Food service employees generally rely on tips to earn a reasonable wage. They and their employers have special withholding and reporting requirements. Internal Revenue Code(IRC) Section 3121(q) requires that “tips received by an employee in the course of his employment shall be considered remuneration” and “deemed to have been paid by the employer” for purposes of FICA (social security retirement and medicare) withholding and reporting.

Joseph D. Cataldo
By Joseph D. Cataldo

Joseph D. Cataldo is an estate planning/elder law attorney, Certified
Public Accountant, registered investment advisor, AICPA Personal
Financial Specialist and holds a masters degree in taxation.

(617) 387-3793

Under IRC Section 6053, each employee is required to report tip income to his or her employer on a monthly basis. Under Treasury regulations Section 31.3402(h)-1, the employer may withhold on the basis of average estimated tips.

In 1991 and 1992, San Francisco’s Fior D’Italia restaurant reported tip income of $247,181 and $220,845 respectively. These amounts were supported by reports from the restaurant’s employees. However, customer credit card slips listed larger tip totals than the amounts the employees reported. Consequently, the IRS calculated and assessed additional FICA taxes.

The IRS used an “aggregate estimation method” to calculate the additional taxes. It compared an average of the tips found on the credit card slips: 14.49% for 1991 and 14.29% for 1992. The IRS multiplied the restaurant’s total receipts by these percentages and subtracted the amounts already reported. It assessed FICA taxes on the difference between the computed and reported amounts.

Fior D’Italia paid part of the taxes and brought a refund suit, arguing that Section 3121(q) required that each employee’s tips be determined and individual deficiencies aggregated to determine any underreported amounts. Under that interpretation the IRS would not be allowed to use its aggregate estimation method. The district court ruled for Fior D’Italia, and the 9th Circuit Court of Appeals affirmed. The IRS petitioned the US Supreme Court for certiorari. The Court granted it due to differing opinions in the 9th, 11th and federal circuits.

The Supreme Court ruled for the IRS. The court went on to say that IRC Section 6201, which requires the IRS to make inquiries, determinations and assessments of the tax, allows it to use reasonable methods to estimate tax due. The Court also ruled the definitional section that used the singular term “employee” does not explicitly require the IRS to make the computations on an individual basis.

The Court also discussed the reasonableness of the aggregate method. It suggested that assessing taxes individually would not have resulted in a better tax computation. Fior D’Italia stipulated it would not challenge the particular IRS calculation as inaccurate, preventing it from presenting evidence that any assessment was inaccurate.

Businesses that must comply with the tip withholding and reporting requirements can take steps to minimize any overstatement of liabilities that might arise from the IRS’ aggregate estimation methods. A restaurant should document:

  • Short-term employees who earn less than $20 in tips.
  • Employees whose total earnings including tips, exceed the wage base.
  • Cash given back to patrons paying with a credit card.
  • A lower tip percentage paid by cash patrons.
  • Credit card fees paid out of tips, resulting in lesser net tips to employees. Although the recordkeeping requirements to support a lower assessment might be substantial, the tax savings could also be quite large.

Restaurant businesses not only need to be concerned with the proper collection and submission of FICA taxes, they also need to be concerned about proper payment of overtime as the U.S. Department of Labor will quickly intervene to assess the employer for additional wages owed to employees. Employees will be entitled to the overtime pay regardless of whether or not the employees have been complying with the federal income tax law by reporting all of their earned income. The Department of Labor does not even follow up to see if the additional overtime pay was subsequently reported by the employee on his or her federal tax return. It is best to pay any overtime due in order to avoid any costly encounter with the Department of Labor. Leniency is not too often found in this area of the law.