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The U.S. restaurant industry consists of thousands of establishments employing millions of workers. Many of these workers rely upon tips as part of their compensation; however, part or all of these tips may be in the form of cash paid directly to the worker by customers. These tips are subject to both income taxes and FICA taxes. A worker who receives more than $20 per month in tips must report these tips to the employer at least once a month. Employers must withhold federal income tax and PICA tax on wages and reported tips and match the PICA amount. An establishment that meets certain criteria must file Form 8027 with the IRS reporting annual sales, chargecard sales, and employee-reported tips. If reported tips are less than 8% of total sales, an employer must allocate tips on the employee's W-2 form.
According to 1998 IRS estimates, however, fewer than 40% of all tips received were reported, an estimated $9-$ 12 billion in unreported income. The issue of unreported tip income is inherently troublesome because tips are often in cash and subject to self-reporting. The IRS has established several initiatives to increase the reporting of tips, including the Tip Rate Determination/Education Program, designed to encourage employees to report the correct amount of tip income to their employer.
In the case of Fior D'ltalia [536 U.S. 238 (2002)], the restaurant met all reporting requirements, yet was assessed additional FICA taxes for 1991 and 1992. On its Form 8027, the amount of tips reported by the workers was less than the amount of tips reported on charge sales alone. The 1RS used an aggregate estimation method to reach the assessment. The restaurant paid part of the assessment, then filed a refund suit. The district court held that the IRS lacked the authority to estimate tip income using an aggregate estimation method, and this ruling was affirmed by the Ninth Circuit Court of Appeals. The Supreme Court reversed the opinion and held that the IRS does have authority to assess a restaurant's HCA taxes on unreported tip income using an aggregate estimation method.
Although this resolved a conflict between circuits over the aggregated estimation issue, other issues remain, such as the estimation methodology, the asymmetry created by an employer paying...