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How Much of Your Employees’ Tip Income Should You Be Reporting?

July 16, 2002 | Franchise Alert

A recent decision by the United States Supreme Court could change the way employers calculate tip income reported by the employer for FICA purposes. The case is United States v. Fior d’Italia, Inc.

Under federal tax laws, tips received by an employee are considered to have been paid by the employer for purposes of determining the amount of FICA tax owed for each employee. Thus, in order to calculate the FICA tax for an employee, an employer must have the employee report his or her income from tips. Because tips are usually in cash, underreporting of such income by employees is thought to be common. Employers may therefore be underreporting tip income to the IRS—and underpaying FICA taxes. But for the same reasons an employer would have difficulty in ensuring accurate reporting of tip income by employees, most believe the IRS would find it difficult to calculate employers’ underpayments of FICA taxes based on tip income.

The Supreme Court’s decision in United States v. Fior d’Italia, Inc. changes that perception. In that case, the IRS had assessed a restaurant owner for underpayment of FICA taxes. In order to calculate the amount of tip income, the IRS had reviewed tips reported on credit card receipts and calculated the average tip amount for all credit card sales at the restaurant. Based on that percentage, the IRS estimated the tip income for all non-credit card sales. From this "aggregate estimate,” the IRS determined the amount of the tax owed and assessed the restaurant owner for the deficiency.

The restaurant owner challenged the assessment, arguing that instead of using the "aggregate estimate” formula the IRS should have based its calculation on an estimate of each individual employee’s tip income. The restaurant owner argued that the aggregate estimate formula was likely to result in an overstatement of actual tip income because it does not take into account ceilings on the amount of annual income for which FICA taxes must be paid. The owner also claimed the IRS’ method was unreasonable because it ignores real-world factors, such as cash tips being lower than credit card tips and "stiffing,” which affect total tip income.

Despite these arguments, the Supreme Court concluded that the IRS’ aggregate estimate formula was a reasonable method of calculating tip income. The Court did not foreclose an employer from submitting evidence in a particular case to show that the IRS’ aggregate estimate was inaccurate. But, the Court held that in auditing the reporting of tip income, the IRS is justified in relying in the first instance on an aggregate estimate formula.

The WRF Franchise Group recommends that business owners contact their accountants or tax advisors to discuss how this case may affect them. Restaurateurs and other business owners whose employees receive tip income should review their reporting policies and procedures to ensure that their FICA payments closely reflect actual tip income received or, at least, are in line with the aggregate estimate formula used by the IRS. As always, the WRF Franchise Group stands ready to assist you with your franchise and other legal needs.

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