The Supreme Court
Taxes on Employee's Tip Income
A controversy over collecting taxes for Social Security and Medicare sent shockwaves through the restaurant industry after the Supreme Court ruled in favor of the Internal Revenue Service's (IRS) position in Fior D'Italia, Inc. v. United States on June 17, 2002. The case started when the IRS billed Fior d'Italia, a restaurant based in San Francisco, for $23,262 in unpaid Social Security and Medicare payroll taxes for tips that its employees allegedly failed to report in 1991 and 1992. The IRS based its case on the restaurant's own records.
“For more than five years, Fior d'Italia has single-handedly fought the IRS through the judicial system. Small businesses like this are the cornerstone of the restaurant industry …. To have the IRS continue to exert pressure on a single operator, and casually extract funds without performing a thorough audit of employees' records, is unconscionable.”
—Bill Hyde, chairman of the NRA's Save American Free Enterprise (SAFE) Fund in the trade publication Restaurants USA in January 2002
The restaurant sued the IRS, claiming it had no legal authority to bill the restaurant for these taxes until the IRS had first determined which employees had actually under-reported tips. Both a federal court and a federal appeals court ruled in the restaurant's favor, so the government took the case to the Supreme Court, which accepted it on January 11, 2002. While the 9th Circuit Court of Appeals ruled in Fior d'Italia's favor, four other Circuit Courts sided with the IRS in similar restaurant cases. Circuit courts siding with the IRS were the 7th Circuit (Illinois), 11th Circuit (Florida and Alabama), and Federal Circuit (Washington, D.C.).
The National Restaurant Association (NRA) contributed $100,000 to Fior d'Italia's legal battle and filed a friend-of-the-court brief to help the restaurant take the case all the way to the Supreme Court. If the restaurant lost the case, NRA vowed to take the fight to Congress because it does not believe restaurants should be forced into the role of “tip police.” This battle is now at Congress' doorstep.
Let's look at how the IRS calculated the tax bill in question. The IRS used the restaurant's charge card data and calculated that credit card customers tipped at the rate of 14.49 percent in 1991 and 14.29 percent in 1992. The IRS then used these averages to estimate tips generated by cash sales received by the restaurant's employees. Using those assumptions the IRS concluded that the restaurant should have reported total tips of $772,100 over the two year period rather than the $468,026 that was reported.
The difference of $304,000 was used to calculate the $23,262 based on the tax of 7.65 percent due for Social Security and Medicare.
The Internal Revenue Service can use aggregate estimates based on credit card receipts to determine the total tips at a restaurant. If tips are underreported, the IRS can bill the restaurant for Social Security and Medicare taxes based on its aggregate estimates.
The restaurant claimed this was not an accurate calculation because the tips on cash sales did not average the same amount as on credit sales. In most cases cash tips are lower than credit card tips, the restaurant stated in its brief. In addition, the restaurant claimed that many of the tips on credit card sales also included cash back to customers, which is done as a service to their customers if requested.
Justice Steven Breyer wrote the 6-3 opinion for the Supreme Court. He was joined by Chief Justice William Rehnquist and Associate Justices John Paul Stevens, Sandra Day O'Connor, Anthony M. Kennedy and Ruth Bader Ginsburg. In his opinion, Breyer comments directly on the restaurant's claim that the IRS method of calculating tips is unreasonable:
Associate Justice Souter wrote the dissenting opinion and was joined by Associate Justices Scalia and Thomas. He believes the majority erred in its opinion and does not think the IRS is carrying out the intent of Congress. Souter states:
For the time being the majority opinion stands and the IRS can use the aggregate method questioned in the Fior d'Italia case until Congress passes a law to stop it. Legal experts for the restaurant industry believe this ruling has the potential to devastate small restaurants because the IRS can go back as far as 1988, which is the first year employers were liable for Social Security and Medicare taxes on all employee tips. “With restaurant profit margins around 3 to 5 percent, this could potentially put a number of restaurants out of business,” according to Peter Kilgore, senior vice president and general counsel for the NRA.