IRS Can Estimate Tip Income, Justices Rule
The U.S. Supreme Court dealt restaurant owners a tax defeat Monday, ruling that the Internal Revenue Service can use an estimate of tips received by servers and bartenders when determining tax bills.
The decision could lead to bills for back taxes throughout the restaurant industry. The ruling also could affect other industries in which employees receive tip income, experts said.
The decision also could help the IRS collect more tax from tipped employees, if it results in restaurants requiring employees to more accurately report their individual tip incomes. Employees typically underreport such income to their employers.
Upscale restaurants could be hit the hardest, given their larger tip revenues, analysts said. It may cause some to raise prices or lay off employees, and could give an advantage to fast-food and fast-casual outlets that don’t collect tip income, experts said.
“This is going to be very painful for many restaurants and cause lots of headaches,” said Hal Sieling, a restaurant consultant in Carlsbad, Calif.
The National Restaurant Assn., a Washington-based industry lobbying group, said the ruling could push struggling operators into insolvency.
But others painted a much less grim scenario. Richard Martin, managing editor of Nation’s Restaurant News, said the new method for calculating employees’ taxable income would add only pennies to the typical meal.
“This isn’t going to send consumers running from restaurants or destroy the industry,” he said.
The 6-3 ruling upholds a move by federal tax collectors to force employers to pay the 7.65% Social Security tax on all income received by their workers, including tips.
The dispute arose over how to calculate the total tip income.
In the past, restaurant owners were told they could rely on reports from their servers and bartenders.
But tips were notoriously underreported. In the early 1990s, the IRS said it would look at credit card slips to calculate how much waiters and waitresses were actually receiving. Then, it would use the average tip to estimate the total of tips.
For example, if customers on average added a 15% tip on their credit cards, the IRS would assume that customers tipped 15% on all of the restaurant’s income, including cash payments. The owner could be assessed back taxes based on this amount.
The restaurant industry cried foul. Customers who pay in cash often leave lower tips, its lawyers said. Sometimes, waiters are stiffed and receive no tip, a lawyer for a San Francisco restaurant told the high court.
But on Monday, the justices brushed aside those complaints and upheld the estimates based on credit card receipts as a reasonable way to assess the taxes owed by a restaurant.
The owner of Fior d’Italia, which proclaims itself as San Francisco’s oldest Italian restaurant, challenged the estimates after receiving a tax bill for 1991 and 1992.
The IRS estimated the tips for 1992 as $368,374, not the $220,845 that the servers had reported. The IRS sent the owner an $11,286 bill for back taxes for 1992 to cover his share of the employee Social Security taxes. They are known officially as the Federal Insurance Contribution Act, or FICA, taxes.
Unquestionably, restaurant owners are free to challenge the accuracy of their tax assessments, said Justice Stephen G. Breyer. But these quibbles do not show “the aggregate estimate method is an unreasonable way of ascertaining unpaid FICA taxes for which the employer is indisputably liable,” Breyer said.
Leaders of the National Restaurant Assn., which represents 200,000 eating establishments, denounced the decision and said they would take their fight to Congress.
“This is grossly unfair, and it has a potentially huge financial impact,” said Peter Kilgore, the group’s general counsel.
He and others also said the ruling may affect all employers--such as hotels, casinos and taxi companies--whose employees receive tips.
Monday’s decision is particularly bad news for California’s eateries, which are already struggling with the nation’s second-highest minimum wage, rapidly increasing workers compensation costs and high real estate and utility costs, said Randall Hiatt, president of Fessel International, a Costa Mesa restaurant consulting firm.
“This is just another jab,” he said.
In Culver City, Pacifico’s stands to lose thousands of dollars a year because of the new method for calculating workers’ taxable income, said Howdy Kabrins, co-owner of the year-old Latin seafood restaurant. Having just raised prices 10% to 12% because of rising halibut and shrimp wholesale costs, he said he would have to raise them again or lay off employees.
Nationally, Hiatt said, the ruling would have the effect of adding about 0.4% to restaurants’ costs. To counteract that, some restaurants probably will raise prices or scale back hours, he said.
Other Southern California eateries reacted to the ruling with worry and panic. Eddie Kerkhofs, owner of Le Dome in West Hollywood, said he probably would have to raise prices at his posh restaurant. With business already down 15% because of the turbulent economy, decline in business travelers and a slump in the music industry, he fears that taking such a step might hurt business.
“I’m going to try to digest this, but it’s like eating rat poison or contaminated food,” he said.
Across town in Santa Monica, the 4-month-old Union Restaurant & Bar has been doing a brisk business by offering hearty American fare at a moderate price.
In light of the ruling, Union’s owners have begun discussing a price hike, a move that could diminish the bistro’s appeal as a place for good value, said managing partner Chuck Craig. “If we raise our prices too high, we might price ourselves out of our market,” Craig said. “We want to be a place where people come four times a month, not four times a year.”
Bob Larive, owner of Fior d’Italia, said he challenged the back assessment to show the unfairness of the IRS policy.
“We hoped a decision in our favor would force the IRS to do their job the right way and not resort to threats and guesses to coerce taxes out of restaurants and employees,” Larive said. However, an IRS lawyer stressed that the “aggregate estimate” method has not been widely used so far. Moreover, it is used only when it appears restaurants are underpaying their taxes, he said.
IRS Commissioner Charles O. Rossotti praised the decision and said it “upholds our ability to make sure all Americans pay a fair share of taxes. The IRS plans to continue working cooperatively with the restaurant industry and other industries were tips are common.”
The San Francisco restaurant won rulings in its favor from a federal judge there and the U.S. 9th Circuit Court of Appeals. Judge Alex Kozinski said the IRS was not empowered to “slap an employer” with back tax assessments based on “rough and somewhat inflated estimates.”
But U.S. Solicitor General Ted Olson appealed the issue to the high court. He noted that the amount of reported tips to the IRS rose from $8.5 billion in 1994 to $14.3 billion in 1999 after the tax agency pressed for better compliance. This suggests tip income was greatly underreported, he said.
Breyer’s opinion reversing the 9th Circuit and upholding the IRS was joined by Chief Justice William H. Rehnquist and Justices John Paul Stevens, Sandra Day O’Connor, Anthony M. Kennedy and Ruth Bader Ginsburg.
Dissenting, Justice David H. Souter said the estimates look to be inaccurate, and they “broadly saddle employers with a burden unintended by Congress.” Justices Antonin Scalia and Clarence Thomas joined his dissent.
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Savage reported from Washington and Ballon from Los Angeles.
