The case is being closely watched and supported by industry advocates like the National Restaurant Association, the California Restaurant Association and the Golden Gate Restaurant Association, located in San Francisco.
The issue is whether the IRS, after deciding that tips have been underreported, has the authority to assess aggregated tip income based on estimates from an employer’s gross receipts in order to collect employment taxes on such estimated assessed tips from the employer.
The IRS’ legal right to collect employment taxes on W-2 wages is established. The problem arises when, following an audit, the IRS determines that there is a proportional disparity between the tips reported and the gross receipts. Then the IRS will simply use the employer’s sales records to estimate the amount of tips that should have been reported. It apparently does not audit individual employees regarding the amount of actual tips they received, nor does it investigate mitigating circumstances that may have reduced the amount received, such as sharing tips with other employees. There are even some employees who are excluded from tip reporting altogether. By way of example, in the Fior D’Italia case the IRS felt that tips had not been properly reported on cash sales, and proceeded to assess an aggregated tip amount by taking the average tip amount stated on a credit card charge and applying that to cash receipts. They then charged the restaurant for the employment taxes on the resulting amount.
The fundamental problem with this approach is that the employer is being held accountable for choices that the employees have made about whether to declare their cash tips or not. The employer does not know and is not legally required to know the amount of tips each staff member actually receives. Additionally, the IRS assessment was made without any audit of the individual employees to ascertain the actual amount of tips received. Further, they applied the average credit card tip to the cash receipts without taking into consideration the practical differences in tipping between credit card and cash transactions. Finally, since the aggregated assessed tips are not attributed to any particular employee, none of the employees get credit toward Social Security benefits based on the assessment -despite the fact that the employer is paying the employment tax portion. In other words, the IRS is taking employment tax money from the restaurant based on an estimate that it cannot substantiate, and without providing any benefit in exchange to the workers on whose behalf the employment taxes are paid.
Fior D’Italia won its case at the district court, and at the 9th Circuit Court of Appeals. The IRS appealed to the U.S. Supreme Court, which agreed to hear the matter because courts in various circuits have reached different decisions on similar cases. We note that while the Supreme Court decision will address the methodology used in this particular matter, the real solution lies in revising the tax code, which is a matter for Congress. In that case, even if Fior D’Italia prevails in this particular case, it may be years before legislative changes are implemented.
What should employers do in the meantime? Educate your employees about the importance of accurate tip reporting. Advise them that 100 percent of all tips received are considered wages and must be reported. Talk to them about the benefits that they are missing if they do not report their tips, as contributions to worker’s compensation, unemployment insurance and Social Security all relate to their reported income. Give them the example of the $23,000 Fior D’Italia assessment, and explain what that would do to the bottom line.
Fair or not, the onus is clearly on the employer to do as much as possible to educate his workforce to report all tips, and to create a system that will enable them to do so quickly, easily and accurately. One solution is the use of point-of-sale software specifically designed for the restaurant industry. According to Kay Branson and Graham Granger of Digital Dining, software products such as the one they provide require employees to report cash tips prior to clocking out, and automatically attribute credit card tips to the server at the completion of each sale. An additional benefit is that the system can consistently provide for accurate record keeping even in the event of high employee or manager turnover. Such reports can not only demonstrate the employer’s due diligence in the tip reporting process but also enable the employer to monitor tip reporting. While there are several such products available, it appears that an appropriate computerized system could eliminate or reduce many managerial headaches.
Until the law changes, employers may still be liable for assessments like the one aimed at Fior D’Italia; however, the more an employer does to educate his employees and to make tip reporting easy and accurate, the better position the employer will be in -if the IRS comes knocking.
Melissa Calhoon and Daniel T. Berkley of the Berkley Law Group, P.C. can be reached at (415) 989-7711 or at info@berkleylawgroup.com.