High court to consider whether IRS is justified in restaurant audit tactic

March 28, 2002 -- The National Restaurant Association today filed an amicus curiae or "friend of the court" brief to support the California restaurant Fior d'Italia in its tip-reporting battle before the U.S. Supreme Court. (Read the press release.)

The case, Fior d'Italia, Inc., v. United States, involves a restaurant that got stuck by the Internal Revenue Service (IRS) with a bill for payroll taxes on tips the agency said restaurant employees earned but did not report.

Noting that the case's outcome will affect not only the more than 200,000 restaurants with tipped employees, but also every other business across the country with tipped employees, the National Restaurant Association's Senior Vice President of Operations and General Counsel Peter Kilgore said "we are filing this brief because we strongly believe that Congress never intended to give the IRS the authority to take aim at employers without determining whether employees underreported their tips."

$23,000 in back taxes

The case got its start when the IRS presented the San Francisco-based Fior d'Italia restaurant a bill for $23,262 in FICA (Social Security and Medicare) payroll taxes on tips that employees allegedly failed to report in 1991 and 1992. The IRS based its assessment solely on a review of the restaurant's paperwork.

The restaurant sued the IRS, claiming that the agency had no legal authority to bill the restaurant for taxes on tips without first determining which employees actually under-reported tips.

After a federal district court and then a federal appeals court ruled in the restaurant's favor, government lawyers petitioned the U.S. Supreme Court to take up the case. On Jan. 11, 2002, the high court agreed. A U.S. Supreme Court hearing is expected in April, with a ruling likely by June 2002.

The tip-audit tactics of the IRS have come under legal fire for more than five years. The Fior d'Italia case marks the first time the U.S. Supreme Court could rule on whether the IRS has the right to assess employers a tax bill for their share of FICA taxes on tips the IRS says employees earned but failed to report -- without ever determining the exact amount of unreported tips, without determining which employees failed to report all their tips, and without crediting employer FICA tax payments to those employees' Social Security accounts.

The U.S. Supreme Court's decision may bring some clarity to an issue that has split four federal appeals courts. While the 9th circuit court of appeals ruled in Fior d'Italia's favor, three other federal appeals courts have sided with the IRS (see cases below).

The IRS has long maintained it has the right to go straight to restaurant employers to collect the FICA federal payroll tax (currently 7.65%) on tip earnings that the IRS claims employees earned but failed to report. The National Restaurant Association strongly believes that Congress never intended for the IRS to use employer-only audits and assessments in this manner.

Association provides financial support too

The National Restaurant Association is also supporting Fior d'Italia's court battle financially, through a contribution from the National Restaurant Association's Save American Free Enterprise (SAFE) Fund (read the press release). The SAFE Fund was created to protect the vitality of the restaurant industry and to preserve the principles of the free enterprise system. Since 1996, the SAFE Fund has provided more than $2.6 million to state restaurant associations, restaurateurs and coalitions working to ensure the strength of the restaurant industry.

Once the U.S. Supreme Court issues a ruling, the issue could go back to Congress -- since the whole issue revolves around what Congress intended by a 1987 law that required employers to pay FICA taxes on all tips. "We do not believe Congress ever intended for restaurateurs to become the 'tip police,'" said Kilgore.

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Tip-reporting cases: where they stand in the courts
Since the IRS first began pursuing employer-only and employer-first restaurant audits in the mid-1990s to collect taxes from employers on tips employees allegedly failed to report, the restaurant industry has mounted several major court challenges.

Several of these challenges have made it to the federal appeals court level. In the Fior d'Italia case, the ninth circuit (San Francisco) ruled in the restaurant's favor. Three other federal appeals courts have sided with the IRS.

Get more details on all the rulings:

• 9th Circuit (California), in Fior d'Italia, Inc. v. United States (March 2001);
  
• 7th Circuit (Illinois), in West Hubbard Restaurant Corp. v. United States (February 2000);
  
• 11th Circuit (Florida), in Quietwater Entertainment, Inc., v. U.S. (June 2000; no published opinion)
  
• 11th Circuit (Alabama), in Morrison Restaurants, Inc. v. United States of America (August 1997)
  
• Federal Circuit (Washington, DC): Bubble Room Inc. v. United States

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