By: A.J. Cook


The Internal Revenue Service is scooping up tip income previously unreported. Proving the unreported amount has been an arduous task, but the agency believes it has discovered how to do it efficiently.

The IRS recognized its problem several years ago after losing cases like Herbert Payne's. Payne, a hair stylist at a beauty salon in Long Island, N.Y., kept a daily record of tips. This showed tips of 2 percent of sales. Unbelievable said the IRS, and increased that to 20 percent.

In court the judge pondered the IRS's position, then brushed it off. He said the IRS couldn't explain why it used 20 percent instead of, say, 10 percent or 5 percent. While the judge dubbed Payne's figure "suspicious," he said the testimony and evidence -- such as it was -- favored Payne.

The Moral: Sometimes it's neat to be on the cutting edge of tax law.

After getting clipped by Payne and others, the IRS started gathering evidence to support its position. For example, it would compare a waiter's reported tip income to the average on charge card tickets and on tax returns of other waiters. This proved inefficient, so it tried another approach.

Moving to casinos, it challenged that whole Nevada industry. First it gathered statewide statistics showing the amount people tipped casino workers. Then the agency notified employers how they could avoid disruptive and expensive audits: They must accept a program encouraging employees to report tips consistent with this data.

Obviously successful, yearly reported tip income of casino employees increased from $200 million in 1992 to $500 million.

Now the IRS is drawing a bull's eye on restaurants. It estimates servers, who usually earn most of their compensation from tips, report only 20 to 25 percent of gratuities. This compares to general taxpayer compliance of 85 percent.

Under the restaurant proposal the employer determines, and the IRS approves, a tip rate reflecting a restaurant's experience during a six-month trial period. If at least 75 percent of employees report at least that percent of sales, the IRS will lay off the restaurant and reporting employees. After that, if employees report less than the established percent, the employer must allocate the shortfall to employees. The allocation will be based on hours and type of work -- like busboy, food server or bartender. Employees can challenge this using their records if they posted tips daily.

This plan has a sunny side up for restaurant owners. First, they avoid an audit. Second, they get a break on their own back taxes. They avoid the law that requires employers to pay Social Security taxes on unreported tips in some cases back to 1988.

But owners are disgruntled. They hate the additional taxes, the paperwork and the fact they become IRS stool pigeons. The servers, of course, hate the additional income and Social Security taxes. Moreover, they have been turned into part-time bookkeepers because of the required records.

The Moral:  Some IRS plans are hard to swallow.