Unreported Tip Income: A Taxing Issue

CPA Journal, The, Dec 2006 by Robertson, John, Quinn, Tina, Carr, Rebecca C

The U.S. restaurant industry consists of thousands of establishments employing millions of workers. Many of these workers rely upon tips as part of their compensation; however, part or all of these tips may be in the form of cash paid directly to the worker by customers. These tips are subject to both income taxes and FICA taxes. A worker who receives more than $20 per month in tips must report these tips to the employer at least once a month. Employers must withhold federal income tax and PICA tax on wages and reported tips and match the PICA amount. An establishment that meets certain criteria must file Form 8027 with the IRS reporting annual sales, chargecard sales, and employee-reported tips. If reported tips are less than 8% of total sales, an employer must allocate tips on the employee's W-2 form.

According to 1998 IRS estimates, however, fewer than 40% of all tips received were reported, an estimated $9-$ 12 billion in unreported income. The issue of unreported tip income is inherently troublesome because tips are often in cash and subject to self-reporting. The IRS has established several initiatives to increase the reporting of tips, including the Tip Rate Determination/Education Program, designed to encourage employees to report the correct amount of tip income to their employer.

In the case of Fior D'ltalia [536 U.S. 238 (2002)], the restaurant met all reporting requirements, yet was assessed additional FICA taxes for 1991 and 1992. On its Form 8027, the amount of tips reported by the workers was less than the amount of tips reported on charge sales alone. The 1RS used an aggregate estimation method to reach the assessment. The restaurant paid part of the assessment, then filed a refund suit. The district court held that the IRS lacked the authority to estimate tip income using an aggregate estimation method, and this ruling was affirmed by the Ninth Circuit Court of Appeals. The Supreme Court reversed the opinion and held that the IRS does have authority to assess a restaurant's HCA taxes on unreported tip income using an aggregate estimation method.

Although this resolved a conflict between circuits over the aggregated estimation issue, other issues remain, such as the estimation methodology, the asymmetry created by an employer paying PICA tax with no credit to an employee's earnings record, and the potential for coercion to a tip reporting program.

Background

Tipped employees often receive the majority of their income from their tips. Because tips are often received in cash, it may be difficult for an employer to know exactly how much tip income an employee receives. The IRS has always suspected that a great deal of tip income went unreported.

Prior to 1965, employers had no reporting or withholding responsibilities for their employees' tip income. In 1965, the law was amended to require employers to withhold Federal Insurance Contribution Act (FICA) tax on tips from the employees' pay, but, unlike regular wages, employers did not have to pay a matching amount. The Social Security Administration would credit the employees' Social Security account for the employees' share. In 1977, the law was changed to require the employer to pay its share of FICA tax, but only up to the minimum wage [see The Bubble Room, inc. v. U.S., 159 F.3d (Fed. Cir., 1998)]. During this period, neither employer nor employee had a strong incentive to report tip income to the government.

In 1982, the Tax Equity and Fiscal Responsibility Act (TEFRA) added IRC section 6053(c), which required employers whose employees failed to report at least 8% of gross sales as tips to allocate tips equal to 8% of revenue among employees (see PL 100-203). This gave employers an incentive to make sure that employees reported tips equal to at least 8% of their sales. Unfortunately, this rule often led employees to think that they would be safe from audit if they reported at least 8% of sales as tips.

Prior to 1987, employers were assessed FICA taxes on tips only up to the minimum wage. The employee, however, was taxed on all wages and tips, including the portion that exceeded the minimum wage. In 1987, Congress amended IRC section 3121(q) by removing the minimum wage ceiling and taxing all tips to both employers and employees. Employees still had no incentive to report all tips.

The restaurant industry wanted some concessions to compensate for the additional tax burden caused by paying FICA on all employee tips, so Congress added IRC section 45B, which provides employers with a dollar-for-dollar tax credit for FICA taxes paid on tips above minimum wage. Because section 45B is a nonrefundable credit, an employer must owe federal income taxes to take advantage of the credit. The credit cannot be used to offset employment taxes. The section 45B credit causes taxable income to increase, because any amount used to calculate the credit cannot be treated as a deductible expense. The usefulness of the credit may also be reduced because it is combined with all other general business credits. Any unused credit can be carried back one year and carried forward 20 years (previously, any unused credit could be carried back three years and carried forward 15 years). If an employer is subject to alternative minimum tax, however, it may not be able to use the entire credit.