A range of benefit programs under the broad umbrella of the Social Security Act is financed largely from taxes paid by employers and employees under the provisions of the Federal Insurance Contribution Act (FICA). The Internal Revenue Code requires every employee to pay a FICA tax, calculated as a percentage of his or her wages. The employer must deduct FICA taxes from wages as they are paid. Independent of the employee's obligation is the employer's duty to pay FICA taxes, which are computed as a percentage of the wages paid by the employer.
With some exceptions, tips received by employees are treated as wages for both the employee's and the employer's share of FICA taxes. On a monthly basis, employees are required to report to their employers in writing all tips received. As far as cash tips are concerned, employees are effectively operating under an honor system, since only they and the customers know the exact amount of the tips.
For the employee's portion of the FICA tax, federal law requires that the employer take into account only those tips that are included in the written report from the employee. However, there is no such statute for the employer's portion. Since the employer's tax must take into consideration tip income not included in the reports from its employees, the question arises as to how the employer must make this calculation. Competing methods advocated by businesses and the IRS have led to litigation in various federal courts, with conflicting results.
Aggregate Method
Most recently, a federal appeals court upheld the IRS in its claim against a restaurant for over $30,000 in back FICA taxes due to the underreporting of tip income received by its employees. The court approved of the IRS's use of the "aggregate method" for calculating the yearly tip income for each employee, including tips not on a written report.
The aggregate method applies an indirect formula that is indirect in the sense that it does not involve an examination of each employee's tax records to determine whether, and to what extent, tip income may not have been fully reported. Instead, the employer calculates the yearly sales attributable to each employee and then multiplies that figure by an average tip rate to arrive at the yearly tip income for each employee. This method advocated by the IRS was approved by the court of appeals in part because a contrary ruling could give an employer an incentive to discourage accurate reporting or simply to ignore inaccurate reporting by employees so that the employer could reduce its FICA taxes.
However, the same argument carried little weight for a federal district court which only a month earlier rejected the aggregate method espoused by the IRS and the resulting IRS claim for $23,000 in back taxes. In that court's view, the federal tax statutes require that the IRS review each employee's tax records and determine that they are inadequate before using an aggregate method to estimate the amount of tips received by the employee.