Appellate court upholds latest IRS tip-tax victory

Nation's Restaurant News, March 6, 2000 by Robin Lee Allen

WASHINGTON -- With a third appellate court upholding the Internal Revenue Service's authority to assess employers only for taxes on tips unreported by employees, the agency has indicated that it will step up its tip-reporting compliance efforts, including resuming the controversial employer-only audits.

The audits have been on hold since 1996 when the food service industry began tallying its lower-court victories on the matter.

During a lengthy conference call with several representatives from various tipped industries, IRS officials said that in the next 60 days they would unveil for comment several proposals intended to increase tip reporting. Among them are a simplified Tip Reporting Alternative Commitment form, new guidelines that would allow employers to develop their own TRAC programs, more vigorous enforcement measures aimed at noncompliant establishments and the employer-only audits. The IRS estimates that $11 billion in tips goes unreported by foodservice employees annually.

IRS officials did not return phone calls.

"I think there will be a tremendous amount of activity in this area," said Tracy J. Power, an attorney with Power & Power in Arlington, Va., who has been involved in several of the tip-tax cases. "Truly, those compliance officers [on the phone call] were chomping at the bit."

For Power and other tip-tax aficionados, the IRS' plan to step up enforcement and resume employer-only audits after a nearly four-year moratorium contradicts the agency's previous action.

The IRS announced last fall that it no longer would revoke TRAC agreements when employers successfully fulfilled their commitment to educate employees on their reporting requirements and to keep records of each employee's charged tips. But employees still underreported tips.

Although the IRS' user-friendly gesture in no way addressed the live wire of employer-only audits, it was interpreted as an acknowledgment by tax officials that it might be more appropriate to focus on employees who flaunt the rules rather than the employers who follow them. The IRS estimates that about 31,000 restaurants participate in either the TRAC or the Tip-Rate Determination Agreement, TRDA, programs.

"They said that signing up for the TRAC program does not necessarily constitute compliance," Power noted. "They said they are looking for accurate reporting, and that they are looking for levels near the charged tip rates." The charged tip rate usually falls between 14 percent and 18 percent, according to Power.

News of the IRS' anticipated compliance initiative comes less than a week after the 7th U.S. Circuit Court of Appeals handed the IRS its fourth victory in the ongoing court battles concerning the legality of employer-only audits. In 330 W. Hubbard Restaurant Corp. v. USA, the appeals court upheld a lower court decision, finding, among other things, "that an employer's FICA tax liability is not necessarily limited to tax on the income reported by its employees."

The lawsuit centered on claims by officials at the Coco Pazzo restaurant in Chicago that they wrongfully had been assessed more than $85,000 for taxes unpaid on tips in 1993, 1994 and 1995. Drawing on two earlier appeals-court decisions, the judges ruled that although no statute specifically authorized the IRS' ability to use an "aggregate method" to collect unpaid taxes, the agency's interpretation of their authority was rational.

Furthermore, the judges wrote that although no employee would be credited for the FICA taxes paid by Coco Pazzo, this was due to the employees' own underreporting and not the aggregate method of tax collection used by the IRS. They also noted that the fact that the IRS may not have taken into account wage-range exceptions in its aggregate assessment was irrelevant. To Coco Pazzo's final argument that without assessing individual employees the company would not receive the tax credit to which it is entitled, the court said that it was Coco Pazzo's responsibility, not the IRS', to prove it was entitled to a credit.

"We conclude that Coco Pazzo has failed to demonstrate that the IRS' aggregate method of collecting employer FICA taxes is an impermissible reading of the tax code," the judges wrote.

"I think they feel exonerated," said Peter Kilgore, senior vice president and general counsel for the National Restaurant Association, in explaining the IRS' decision to increase enforcement efforts.

In the growing ledger of decisions, four out of seven, including all of the appeals court decisions, have upheld the IRS' right to audit employers only for taxes unpaid on tips unreported by employees. But while the most recent ruling now tilts the scales of justice in the IRS' direction, the industry's tip-tax experts are not losing heart. Several cases are still pending, including two in the 9th and 11th circuits, where district courts found in favor of the foodservice industry and the IRS appealed. Industry advocates are hoping for an appellate court ruling in favor of the industry, which could prompt the Supreme Court to consider the employer-only-audit issue.