Unless the U.S. Congress intervenes, the high court's ruling gives the IRS the OK to continue the controversial employer-only and employer-first tip audits and assessments the agency has been pursuing since the mid-1990s. In these cases, the agency goes straight to restaurant employers with bills for payroll taxes on previously unreported tips--without first determining that individual employees actually underreported their tips or the amount by which they underreported, and without crediting employer FICA tax payments to those employees' Social Security accounts.

The 6-3 decision in Fior d'Italia vs. United States appears to have actually given the IRS more power because it appears to allow the agency to estimate the amount of cash tips given to employees based on tips included on credit-card receipts.

National Restaurant Association legal experts say the ruling has grave implications for restaurants as well as any other business that employs tipped workers. IRS tip-tax assessments have the potential to devastate small restaurants, experts say, since the IRS can go as far back as 1988--the first year employers were liable for FICA taxes on all employee tips-to assess back taxes. Restaurateurs, who do not maintain records that could help them refute an IRS assessment (indeed, the law specifically protects employers from onerous monitoring obligations), could literally be put out of business as the result of an IRS action. See more on the Association's reaction to the ruling.

Court says "aggregate estimation" is valid

In the case of Fior d'Italia, the IRS billed the San Francisco restaurant in 1995 for $23,262 in taxes on tips that the agency says employees failed to report in 1991 and 1992.

The restaurant sued over the method the IRS used to come up with the assessment: First, the IRS took a look at the restaurant's charge-card data and calculated that credit-card customers tipped at a rate of 14.49% in 1991 and 14.29% in 1992. Then, assuming the same credit-card tip rate applied to cash sales, the IRS calculated that employees should have reported total tips of $772,100 over the two years rather than the $468,026 they reported. Applying the 7.65% FICA tax rate to the difference--$304,000--the agency stuck Fior d'Italia with the tax bill for $23,262.

The IRS based its assessment solely on a review of the restaurant's paperwork, including the IRS Form 8027 (Employer's Annual Information Return of Tip Income and Allocated Tips) that many restaurant employers are required to file with the IRS each February detailing broad tip-reporting data.

Fior d'Italia--aided in its U.S. Supreme Court case by a contribution from the National Restaurant Association's Save American Free Enterprise (S.A.F.E.) Fund, won its case in federal district court and a federal appeals court. However, the U.S. Supreme Court overturned the earlier rulings, saying that the IRS's aggregate estimation method--basing the assessment on an estimate of all tip income paid to all employees aggregated together--did not fall "outside the bounds of what is reasonable."

Justice Steven Breyer, who wrote the majority opinion, was joined by Chief Justice William H. Rehnquist and Justices John Paul Stevens, Sandra Day O'Connor, Anthony M. Kennedy and Ruth Bader Ginsburg.

What the ruling means for restaurants

"The impact of the ruling is enormous," says Peter Kilgore, senior vice president and general counsel for the National Restaurant Association. "Financially, the IRS can go after the restaurant industry and the industry could be hit with a potential tax assessment back to 1988, when Congress first said restaurants owe taxes on all reported tips." Kilgore noted that even the dissenting opinion in Fior d'Italia indicated that restaurateurs could be held liable for taxes back to 1998, and that a statute of limitations does not apply on an employer's FICA tax liability for taxes on unreported tips.

"With restaurant profit margins typically around 3 to 5 percent, this could potentially put a number of restaurants out of business," says Kilgore.

"From a labor-relations standpoint, it turns employers into the 'tip police' because the ruling will in effect force employers to police employee tip reporting in order to protect themselves from IRS employer-only assessments," adds Kilgore. The ruling is likely to increase both the number of IRS audits and the pressure restaurateurs feel to get more involved in employee tip reporting through such measures as signing tip-reporting agreements with the IRS.

What next?

The Association vowed to take the fight over tip reporting to Capitol Hill and began lobbying Congress before the Supreme Court made its ruling on June 17. "Our primary emphasis is to get the tax code changed," says Kilgore. "But that could take a long time and there's no guarantee that any law will pass."

Justice David H. Souter wrote the dissenting opinion in the Fior d'Italia case, saying that the court's ruling "saddles employers with a burden unintended by Congress." Justices Antonin Scalia and Clarence Thomas also dissented. "It seems clear that Congress did not mean to solve [the problem of underreporting tips] by allowing the IRS to use its assessment power to shift the problem to employers," the dissenting justices wrote.

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Question & Answer on the Supreme Court Ruling
Q: What did the U.S. Supreme Court say in its Fior d'Italia ruling?
A: Under the June 17 ruling, the U.S. Supreme Court said:
• The Internal Revenue Service (IRS) can use aggregate tip estimates to ensure that the employer is paying enough FICA taxes on allegedly unreported tips. That means the IRS can take a look at a restaurant's records, come up with a total amount of tips it thinks employees should have reported, and bill the restaurant for the employer's share of FICA taxes (currently 7.65%) on any allegedly unreported tips. Under the Supreme Court's ruling, the IRS does not need to examine individual employees' records or credit employer FICA tax payments to individual employees' Social Security accounts.
• It is permissible for the IRS to estimate the amount of cash tips given to employees based on tips included on credit-card receipts.

Q: What does the ruling mean for restaurateurs with tipped workers?
A: Potentially, a restaurant could face a tax bill for FICA taxes on allegedly unreported tips going as far back as 1988, when Congress first began requiring employers to pay FICA taxes on all tips.

Q: How does this affect current tip-reporting procedures in restaurants?
A: There is much uncertainty about this. Literally, the laws on tip reporting have not changed as a result of the decision; that is, tipped employees are required to report all tips they receive (cash as well as credit-card tips) to their employers at least once a month. Employers in turn must report those amounts to the IRS and pay the federal FICA tax on the reported tips. However, because the IRS now has a legal license to use an aggregate estimate method to calculate underreported tips and assess only the employer, the U.S. Supreme Court's decision may result in employers feeling forced to more closely police tip-reporting procedures at their restaurants in order to better protect themselves from IRS audits and aggregate FICA tax assessments.

Q: This seems to give the IRS the power to make very arbitrary assessments of what employees should have reported in tips--including assuming that tip rate for cash tips is exactly the same as for credit-card tips. I wouldn't even have the records to disprove an IRS assessment! It's up to my employees to keep track of their earnings. How is this fair?
A: It's not. That is why the National Restaurant Association is going to Congress. We want Congress to clearly state that aggregate assessments against employers are not permissible; that the IRS may not use the aggregate assessment method to pressure employers to police tipped employees as to their tipped income; and that employer FICA tax payments on tips must be credited to their employees' Social Security accounts.

Q: Is the IRS likely to begin auditing more restaurants?
A: There's no word from the IRS on that. IRS Commissioner Charles Rossetti, in a brief statement issued June 17, said "The Court's important decision updholds our ability to make sure all Americans pay a fair share of taxes. The IRS plans to continue working cooperatively with the restaurant industry and other industries where tips are common. Our goal is to create a fair, accurate system for reporting tip income while minimizing burden on taxpayers and businesses."

Q: What does the National Restaurant Association recommend members and operators do?
A: Two years ago, when the IRS announced it was lifting a five-year moratorium on its employer-only audits, the National Restaurant Association Board of Directors passed a resolution urging members and all restaurateurs to consider signing a contract with the IRS called the Tip Reporting Alternative Commitment (TRAC). Under the TRAC (or under a more customized employer-created approach called an "EmTRAC"), a restaurant agrees to assume greater responsibility for educating and getting employees to report their tips. In return, the IRS agrees that it will not bill the restaurant for FICA taxes on allegedly unreported tips unless it has first examined which employees had not reported tips accurately. "The TRAC gives you freedom from employer-only assessments if you comply with it," says Kilgore. "It's the best protection an operator has." Get more details on the IRS's tip reporting agreements.

Q: What next?
A: The Association vowed to take the fight over tip reporting to Capitol Hill and began lobbying Congress before the Supreme Court made its ruling Monday. Stay tuned for more details.

Q: How can I learn more about TRAC and tip reporting?
A: Visit our tip reporting resources online.

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