Since the United States Supreme Court’s 2002 decision in United States v. Fior D’Italia, Inc., service businesses, including restaurants, beauty salons, hotels, and taxi and limousine companies have complained that they have become “tip police.” This is because, pursuant to United States v. Fior D’Italia, Inc., if the Internal Revenue Service believes the amount of tip income reported by the business’ employees is not accurate, the IRS may conduct an employer-only audit, bill the employer using an aggregate estimate based on the business’ total receipts and collect the employer’s portion of the FICA taxes. Proposed legislation, entitled the 2002/2003 Tip Tax Fairness Act, prohibits employer-only audits and requires the IRS to precisely determine the total underreported tips. On July 15, 2004, the Oversight Subcommittee of the House Ways and Means Committee considered testimony in support of the Act.

In Fior D’Italia, the restaurant filed a refund suit claiming that tax statutes do not authorize the aggregate estimation method; rather the statutes require the IRS to first determine the tips that each individual employee received and then calculate the employer’s total FICA taxes. The United States Supreme Court reversed the Court of Appeals for the Ninth Circuit and the District Court for the Northern District of California and ruled that the IRS may conduct an employer-only audit if it suspects employees have underreported their tips and may calculate additional FICA taxes due from the employer based on an aggregate estimated assessment. To calculate the aggregate estimated assessment, the IRS examines the business’ credit card receipts and calculates the average tip amount. The IRS then assumes that cash-paying customers give tips at the same rate as the credit-paying customers and multiplies the estimated tip rate by the business’ total cash and credit receipts. Next, the IRS subtracts the tips previously reported, applies the FICA tax and assesses the additional taxes owed by the employer.

Proponents of the Act contend that this method is inherently problematic because it fails to focus on those individual employees who allegedly underreported their tips and, in effect, pits the employer against its employees. Furthermore, the aggregate estimate is based on an unsupported assumption that cash- and credit-paying customers tip at the same rate. Supporters of the proposed legislation also contend that, contrary to congressional intent, employer-paid FICA taxes based on the IRS’ aggregate assessments are never properly credited to individual employees' Social Security records. The Tip Tax Fairness Act of 2002/2003 would supercede the estimate method approved by the Supreme Court in Fior D’ Italia and would curtail the IRS’ power to conduct employer-only audits and collect an aggregate amount of FICA taxes from employers on unreported tips. The proposed legislation requires the IRS to precisely determine the actual amount of the employee’s underreporting for the purpose of determining the employer’s FICA taxes.

Groups including the National Restaurant Association and the American Hotel & Lodging Association support the legislation and believe that it will improve what are now strained working relationships in the service industry.