Restaurateur Challenges IRS Tip Law

Fior d'Italia, one of the nation's oldest Italian restaurants, has survived devastating earthquakes and a fire. It's even operated out of a tent.

Now the 115-year-old San Francisco establishment is coming to grips with another force: the Internal Revenue Service.

In a dispute closely followed by the restaurant industry, the U.S. Supreme Court on Monday will hear a case expected to resolve how the nation's restaurants pay Social Security taxes on their employees' tips — which the IRS said totaled $14.31 billion in 1999.

Fior d'Italia is challenging an extra $23,000 Social Security tax that was calculated on estimates.

The intricate case hinges on an IRS policy in which the agency levied Social Security taxes on audited restaurants based on assumptions of the tips workers earn, rather than the actual amount.

Determining taxes from tips has long been a troublesome task because often the tips are cash and workers handle their own paperwork.

Restaurants must pay 7.65 percent Social Security taxes on the amount of tips their employees generate. The employee also must pay 7.65 percent of the total.

In Fior d'Italia's case, a San Francisco-based federal appeals court ruled last year the IRS cannot estimate how much a restaurant owes in Social Security taxes.

The 9th U.S. Circuit Court of Appeals ruled the IRS must audit the tip earners and not "slap the employer with assessments based on ... estimates." But other circuits have sanctioned the practice of estimating, forcing the nation's highest court to resolve the conflict.

The government made no effort to collect the unpaid taxes from the tip earners, nor did it credit the taxes to the individual workers' credit histories.

Bob Larive, co-owner of the restaurant, told CBS News Correspondent Sharyl Attkisson the taxes should be based on individual audits of the employees, not estimates or speculation.

"It's arbitrary, it's wrong. It is not what congress intended. It is not the right way to do it,'' said Larive. "We're not fighting over $23,000. We're fighting something that is wrong."

"Such folly circumvents the wisdom of Congress that determinations about tip income be made on an individual basis," said Peter Kilgore, an attorney for the National Restaurant Association.

Federal officials declined comment. But in briefs to the high court, the federal government said the IRS was authorized to estimate the amount of Social Security taxes.

Solicitor General Theodore Olson also told justices that, if the IRS were to audit individual tip earners from a restaurant, its audits would be based on assumptions as well.

"It is obvious that any cash tips that are not reported on the credit charge slips retained by the employer cannot be traced and determined with precision," Olson wrote. "A method of estimation based on the average tip rate and the gross sales of the restaurant is far more likely to achieve factual accuracy than the individual audits suggested by the court of appeals."

But Tracy J. Power, Larive's attorney, said the government's position is flawed. Larive said waiters, waitresses and bartenders, for example, don't earn the amount of tips shown on credit card receipts. The workers share tips with lower-rung employees, some of whom are exempt from paying taxes on their nominal tips.

Also, she said, people tend to give larger tips with credit cards than they do with cash, so it isn't fair to assume cash tips were the same as credit-card tips.

The case is United States v. Fior d'Italia, 01-463.