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Home News Tribune

Tips, Taxes, and the IRS

The Supreme Court is about to weigh in on a 10-year-old conflict between restaurants and the IRS, over auditing procedures. The outcome will have ramifications throughout the restaurant industry, a fact which has Francis Schott and Raoul Momo, two of New Jersey's most prominent restaurateurs, talking.

The issue at hand is whether the IRS, during a restaurant audit, can rightfully determine the amount of taxes owed by the establishment on unreported tip income.

"The way the law works right now," Schott said, "the IRS sends an agent who knows nothing about the restaurant business into our business and says (for example), 'I think you owe us $100,000, and you have $50,000 in fines and $20,000 in interest, and that's what we think you owe us."

If the restaurant industry has its way, the tables may soon be turned on the IRS.

After a conflict that's been brewing for 10 years between restaurateurs and the IRS over auditing procedures, justice is set to be served this spring when the Supreme Court--in a landmark move--considers this multilayered issue:

Is it right that the IRS, in conducting a restaurant audit, be allowed to determine how much taxes on unreported tip income an establishment allegedly owes the government based on an estimate?

Tracy Power, a Washington, D.C.-based tax attorney with Power & Power, specializing in the restaurant industry, offers a resounding "no."

"This procedure results in the denial of all social security benefits to the employees on (their) tip earnings," Power recently wrote in a statement. "Because the IRS bases its assessment on an estimate of tips earned by all employees collectively in the aggregate without identifying the individual employees and their individual tip earnings, no one's wage earnings accounts can be credited for the tips and the social security taxes collected."

In addition, "the IRS is under the mistaken impression that the employer is in a position to know what the employees make," Power says. "They are not--even when a tip is left on a credit card." The employer still has no way of knowing how much of the tip total the employee paid out to others, such as the busperson, host and bartender, she adds.

"No matter how it adds up, restaurateurs should not have to pay taxes on what may well be phantom income," Power says.

For now, the IRS is keeping mum.

"The bottom line -is that when (a case) is in litigation, we cannot comment, says Gregg Semanick, IRS spokesman in Springfield, NJ

On Jan. 11 of this year, the Supreme Court announced it will consider the Ninth Circuit Court of Appeal's decision (made in March 2001) in the United States v. Fior d'Italia case.

Power is representing Flor d'Italia, a San Francisco, California-based restaurant whose case has attracted national attention for being the first of its kind to land in the Supreme Court.

"What was different about this case that got the Supreme Court to notice it was that the restaurant industry won," Power says.

The Supreme Court's acknowledgement alone is a victory of sorts for restaurateurs, as three similar cases scattered throughout the country played out with the restaurant industry winning at the district court level, but the IRS winning on appeal, Power says.

Now, the case is on the Supreme Court's Fast Track.

The government's brief is due tomorrow, Power says. Hers is due March 27 and oral argument is scheduled for the week of April 21, with a decision likely to be made this term, she says.

Bob Larive, owner of Fior d'Italia, filed suit in 1993 after his local IRS office audited his business and slapped him with a $22,000 bill.

About 40 years ago, "Congress decided that tips were wages for FICA (social security tax) purposes," Larive says. "And for the longest time, there was kind of an unwritten rule put out by the IRS that 8-1/2 percent of our sales was a good number. It was kind of a safe haven."

So every year, Larive's employees reported 8-1/2 percent of the restaurant's sales as the tip amount and paid the corresponding FICA money, he says. "Everything was copacetic. Everybody was happy."

Larive says the IRS changed its auditing system for restaurants in the early 1990s, opting instead to determine alleged tax dollars owed based on a restaurant's gross sales.

"They would plug a percentage on that (sales number), go back and see what the employees (waiters and/or waitresses) reported," he explains, "and if there was a difference, (they would) charge the employer."

Restaurateurs in central New Jersey are anticipating the outcome of the Fior d' Italia case, notes Francis Schott, restaurant co-owner and board member of the New Jersey Restaurant Association. Along with Mark Pascal, Schott owns Stage Left Restaurant, a popular establishment in downtown New Brunswick.

Schott, one of few local restaurant owners who agreed to be be interviewed for this story, says he knows why others won't talk.

"Nobody knows how you get selected for this audit and everybody wants to fly under the radar because they're scared--we're all scared to death," Schott says. "Because the way the law works right now, the IRS sends an agent who knows nothing about the restaurant business into our business and says (for example), 'I think you owe us $100,000 and you have $50,000 in fines and $20,000 in interest, and that's what we think you owe us. And you either pay us or you prove us wrong with expensive lawyers.' With the IRS, you're guilty until proven innocent."

In New Jersey, there are approximately 8,000 privately owned restaurants that may one day face such an IRS audit, says Deborah Doweled, executive vice-president of the New Jersey Restaurant Association. "And there are 180,000 employees in the industry, making us the largest private sector employers in the state."

One reason Schott isn't too worried about an IRS audit is because his business is 93 percent credit cards, so "I have nothing to hide." He also includes his employees' tips in their paychecks. Further, he keeps an elaborate bookkeeping system. "I can afford $85,000 worth of computer equipment (but) not everybody can afford that." He also spends $10,000 a year to maintain the system.

"Now, you have a little restaurant--a mom and pop where two people own it--how are they going to find time to follow-up on all of their employees?" Schott rhetorically asks.

For the IRS' part, in the last several years, the agency has worked to promote itself as a kinder, gentler IRS, offering free workshops and seminars to small business owners and advertising its Web site as a user-friendly tool for the public to simply filing their tax returns. That said, why does it appear that the IRS is bullying the restaurant industry?

Schott believes there are a number of reasons.

"Here's why the IRS is a kinder, gentler IRS to (big corporations like) Enron but they're a nasty IRS to restaurants: because Enron is owned by big, fat stockholders with a lot of influence in Washington," he says. "Restaurants in general are one of the last bastions of mom and pop businesses."

Still, Schott says he also understands why the IRS may be tougher on the restaurant industry.

"Let's admit it, for many years, the restaurants were a cash business and waiters ... would not report their tips and employers would not report their tips," he says. "In New Jersey, our industry has become increasingly professional over the years. But there are restaurants out there that are taking money and I say to the IRS, 'Let's go get them. But let's go get them in a fair way.'"

Raoul Momo, co-owner of T2 Ventures with his brother, operates nine restaurants in three states, including Mediterra in Princeton and Teresa's (with locations; both in New Brunswick and Princeton). He says that he has no beef with how the IRS conducts its restaurant audits.

"We're required to pay the 8 percent social security tax and that's it, no matter what," Momo says. "And in my restaurants, it's always higher than that so (this is) a non-issue."

Momo says that if he were to be audited, he wouldn't be concerned.

"They would see that I'm paying more than 8 percent, so they would be happy. They'll go after the guy who pays less than that."

Attempts to speak with restaurant employees about this topic proved futile, which came as no surprise to one New Jersey restaurant owner who wished to remain anonymous.

"The reason you can't get a server to talk about the issue is that everybody in the restaurant business is afraid of unfair treatment by the IRS--not because of any impropriety."

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