Summary:
Policing employee tips is up to the company. IRS will audit employers if tip reporting is inadequate and can increase employer's taxes.

It's official: Restaurants are now tip police.

The U. S. Supreme Court says so.

If employees' reports of tip income to their employer aren't adequate, the employer must estimate how much employees made and report it to the Internal Revenue Service.

The IRS audit. The court's ruling came from a case involving Fior D'Italia, a 350-seat restaurant in San Francisco. In auditing Fior, the IRS estimated tips were 14 percent of customer's bills. This rate was the average tip on charge tickets. Agents applied it to restaurant receipts and increased Fior's share of Social Security taxes based on that. Fior, however, had paid based on what employees reported, a much lower amount.

Employee tips of more than $20 a month are treated as wages subject to Social Security taxes payable by both worker and employer.

The Court of Appeals. This court, which was overruled, had said: The IRS attempts to shift its collection responsibility to employers. It forces them to pay a "price" if their employees fail to keep adequate tip records. The price is an IRS audit, where the employer pays Social Security taxes on the agency's estimate. This is usually impossible for the employer to refute. Except for credit card charges, how does the employer know what employees receive? The agency, not the employer, should audit employees' records or use another method of arriving at an employee-by-employee determination of tips.

The Supreme Court. In reversing the appeals court, the Supreme Court agreed with earlier decisions by the Seventh, Federal and Eleventh Circuits. The IRS can collect the employer's share of Social Security tax using an estimate based on average tips. It need not estimate each employee's tips, and then add them as the basis for employer's total Social Security tax. Still, the high court left open the opportunity for employers to challenge the accuracy of using credit card tips alone, without considering that cash customers leave smaller tips.

The IRS offer. A restaurant, like other employers, can avoid a tip audit by initiating a deal with the agency. Here's the deal: The restaurant may use a tip rate, based on experience, if approved by the IRS. The restaurant then starts paying Social Security tax on this rate. If servers report less, the restaurant allocates the shortfall among them, on which they then must pay their share of the tax. Employees can challenge this if they post tips daily, which they seldom do, in their own journals.

The agency encourages deals with other businesses as well as restaurants, such as employers of cab drivers, cosmetologists, barbers and workers in the gaming industry.

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