Unreported Tip Income: A Taxing Issue

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

330 West Hubbard Restaurant Corporation

Another case [330 West Hubbard Restaurant Corporation v. U.S., 37 F.Supp.2d 1050 (N. Dist. IL, 1998) and 330 West Hubbard Restaurant Corporation v. U.S., 203 F.3d 990 (7th Cir., 2000)] also involved an employer audit of FICA taxes. This case is factually different from the other three cases because the employer maintained a mandatory "tip pool." In tip pooling, the employer collects all tips and distributes them among specified groups of employees. A tip pool might include otherwise nontipped employees (e.g., table bussers), and it might allow for a more level distribution of tips between highly tipped employees, such as table waitstaff, and less highly tipped employees, such as bartenders and cocktail waitstaff. Assuming all cash tips are turned in to management, a restaurant that maintains a tip pool knows how much each employee actually receives in tips.

The 330 West Hubbard Restaurant Corporation operated Coco Pazzo, a restaurant in Chicago. An audit of Coco Pazzo's 1993, 1994, and 1995 returns indicated that the tips reported by employees were $450,837.70 while charged tips were $1,412,786.29. The tip pool was divided weekly among the staff. The company's own records indicated that it had collected and divided $1,556,301.15 in tips for the three years. The 1RS compared tips reported on Form 941, Employer's Quarterly Federal Tax Return, to the company's records of the tip pool. The 1RS determined that $1,112,453.92 of tips had not been reported, and assessed additional employer-only PICA taxes of $85,104. Coco Pazzo paid $1.53 and sued for a refund in the District Court for the Northern District of Illinois. The government countersued for the balance of the assessment. The court found in favor of the government.

Coco Pazzo appealed to the U.S. Court of Appeals for the Seventh Circuit. The appeals court affirmed the trial court. The Seventh Circuit required Coco Pazzo to show that the Treasury's interpretation of IRC section 3121(q) was unlawful. The court required only that the government apply a rational interpretation of the statute. The court did not find the restaurant's reliance on the statutory term "employee" to be sufficient. As the 1 lth Circuit and the Federal Circuit had previously noted, the use of the singular "employee" is not determinative.

Fior D'Italia, Inc.

Fior D'Italia, Inc., operated an upscale restaurant. The case [Fior D'ltalia, Inc. v. U.S., 21 F.Supp.2d 1097 (N.D. CaI., 1998); Fior D'ltalia, Inc. v. U.S., 242 F.3d 844 (9th Cir., 2001); and Fior D'ltalia, Inc. v. U.S., 536 U.S. 238 (2002)] involved an employer-only FICA tax audit of 1991 and 1992. Fior D'ltalia's Forms 8027 showed that employees underreported tips. Charge tips were $364,786 in 1991 and $338,161 in 1992. Tips reported by employees were $247,181 and $220,845 for those same years. In response to this, the 1RS audited the restaurant. The 1RS calculated the tip percentage by dividing charged tips by charged sales. This was 14.49% in 1991 and 14.29% in 1992. The tip percentage was then multiplied by total sales. Based upon this result, unreported tips were calculated to be $156,545 in 1991 and $147,529 in 1992. The 1RS then assessed the employer's share of PICA taxes on the unreported tips. Fior D'ltalia paid part of the assessment and sued for a refund in the Northern District of California. Neither party disputed the calculation of the unreported tips.