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IRS Can Estimate Tip Income, Justices Rule

Litigation: High court disagrees with restaurant industry on how to determine Social Security taxes. Analysts say decision could prompt higher prices.


WASHINGTON — 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.

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