires employers to withhold and pay matching FICA taxes on these tips as they would on regular hourly wages.
Section 3121, however, provides two exceptions to this withhold-and-match requirement:
* Amounts in excess of the annual Social Security wage base.
* Tips of $20 or less received by individual employees in any one month. These two exceptions are often referred to as the "wages band."
COURT REJECTS AGGREGATE APPROACH
In Fior D'Italia, the Ninth Circuit sharply criticized the IRS's aggregate approach of using the tip rate on credit sales to estimate tips on cash sales. Saying the tip rate on cash sales is generally lower, the court reasoned
* It's much easier for patrons to spend credit than cash.
* People with business expense accounts frequently use credit cards and tipping with company credit is even easier than paying with one's own card.
* People tipping with cash feel limited to the currency in their pockets.
The Ninth Circuit also said the IRS was unrealistic to effectively assume none of its estimated amounts of unreported tip income would have been collected by tipped employees individually making less than $20 per month in tips or tipped employees over the annual Social Security wage base. (Fior D'Italia was an upscale restaurant.) The IRS made no effort to estimate tip amounts outside the wages band, which, the court said, could have accounted for a large portion of the estimated unreported tips.
The court was equally emphatic that the only accurate way to determine the restaurant's FICA liability would be to audit all of the individual employees. Applicable FICA taxes assessed could then be attributed to these employees and their Social Security wage histories appropriately updated. Since the entire statutory scheme surrounding Social Security centers on the individual, it seems logical that …