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Paying Taxes on Your Tips

Paying Taxes on Your Tips

Pssst. Want to hear about an occupation in which thousands of people earn up to $50,000 or more annually but pay very low taxes?

Here's the deal: You too can become a restaurant waiter, join in the widespread practice of underreporting your tips, and, if you work your way up to a fine-dining gig, achieve an enviably high net income.

But Wait a Minute, Waiter -- There's a Fly in Your Soup

The IRS can use a "reasonable estimate" of tips received by employees to calculate a restaurant's share of FICA taxes, per the Supreme Court's 2002 decision on US vs. Fior D'Italia. In this case, the court allowed the IRS's levy of an additional $23,000 against the venerable San Francisco restaurant for taxes on underreported tips, especially those paid in cash.

The IRS's interest in unearthing these tax liabilities is clear. Billions of dollars in tips go unreported each year. The 7.65 percent employer tax on those billions isn't chump change.

But why should higher tax bills for restaurants be of concern to the nation's 2 million waiters and waitresses? Because the IRS's progress in collecting employer FICA could open new avenues for assessing the taxes on employees' tips, and for employees, both FICA and income taxes are at stake. To see why, you've got to understand how the IRS might use this victory to go after employer FICA taxes.

Restaurants and FICA Tax Liability

Maintaining the status quo, restaurants can allow waiters and other tipped employees to report gratuities monthly, as they have been required to do since 1988. But restaurants run the risk of having the IRS forcibly estimate waiters' cash tips based on the credit-card tipping rates, à la Fior D'Italia. Waiters may feel compelled to report more tips, so that their own tax returns don't conflict with their employers'.

Alternatively, restaurants can institute a more rigorous system of tip reporting, and perhaps enter into an agreement with the IRS that will reduce the likelihood the establishment will be audited. "The IRS is telling restaurants, 'We want you to be the policeman,'" says Isidore Kharasch, president of Hospitality Works Inc., a Deerfield, Illinois, restaurant consultancy.

Restaurants in some states have signed tip agreements with the IRS. These include, for example, eateries belonging to the Illinois and Nevada affiliates of the National Restaurant Association, a trade group in Washington, DC.

"In Illinois, the staff at the end of the night gets a printout of all their checks and they have to write in a tip for each," says Kharasch. The IRS may question the restaurant if reported tips amount to only 5 percent or 10 percent of total receipts. So the restaurants, in turn, hold their waiters' feet to the fire and create a paper trail to back up the calculation of employer-side FICA tax.

In Nevada, casinos have had tip rate determination agreements with the IRS for many years, notes Glen Arnodo, political director of the Culinary Workers Union's Las Vegas local. In these agreements, the establishments accept IRS estimates of tips, and in exchange, the IRS says it won't audit the establishments or their workers.

In addition to reducing net income for employees who have been underreporting their tips, the agreements "put employers almost between employees and the IRS," Arnodo says. He believes establishments in other states may be forced down a similar path. "The IRS typically starts things in Nevada and attempts to spread them elsewhere," says Arnodo.

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