Got Tips? Better Report Them
The inside scoop on computing and reporting taxes on restaurant gratuities. You've just eaten an exquisite meal in a fine restaurant. Feeling satiated and generous, you decide to leave the superb wait staff a rather large gratuity. Hours after you've left the restaurant, that tip is pooled with others and divided among the staff. Who pays taxes on tips? Employers, employees or both? CPAs with restaurant clients know that a restaurant is responsible for paying Federal Insurance Contributions Act (FICA) taxes (at 7.65%) on its employees' wages, including tips. Employees also pay a 7.65% share via withholding. These contributions are used to fund Social Security. Because restaurants typically do not know how much tip income employees actually collect, employees are required to report tips to the IRS on Form 4070, Employee's Report of Tips to Employer. Therefore, when employees underreport their tips, restaurants underwithhold the employee share due under IRC section 3101 and also underpay the employer share due under IRC section 3111. Under regulations section 31.3111-3, an employer is obligated to pay employer FICA taxes based only on the amount of income their employees actually report when employees fail to furnish tip reports or their reports are inaccurate. However, under IRC section 3121(q), once the IRS determines that employee tip income is greater than that reported by the employee and sends the restaurant owner notice and demand, the restaurant owner must pay employer FICA tax on those wages. In assessing unreported tip income, the IRS audits the restaurant (not individual employees, as that would be administratively burdensome) and assesses the employer share of FICA based on the aggregate amount of unreported tips from all the restaurant's tipped employees. This is known as use of an aggregate method. One such aggregate method is based on A.J. McQuatters (TC Memo 1973-197). The McQuatters formula works as follows: The IRS reduces the restaurant's total sales by a percentage to account for sharing tips and customers who leave little or no tip. The result is divided by the total number of hours worked by all servers during the year to determine a sales-per-hour average. That average is multiplied by the number of hours worked by each server to determine the server's yearly sales. Each server's annual sales are multiplied by the average tip rate to determine each one's annual tip income. The formula uses the charged tip rate (the tip rate computed on bills charged on credit cards) as a reference point for the average tip rate. While the Seventh, Eleventh and Federal Circuit Courts of Appeal have agreed with the IRS's use of such indirect methods, some district courts have disagreed. The controversy over the validity of the methods warrants an examination of the cases and guidelines by tax advisers to avoid or contest an assessment. SEVENTH CIRCUIT In 330 West Hubbard Restaurant Corp., 203 F3d 990 (7th Cir. 2000), aff'g 37 F. Supp.2d 1050 (1999), Coco Pazzo, a Chicago restaurant, declared both its total charged tips and cash tips reported by employees on Form 8027, Employer's Annual Information Return of Tip Income and Allocated Tips, for 1993-95, the years at issue. By comparing the amounts Coco Pazzo reported on its Form 941, Employer's Quarterly Federal Tax Return, with the amounts it reported collected on form 8027, the IRS determined that the restaurant's employees had underreported $1,112,454 in tips for the three years at issue. The IRS thus demanded an additional $85,104 in FICA taxes from the restaurant. The only issue for the appeals court was whether the IRS could use the aggregate method to assess the employer's share of FICA taxes. The taxpayer contended that the IRS first had to individually determine the tips each employee had underreported. Coco Pazzo's initial argument was that section 3121(q) refers to wages subject to FICA as "tips received by an employee," requiring a prior assessment of individual employees. …