Tip Case Goes Against IRS

IRS Loses But Refuses To Give Up

by Robert Wagner, CPA

On February 29, a federal judge in Mobile, Alabama handed the IRS a stunning defeat. In the landmark case Morrison Restaurants, Inc. vs. U.S., the judge said that IRS’s “employer first” tip audits are illegal. IRS was ordered to repay Morrison Restaurant $10,124 in taxes plus $3,111 in interest. This case has enormous impact on restaurants and IRS efforts to collect more taxes on employee tips.

In this case the IRS agent reviewed the restaurant’s tip compliance records because the restaurant was reporting charge tips at 16% but cash tips at only 7%. The agent applied the so-called McQuatters formula. Based on a 1973 court case, the formula established a maximum acceptable variance between charge and cash tips. The agent then assessed Morrison’s for payroll taxes on unreported cash tips. The IRS agent did not do a tip audit where each employee’s tip records are examined for under-reporting of income.

True Tip Audits Still Legal

A full-blown tip audit is still completely legal. When it chooses, the IRS can perform an audit of employee tip records and assess taxes, interest and penalty on unpaid tip income. The problem for the IRS is that a true tip audit means looking at detailed employee tip records which is incredibly time consuming and expensive. The IRS simply doesn’t have the staff or the budget to perform tip audits.

The Morrison’s case is disastrous for the IRS because the method that the IRS agent used to extract taxes from Morrison’s is the same method used by IRS agents all over the country to assess back taxes from restaurateurs. If the IRS’s defeat is sustained by the appeals courts, the IRS will owe restaurants millions of dollars in illegally collected taxes and related interest. In addition, this case eliminates the most effective weapon from IRS’s tax collection arsenal.

IRS Plans Appeal

The IRS plans to appeal the Morrison’s ruling. The appeal will likely take a year and will be decided by the appeals court in Atlanta. Currently Georgia restaurants are not covered by the Morrison’s ruling. However, if the Atlanta appeals court upholds the lower court, Georgia restaurants will be covered and can bid farewell to the threat of “employer first” tip audits.

Morrison’s is represented by Tracy J. Power of Power and Coleman, a law firm based in Arlington, Virginia. She is a strong and effective advocate for the restaurant industry and can be reached at 703-841-1330.

IRS Tip Initiative Continues

My sources in the IRS Atlanta District tell me that IRS plans to carry on business as usual in Georgia as it seeks to sign up restaurants to its “voluntary” tip compliance programs. The IRS continues to request restaurants sign up either for the TRAC (Tip Rate Alternative Commitment) or the TRDA (Tip Rate Determination Agreement).

Last October, the IRS contacted 250 Georgia restaurants to “invite” them to sign up. Restaurants that don’t sign up are subjected to a tip audit and assessment of back taxes. The first 250 restaurants were processed by February, 1996. In May, IRS contacted another 250 Georgia restaurants. The original group were larger eateries, generally with sales of $1 million or more, while the second batch of restaurants have sales of less than $1 million -- some less than $500,000. Currently, the Atlanta IRS office has 11 agents assigned to the tip initiative program. Of the first 250 restaurants contacted, the IRS reports that 99% have elected to participate in TRAC -- only 1% have chosen TRDA. On a national level, over 900 employers with over 6,000 locations have signed up for TRAC.

Stay Tuned

The Morrison’s case will not impact the TRAC agreement or comprehensive tip audits. However, if you have paid IRS taxes based on participation in TRDA or from an “employer first” tip audit, you may soon have grounds to request a refund! Stay tuned!

Robert Wagner is a principal in Robert Wagner & Company, LLC, CPAs. The firm provides tax and accounting services to restaurants, bars and hotels. He can be reached at 404-874-7000, fax 404-874-1132, email: rwagner@bellsouth.net.