Supreme Court Rules in Tip Taxation Controversy

Sending a blow to the restaurant industry, the U.S. Supreme Court ruled Monday, June 17 that the Internal Revenue Service has the right to arbitrarily assess Social Security tax to restaurants and other businesses where employees regularly receive tips if the Service has reason to believe employees of the business are underreporting tip income. According to the ruling, the IRS does not have to determine the exact amount of tip income earned to assess the tax, but instead may make what it determines is a reasonable estimate. In addition, in the case of such an assessment, the IRS may charge the Social Security tax to the employer without crediting the employer's payment to the Social Security accounts of the employees. Affected businesses include casinos, hotels, barber and beauty shops, as well as food service establishments and bars.

In United States v. Fior D'Italia, a San Francisco restaurateur argued that the IRS improperly assessed tax on tip income based on estimates of tips recorded on credit card charge slips. The plaintiff argued that the only way to accurately know how much tip income has been received is to rely on reporting by employees. Tips on credit card slips, Fior D'Italia argued, may be more generous than cash tips because people leaving cash tips are limited by the amount of cash in their wallets.

"We are deeply disappointed by the Supreme Court's decision, which basically condones the IRS's unfair and unjust tactics to pit restaurateurs against their own employees, turning them into 'tip police,'" said Peter Kilgore, general counsel and senior vice president of operations of the National Restaurant Association. "This decision could mean the difference between a restaurant staying in business or closing its doors."

"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," said Fior d’Italia president Bob Larive in a statement.

IRS Commissioner Charles O. Rossotti said the decision "upholds our ability to make sure all Americans pay a fair share of taxes."

The Supreme Court voted 6-3 to uphold the IRS's right to assess the tax. The ruling complements the Court's 1973 decision that the IRS can make an educated guess about tip receipts where written records are inadequate. That case related to taxes paid by workers, where the present case relates to taxes paid by employers. Justices David Souter, Antonin Scalia, and Clarence Thomas dissented in the Fior D'Italia decision.

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