If your employees take home tips, you should be aware that a new U.S. Supreme Court decision approves the way the Internal Revenue Service figures your tax liability on those tips. And if you should want to dispute the amount owed, you’ll now need to keep more detailed records of each employee’s tips.
Estimate Of Tips OK’d
Employees must report their tips to their employers, who in turn pay FICA taxes on a percentage of those tips. But as restaurant owners know, employee underreporting is common.
In the new case, which arose out of a dispute between the IRS and Fior d’Italia Restaurant in San Francisco, the high court has approved the IRS practice of calculating the amount an employer owes based on a total estimate of all the tips that customers have paid, rather than estimating each employee’s tip income separately.
The HR Management & Compliance Report: How To Comply with California Wage & Hour Law, explains everything you need to know to stay in compliance with the state’s complex and ever-changing rules, laws, and regulations in this area. Coverage on bonuses, meal and rest breaks, overtime, alternative workweeks, final paychecks, and more.
For example, suppose a restaurant’s employees report a total of $10,000 in tips in a given year but the restaurant’s receipts indicate that credit card tips alone exceed this amount. Clearly, not everything has been reported. So the IRS would look at the credit card slips in question and determine the average percentage left as a tip on them—say, 15.3%. The IRS would then assume that cash-paying customers also tipped an average of 15.3% and calculate the total tips by multiplying the tip rate by the restaurant’s total receipts. It would then subtract the tips already reported and apply the FICA tax to the remainder.
The restaurant owner in this case pointed out several problems with this logic. First, tips above and below a certain level are not subject to FICA tax, but this formula lumps all tips together as taxable. Also, the formula fails to account for the possibilities that: 1) cash customers tend to tip at a lower rate; 2) some customers leave no tip at all; 3) customers sometimes write a high tip on the credit card receipt but then ask for cash back; and 4) some restaurants deduct the credit card company fee from the tip, leaving employees with a lower net amount.
New Recordkeeping Burdens
But the court said that the IRS estimating method was reasonable and that an employer could present evidence that an assessment was inaccurate in a particular case.
Three justices disagreed with this decision, noting that it goes after restaurant owners rather than the employees who underreport their tips. Also, to challenge an IRS assessment based on aggregate tips, a restaurant owner must keep close track of every single employee’s tips—information that employers aren’t even required by law to keep. The dissent said that the decision “saddles employers with a burden unintended by Congress,” and there’s no question that it adds to your recordkeeping burden should you decide to challenge the IRS.