D'Itania v. USA.

• Decision Date: 07 March 2001
• Docket Number: No. 99-16021,99-16021
• Parties: (9th Cir. 2001) FIOR D'ITALIA, INC., Plaintiff-counter-defendant-Appellee, v. UNITED STATES OF AMERICA, Defendant-counter claimant-Appellant
• Court: U.S. Court of Appeals — Ninth Circuit

Page 844

242 F.3d 844 (9th Cir. 2001)

FIOR D'ITALIA, INC., Plaintiff-counter-defendant-Appellee, v. UNITED STATES OF AMERICA, Defendant-counter claimant-Appellant.

No. 99-16021

UNITED STATES COURT OF APPEALS FOR THE NINTH CIRCUIT

Argued and Submitted March 15, 2000

Filed March 7, 2001

Jeffrey R. Meyer, Attorney for the Department of Justice Tax Division, Washington, D.C., for the appellant.

Tracy J. Power, Power & Power, Arlington, Virginia, for the appellee.

Peter G. Kilgore, for amicus curiae National Restaurant Association in support of Appellee.

Appeal from the United States District Court for the Northern District of California Charles A. Legge, District Judge, Presiding. D.C. No.CV-97-04613-CAL

Before: Alex Kozinski, Andrew J. Kleinfeld and M. Margaret McKeown, Circuit Judges.

Opinion by Judge Kozinski; Dissent by Judge McKeown

KOZINSKI, Circuit Judge.

In a dispute involving a restaurant's share of Social Security taxes on its employees' tip income, we explore the outer bounds of the IRS's power to make tax assessments.

I

Like most restaurants, Fior D'Italia employs waiters, table bussers, bartenders and others whose earnings come in part from tips left by customers. Although these tips are paid by customers directly to employees, federal law deems them to have been paid by the employer for purposes of FICA taxes. See I.R.C. SS 3101, 3111, 3121(a) & (q). This puts employers in an awkward position: They are "deemed" for purposes of tax law, to have paid large sums of money that they have never touched and whose exact amounts they have no way of ascertaining. See I.R.C. S 3121(q). ¹ Yet employers need to know how much tip income employees receive in order to calculate their own FICA taxes and withhold appropriate amounts from the wage portion of the employees' compensation, pursuant to I.R.C. S 3102.

To make this information known to employers, tipped employees must submit monthly statements (usually on Form 4070) reporting all tip earnings that qualify as wages under the statute. See I.R.C. S 6053(a); Treas. Reg. S 31.6053-1(a). Employers, in turn, must report to the government (on Form 8027) their gross sales, charged tips and the tip amounts reported by employees. See I.R.C. S 6053(c)(1).

The dispute before us arose because in 1991 and 1992, Fior D'Italia reported aggregate tips that were significantly less than the tips that appeared on its credit card charge slips.² The Internal Revenue Service assessed Fior for additional FICAtaxes on what it deemed was unreported tip income for those years. To determine what Fior owed, the IRS used a simple calculation: For each year, it divided total tips charged on credit cards by total credit card receipts, yielding an average tip rate of 14.49% and 14.29% for 1991 and 1992, respectively. It then applied this "tip rate" to the restaurant's gross receipts to get a presumed tip total for the year. The IRS assessed Fior additional FICA taxes based on the difference between its presumed total and the amount of tips Fior's employees had reported.³ The IRS did not readjust the FICA or income tax liability of the various employees who may have understated tip income on their 4070 forms.

Fior challenged the assessment method in district court, arguing that it exceeded the IRS's authority. The district court agreed, Fior D'Italia, Inc. v. United States, 21 F. Supp. 2d 1097 (N.D. Cal. 1998), and the government appeals.

II

Because we must decide whether the IRS's assessment is valid, we begin by examining what exactly the IRS is assessing. Section 3111 imposes on every employer a tax equal to a percentage of "the wages . . . paid by him with respect to employment." I.R.C. S 3111(a). These wages are defined to include "tips received by an employee in the course of his employment." I.R.C. S 3121(q). But Congress did not treat all tips as taxable wages for this purpose. In section 3121(a)(1), it excluded all remuneration from the employer (salary plus tips) that exceeds the Social Security wage base for that year.⁴ In section 3121(a)(12)(B), it excluded all cash tips received by an employee if that amount was less than $20 in a given month. These latter two provisions are often described as defining the "wages band" outside of which tip income is not taxed. See Bubble Room, Inc. v. United States, 159 F.3d 553, 555-56 (Fed. Cir. 1998) (Bubble Room II). For the IRS's aggregate assessment method to precisely equal the tips on which the employer's FICA tax is calculated, the cash tipping rate must be exactly the same as the tipping rate on Charge slips, and total tips received must be distributed among employees so that none falls outside the wages band.

Neither condition will hold true in most cases. First, experience shows that charged tips generally exceed cash tips. See Yukimura v. Commissioner, 43 T.C.M. (CCH) 467, 470 (1982). One can think of many reasons why this would be so. Spending credit is easier than spending cash, because actual payment is deferred. Also, people dining on expense accounts generally pay with credit cards, and spending someone else's credit is even easier than spending one's own. Then there is the convenience of being able to write a tip in precisely the amount one deems appropriate. People paying in cash, however generous they may feel, are limited by the amount actually in their wallets and the need to keep some cash until their next visit to Gringott's. Applying the charged tip rate to cash receipts will thus tend to overestimate the cash tips actually paid. And charged tips paid to employees may be less than appears on the credit card receipts, because some employers pass on the three percent fee assessed by the credit card companies. See Bubble Room, Inc. v. United States, 36 Fed. Cl. 659, 663 (1996) (Bubble Room I), rev'd , Bubble Room II, 159 F.3d 553.

The assumption that all tip income falls within the wages band is even more problematic because Fior's employees, like those of many other restaurants, engage in tip sharing. Waiters receive tips from the customers and then share them with table bussers, bartenders and other employees. Much like tips left by the customer, the exact amount shared with others depends on the waiter's generosity and his evaluation of how much other employees contributed to customer satisfaction. Looking only at the aggregate tips collected, we cannot tell how many table bussers made less than $20 in indirect tips per month for some or all of the periods in question.⁵ Nor is there any way of knowing how many waiters and hosts received salaries plus tips exceeding the Social Security wage base--something we cannot rule out for an upscale restaurant like Fior D'Italia.

While an employer may be aware that reported tips are less than actual charged tips, it cannot be sure that employees are understating tips in their 4070 forms. Some or all of the discrepancy could be explained by the fact that employees are not required to report tips falling outside the wages band. Even if the employer suspects that some employees are understating their tip income, it has no way of knowing who is under reporting or by how much. Restaurants cannot force waiters to divulge how much they have actually received in tips, and how those amounts were shared with other employees. Nor are employees likely to volunteer such information, because they would be admitting that they committed tax fraud by understating their tip income on the IRS form they submitted to the employer.

The IRS is unimpressed. It believes itself empowered to use any rational method for assessing the tax; the difficulties the employer raises can be considered in determining the precise amount of tax actually owed. If the assessment is valid, the burden shifts to the taxpayer to prove the amount (if any) by which the assessment overstates the tax owed. The question remains whether the assessment is valid.

III

The IRS's authority to make assessments is a very powerful tool. By making a valid assessment, the IRS shifts to the taxpayer the burden of proving that it does not owe the amount of tax the IRS has assessed it. If the taxpayer cannot persuade a trier of fact that the amount assessed is incorrect, the IRS wins and the taxpayer is required to pay that amount. See Palmer v. IRS, 116 F.3d 1309, 1312 (9th Cir. 1997). So long as the assessment is supported by a "minimal factual foundation," the IRS need not present any additional evidence; the risk of uncertainty falls on the taxpayer. Id .

In the income tax context, an assessment becomes even more powerful when coupled with the IRS's authority pursuant to I.R.C. S 446 to redefine the manner in which the taxpayer computes income. Section 446 has been interpreted as giving the IRS authority to make an assessment based on an estimate rather than a computation. See McQuatters v. Commissioner, 32 T.C.M. (CCH) 1122, 1125 (1973). This means that, in making the assessment, the IRS need not rely on the actual records kept by the taxpayer. Where such records are inadequate, the IRS may make an educated guess as to how much tax is owed, and then put the burden on the taxpayer to prove it wrong.

McQuatters also involved tip income but, unlike our case, it involved the income taxes of the employees who had actually received the income. See also Mendelson v. Commissioner, 305 F.2d 519 (7th Cir. 1962). The tipped employees had failed to maintain adequate records of the tips they had received, and the courts held that the IRS was authorized to use an estimate in making its assessment. Because the employees should have maintained records of their income but failed to do so, it was deemed entirely appropriate to put the burden on them to prove that the IRS's estimate overstated their taxable income. See id. at 523 ("Obviously, where a taxpayer keeps no records disclosing his income, no method can be devised which will produce an exact result. The law does not require that much."); McQuatters, 32 T.C.M. (CCH) at...