Court rules for IRS on tips audits

By MICHAEL KIRKLAND, UPI Legal Affairs Correspondent   |   June 17, 2002 at 1:39 PM

WASHINGTON, June 17 (UPI) -- The Supreme Court had bad news Monday for restaurants, hotels and beauty salons and their service staff.

The justices ruled 6-3 that the Internal Revenue Service can use its own method for calculating tips during tax audits.

The case doesn't involve petty change.

Since the IRS began its enforcement program in response to a 1984 study, reported tips from the restaurant industry alone "increased from $8.52 billion in 1994 to $9.45 billion in 1995, to $10.19 billion in 1996, to $11.14 billion in 1996, to $12.17 billion in 1998 and to $14.31 billion in 1999."

The case also involves the self-described "America's oldest Italian restaurant," San Francisco's Ristorante Fior D'Italia.

At issue was whether the Federal Insurance Contribution Act tax on employee tip income must be determined by looking at the totals of individual audits -- for example, audits of every waiter or waitress in an establishment -- or may instead be based on a "reasonable estimate of the aggregate amount of tips received by all employees."

FICA treats tips in excess of $20 a month as wages. Both the employee and employer are required to pay FICA taxes on them.

Since the IRS began its FICA enforcement program in response to a 1984 study, reported tips from the restaurant industry "increased from $8.52 billion in 1994 to $9.45 billion in 1995, to $10.19 billion in 1996, to $11.14 billion in 1996, to $12.17 billion in 1998 and to $14.31 billion in 1999."

Usually, employees such as waitresses make monthly reports to their employers on the tips they receive so that FICA contributions can be calculated. Restaurants with 10 or more employees are required to make annual reports to the IRS of the tips reported by employees.

Fior D'Italia filed forms showing that employees reported tips to supervisors of $247,181 for 1991 and $220,845 for 1992.

However, the forms also showed that the total amount of tips reported on customer credit card receipts alone at the restaurant far exceeded both those figures -- $364,796 in 1991 and $338,161 in 1992.

Nevertheless, the restaurant calculated its share of the FICA tax on the lower figures.

The IRS moved into action, conducting a compliance check of the restaurant.

Looking at the credit slip information, the IRS deduced that there was a 14.49 percent tip rate for 1991 and a 14.29 percent tip rate for the following year.

By multiplying those tip rates by the restaurant's gross receipts for those two years, and then subtracting the total tips actually reported on the restaurant's forms, the IRS determined that unreported tip income was more than $156,000 in 1991 and more than $147,000 in 1992.

The IRS told Fior D'Italia that meant it owned $11,976 for 1991 and $11,286 for 1992 in employer's FICA taxes.

Instead of paying up, however, the restaurant only paid a portion of the tax, and then filed suit against the IRS.

In its suit, Fior D'Italia said it didn't dispute the IRS calculations. It just argued that the IRS lacked the authority to assess taxes on employers by using an aggregate estimate of tip income.

The restaurant argued that under the law the IRS must first conduct individual audits of employees, then base any assessment of employer FICA taxes on the total indicated by the audits.

A federal judge agreed with the restaurant. A federal appeals court panel, by a vote of 2-1, agreed with the judge. The IRS, acting through the Justice Department, then asked the Supreme Court for review.

The justices heard argument in April, and reversed the appeals court Monday.

Basically, Fior D'Italia attacked the aggregate audit method as an unreasonable interpretation of the law, Justice Stephen Breyer said in the majority opinion.

But all the pitfalls of aggregate estimation would be present in individual audits. "Consequently, we cannot find that the aggregate method is, as a general matter, so unreasonable as to violate the law," Breyer said.

Writing for himself and two other dissenters, Justice David Souter said the court had to read the law "broadly" to agree with the government.

"I believe that reading the statute so broadly saddles employers with a burden unintended by Congress," Souter said, "and I respectfully dissent."

(No. 01-463, USA vs. Fior D'Italia)

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