Do Tips Count as Income?

The IRS wrestles with restaurants over tip reporting and scores a big win.
Magazine Contributor
2 min read

This story appears in the October 2002 issue of Entrepreneur. Subscribe »

The restaurant industry and other small businesses employing workers who receive tips recently took a hit from the Supreme Court. In June, the court ruled that the IRS has the right to charge restaurants additional Social Security taxes if it believes employees are underreporting their tips.

Seven out of 10 restaurants are small businesses, many of which operate with slim margins, says Peter Kilgore, general counsel and senior vice president of operations for the National Restaurant Association. The restaurant industry maintains that holding employers liable when the IRS fails to determine which workers failed to report tips pits restaurant owners against their own employees.

The case of Fior d'Italia v. the U.S. involved a claim of underpayed tip taxes by the San Francisco restaurant. After a federal district court and a federal appeals court ruled in the restaurant's favor, government lawyers petitioned the U.S. Supreme Court to take up the case.

The ruling comes as the IRS is expected to step up its audits of restaurants, says Bill Zaagman, director of government affairs for the Michigan Restaurant Association. As a result, more restaurants are likely to enter into a TRAC (Tip Reporting Alternative Commitment) agreement with the IRS to limit their exposure to these audits. Under a TRAC, an employer promises to set up a system where employees are provided a written statement of charged tips attributed to the employee. In addition, the restaurant agrees to educate employees about the need to report 100 percent of all tips.

Says Zaagman: "The ruling affirms the actions the IRS has been taking with regard to audits of restaurant employers. Our next step is to go to Congress and ask for redress there."

Great Falls, Virginia, writer Joan Szabo has reported on tax issues for more than 14 years.

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