Employer FICA Tax on Unreported Tip Income

In Fior D'Italia, Inc., 122 S.Ct. 2117 (2002), the Supreme Court reversed the Ninth Circuit, granting the IRS the authority to assess employer FICA taxes on estimated unreported tip income. Moreover, the IRS has the authority to determine these estimates based on the aggregate-estimation method. This latest development creates a new headache for employers with tip employees (primarily in the restaurant industry).

Overview

The IRS has attempted to force accurate reporting of tips, to no avail. Prior to Fior D' Italia, it implemented TRAC (Tip Reporting Alternative Commitment). Expiring in 2005, TRAC was meant ideally to lessen an employer's burden by educating employees on the importance of correctly reporting tip income. If the employer participated, the IRS would not pursue aggregate assessments based on estimates of unreported tip income. Further, under Sec. 45B an employer receives a credit for FICA taxes paid in excess of tips treated as wages for minimum-wage purposes.

Employer Tipping Options

With the IRS's new-found authority, an employer has two options in planning for a potential IRS assessment.

Option #1. The employer could do nothing and prepare a defense if the tip income reported is challenged. The potential benefit is a large savings after taking into account employee FICA and income tax, and employer FICA, FUTA, unemployment insurance and workers' compensation on each additional dollar reported, plus no penalties or interest incurred up until an assessment. However, this is a risky approach; an unsuccessful defense could mean payment of aggregate assessments of tax, penalties and interest for three years or more. Does the benefit of a tax savings today outweigh the cost of a potentially large assessment in the future?

Option #2. An employer could do everything within reason to promote accurate tip reporting. For example, it could continue to educate employees and compare tip income reported with that charged. While employers have little control over how much their employees report, they are hardly free from responsibility. Under this approach, tips reported could more correctly reflect those actually received, resulting in no additional tax.

A problem arises for employers with high levels of excludible tips (e.g., employees with less than $20 per month in tips, customers who request change on credit card charges over the amount owed, credit card usage fees and employees over the Social Security wage base). The Supreme Court has already determined that estimates (including excluded tips) must be reasonable. If IRS estimates do not take these circumstances into consideration, additional employer FICA may still be assessed. Nevertheless, an employer may raise these issues when contesting any additional FICA tax.

Other issues affecting reportable tips include people who do not tip, an IRS rate for cash tips that is too high in relation to charged tips and tip-splitting with other employees who might be under the monthly threshold (e.g., busboys or hostesses).

Conclusion

Tax practitioners with clients affected by Fior D'Italia should advise them to accurately report tip income and encourage them to record and be prepared to document the reasons for any discrepancies. These justifications should aid in defending against an assessment based on IRS estimates, and possibly reduce exposure to additional tax. (For further discussion, see Tax Practice & Procedures, “Restaurateurs, Count Your Tips!” , p. 672, this issue.)

From Polly Hurd, MACC, Aidman, Piser & Co., Tampa, FL