By: A.J. Cook

The Internal Revenue Service threatens restaurants and certain other employers with audits if they don't agree to police employee tip reporting. These audits require the employer to pay Social Security taxes based on the agency's speculative estimates. Courts consistently supported these estimates - until now.

Tips are taxable - taxable to the waiter, bartender or cab driver who receives them. They are also largely made in cash - which is notoriously hard to verify.

The IRS has difficulty figuring out how much an employee received in cash tips, so it shifts that burden to the employer. Of course, it isn't easy for the employer either.

The Social Security law deems that tips flow from the customer to the restaurant to the employee. This puts the restaurant in an awkward position: It is assumed to have paid large sums of money to workers without knowing how much - and it needs to know to determine its Social Security tax.

A restaurant, like other employers, can avoid an IRS tip audit if it cuts a deal with the agency.

Here's the deal: The restaurant determines a tip rate, based on experience, which the IRS approves. Then, if employees report less than this rate, the employer allocates the shortfall among employees. Employees can challenge this if they post tips daily, which they seldom do, in their own journals. The restaurant owes Social Security taxes based on this estimated employee income.

The IRS Loses in court: Fior D'Italia, a 350-seat restaurant in San Francisco, had no deal with the IRS and - surprise - got audited. Average customer tips on charge tickets were 14 percent.

To estimate total tips, the agents applied that rate to the restaurant's receipts. Fior's employees reported a much lower tip amount to the restaurant. So the IRS increased Fior's Social Security taxes based on this higher amount.

Fior screamed that it had been burned; it said the IRS cooked the books.

An appeals court said in these tip cases the IRS attempts to shift its collection responsibility to employers. It forces employers to pay a "price" if its employees fail to keep adequate tip records. The price is an IRS audit where the employer must pay Social Security taxes on the agency's tip income estimate.
In the present audit, the court continued, the IRS made two estimating mistakes:

• It used the credit card percentage without considering that cash customers leave smaller tips.
• Two, it should have audited the employees' records or used some other method of arriving at an employee-by-employee determination of tips. An aggregate estimate is impermissible.
  

Here, the agency made an educated guess as to how much tax the restaurant owes and then put the burden on it to prove the IRS wrong. The court added the restaurant isn't in a better position than the agency to determine tip income.

Quite the contrary. Fior lacks the IRS power to audit employees. The agency's preparing an estimate and forcing the restaurant to prove it wrong makes the agency's numbers "virtually conclusive".

Comment: Tips are important to the IRS. They represent between $8 billion and $10 billion a year in unreported and untaxed income.

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

The IRS will surely challenge this case or others like it. If it loses, it will probably go to Congress to get the law changed.

Employers won one battle, but more battles will be fought before this war is over.

The moral: Restaurateurs should still tip-toe around tip reporting.