[House Hearing, 108 Congress]
[From the U.S. Government Publishing Office]
IRS ENFORCEMENT OF THE REPORTING OF TIP INCOME
=======================================================================
HEARING
before the
SUBCOMMITTEE ON OVERSIGHT
of the
COMMITTEE ON WAYS AND MEANS
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED EIGHTH CONGRESS
SECOND SESSION
__________
JULY 15, 2004
__________
Serial No. 108-67
__________
Printed for the use of the Committee on Ways and Means
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_____________________________________________________________________________
For Sale by the Superintendent of Documents, U.S. Government Printing Office
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COMMITTEE ON WAYS AND MEANS
BILL THOMAS, California, Chairman
PHILIP M. CRANE, Illinois CHARLES B. RANGEL, New York
E. CLAY SHAW, JR., Florida FORTNEY PETE STARK, California
NANCY L. JOHNSON, Connecticut ROBERT T. MATSUI, California
AMO HOUGHTON, New York SANDER M. LEVIN, Michigan
WALLY HERGER, California BENJAMIN L. CARDIN, Maryland
JIM MCCRERY, Louisiana JIM MCDERMOTT, Washington
DAVE CAMP, Michigan GERALD D. KLECZKA, Wisconsin
JIM RAMSTAD, Minnesota JOHN LEWIS, Georgia
JIM NUSSLE, Iowa RICHARD E. NEAL, Massachusetts
SAM JOHNSON, Texas MICHAEL R. MCNULTY, New York
JENNIFER DUNN, Washington WILLIAM J. JEFFERSON, Louisiana
MAC COLLINS, Georgia JOHN S. TANNER, Tennessee
ROB PORTMAN, Ohio XAVIER BECERRA, California
PHIL ENGLISH, Pennsylvania LLOYD DOGGETT, Texas
J.D. HAYWORTH, Arizona EARL POMEROY, North Dakota
JERRY WELLER, Illinois MAX SANDLIN, Texas
KENNY C. HULSHOF, Missouri STEPHANIE TUBBS JONES, Ohio
SCOTT MCINNIS, Colorado
RON LEWIS, Kentucky
MARK FOLEY, Florida
KEVIN BRADY, Texas
PAUL RYAN, Wisconsin
ERIC CANTOR, Virginia
Allison H. Giles, Chief of Staff
Janice Mays, Minority Chief Counsel
SUBCOMMITTEE ON OVERSIGHT
AMO HOUGHTON, New York, Chairman
ROB PORTMAN, Ohio EARL POMEROY, North Dakota
JERRY WELLER, Illinois GERALD D. KLECZKA, Wisconsin
SCOTT MCINNIS, Colorado MICHAEL R. MCNULTY, New York
MARK FOLEY, Florida JOHN S. TANNER, Tennessee
SAM JOHNSON, Texas MAX SANDLIN, Texas
PAUL RYAN, Wisconsin
ERIC CANTOR, Virginia
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C O N T E N T S
__________
Page
Advisory of July 8, 2004, announcing the hearing................. 2
WITNESSES
Internal Revenue Service, William F. Conlon, Director, Reporting
Compliance..................................................... 43
______
American Gaming Association, and Aztar Corp., Joseph J. Jablonski 23
Marriott International, Inc., Edward A. Rosic, Jr................ 12
National Restaurant Association, and K-Bob's USA, Inc., Edward R.
Tinsley........................................................ 16
Power & Power, Tracy J. Power.................................... 8
The Salon Association, and Zona Salons, Frank Zona............... 28
SUBMISSION FOR THE RECORD
Darden Restaurants, Inc., Orlando, FL, Richard J. Walsh.......... 61
IRS ENFORCEMENT OF THE REPORTING OF TIP INCOME
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THURSDAY, JULY 15, 2004
U.S. House of Representatives,
Committee on Ways and Means,
Subcommittee on Oversight,
Washington, DC.
The Subcommittee met, pursuant to notice, at 10:22 a.m., in
room 1100, Longworth House Office Building, Hon. Amo Houghton
(Chairman of the Subcommittee) presiding.
[The advisory announcing the hearing follows:]
ADVISORY FROM THE COMMITTEE ON WAYS AND MEANS
SUBCOMMITTEE ON OVERSIGHT
CONTACT: (202) 225-7601
FOR IMMEDIATE RELEASE
July 08, 2004
No. OV-15
Houghton Announces Hearing to Review
the IRS Enforcement of the Reporting
of Tip Income
Congressman Amo Houghton (R-NY), Chairman, Subcommittee on
Oversight of the Committee on Ways and Means, today announced that the
Subcommittee will hold a hearing to review the Internal Revenue Service
(IRS) enforcement of the reporting of tip income. The hearing will take
place on Thursday, July 15, 2004, in the main Committee hearing room,
1100 Longworth House Office Building, beginning at 10:15 a.m.
In view of the limited time available to hear witnesses, oral
testimony at this hearing will be from invited witnesses only.
Witnesses will include representatives of the IRS, the National
Restaurant Association, The Salon Association, and an individual from
the gaming industry.
BACKGROUND:
Over the last decade there has been significant growth in the
service industries. In 1994, tip wages reported to the IRS totaled
$8.52 billion, and in 2003, this number grew to just over $18 billion.
Despite the increase in reported income, the IRS estimates that
unreported tip income may exceed $9 billion annually. The IRS first
addressed the issue of compliance with its creation of the Tip
Reporting Determination/Education Program (TRD/EP) in 1993. The TRD/EP
was designed to educate employers and employees in the service industry
about tip reporting laws in order to increase compliance.
Businesses may voluntarily participate in one of two types of
agreements, the Tip Reporting Alternative Commitment (TRAC) or the Tip
Rate Determination Agreement (TRDA). The TRAC emphasizes employee
education and tip reporting procedures. Employers must agree to assume
responsibility for having their employees report tips, and the IRS
agrees to not assess the business employment taxes on unreported tips
unless the employees are examined first. The TRDA requires the
determination of tip rates using historical data that the IRS works
with the employer to establish. Employees are required to sign an
agreement with their employer that they will report tips at or above a
determined rate established by the employer and the IRS. Under the
TRDA, the employer reports non-compliant employees to the IRS, but is
not required to educate the employees on reporting tips. The TRDA
agreements have become common in the gaming industry.
In December of 2000, the IRS began to offer a third option called
the Employer-designed Tip Reporting Alternative Commitment (EmTRAC).
The EmTRAC contains the same elements of TRAC, but goes a step further
by giving the employer the latitude to train and educate their
employees of their responsibility to properly report tip income.
Currently, EmTRAC is only available to the food and beverage industry
and each individual plan needs to be approved by the IRS. Depending on
its success, EmTRAC may be expanded to cover other service industries.
In June of 2002, the U.S. Supreme Court heard the case of United
States v. Fior D'Italia, Inc., 122 U.S. 2117 (2002). The central
question involved whether current law authorized the IRS to assess a
restaurant for employment taxes based upon tips their employees may
have received, but failed to report. The Court held that the IRS is
authorized to use an aggregate estimation method when a restaurant or
business underreports its tip income, and that employers could be held
liable for taxes beyond what their individual employees reported for
tips. The aggregate estimation method uses overall credit card charges
to determine the average percentage tip rate paid by the customer. This
rate is then applied to the total sales reported on the annual Form
8027. The restaurant is then required to pay this percentage based on
cash tips. Employers in the restaurant and other service industries
have argued that it is unfair to assess them using the aggregate
estimation method and hold them liable if their employees are not
accurately reporting their tip income. They argue that it is unfair to
assume cash tips are the same as credit card tips.
Legislation has been introduced to address some of the problems
surrounding audits and the aggregate estimation method. Representative
Wally Herger (R-CA) introduced H.R. 2034, the ``Tip Tax Fairness Act of
2003,'' which would require an accurate evaluation of unreported tips
by the IRS. In addition, the bill would bar the IRS from conducting
employer-only aggregate assessments for the purpose of determining
Federal Insurance Contribution Act (FICA) taxes on underreported tip
income. Representative Nancy L. Johnson (R-CT) introduced H.R. 2133,
the ``Cosmetology Tax Fairness and Compliance Act of 2003,'' which
would extend to the cosmetology industry the nonrefundable income tax
credit for employer-paid Social Security taxes on employee cash tips to
meet Federal minimum wage requirements. The tax credit allows
businesses to offset part of the taxes they pay on the tip income of
their employees. Under current law, Section 45B of the Internal Revenue
Code provides a tax credit for employers only in the food and beverage
industry.
FOCUS OF THE HEARING:
The hearing will examine IRS enforcement of tip reporting, the
progress of the TRDA, TRAC, and EmTRAC agreements, proposed legislation
addressing the restaurant and salon industries, and solutions to
increase compliance from employers and employees in the service
industries.
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Chairman HOUGHTON. The hearing will come to order. We thank
you very much for coming. Particularly our witnesses in the
panels. We are here today to review the IRS (IRS) programs that
encourage the reporting of tip income. Over the last 10 years,
the service industry has grown significantly, and many service
employees receive a good portion of their income from tips. The
IRS has estimated that a very significant amount of these tips
remain unreported. I believe that everyone needs to pay their
fair share of taxes, and I hope we can explore today how to
improve compliance with the law.
Two Members of our Committee, Mr. Herger and Mrs. Johnson,
have introduced bills that would do a variety of different
things to address issues of tip-reporting in the service
industry. We are going to hear from a panel of witnesses which
includes: an individual who worked with the IRS in developing
one of their tip compliance programs, as well as litigated a
relevant U.S. Supreme Court case; second, a representative from
the National Restaurant Association (NRA); thirdly, an
individual from Marriott International; and then a
representative from both the Gaming Association and the Salon
Association (TSA). One of the witnesses on this panel is a
restaurant owner who created his own successful tip-reporting
compliance program. We are certainly interested in hearing how
he has done this.
On the next panel, we are going to hear from a
representative from the IRS, who will provide us with
background on the tip-reporting issue and explain how
compliance is progressing. I look forward to hearing from the
witnesses, and I am hopeful that this hearing will provide the
Members with a better understanding of the reporting of tip
income. I now yield to the Ranking Member, Mr. Pomeroy, for any
statement he would like to make.
[The opening statement of Chairman Houghton follows:]
Opening Statement of The Honorable Amo Houghton, Chairman, and a
Representative in Congress from the State of New York
Good morning. We are here today to review the IRS programs that
encourage the reporting of tip income. Over the last 10 years the
service industry has grown significantly. Many service employees
receive a good portion of their income from tips. However, the IRS has
estimated that a significant amount of these tips remain unreported. I
believe that everyone needs to pay their fair share of taxes, and hope
we can explore today how to improve compliance with the law.
Two Members on the Committee have introduced legislation addressing
issues of tip reporting within the service industry. Rep. Nancy Johnson
introduced a bill that would extend to the cosmetology industry a
nonrefundable income tax credit, which is currently only available to
the food and beverage industry. Rep. Wally Herger introduced a bill
that would require the IRS to conduct an accurate evaluation of
unreported tips and bar the use of employer-only aggregate assessments
for the purpose of determining FICA taxes on underreported tip income.
First, we will hear from a panel of witnesses which includes an
individual who worked with the IRS in developing one of their tip
compliance programs, as well as litigated a relevant Supreme Court
case, a representative from the National Restaurant Association, an
individual from Marriott International, and a representative from both
the gaming industry, and The Salon Association. One of the witnesses on
this panel is a restaurant owner who created his own successful tip
reporting compliance program. We are all interested in hearing how he
does this.
On the next panel, we will hear from a representative from the IRS,
who will provide us with background on the tip reporting issue and
explain how compliance is progressing.
I look forward to hearing from the witnesses and I am hopeful that
this hearing will provide Members with a better understanding of the
reporting of tip income.
I now yield to the ranking Member, Mr. Pomeroy, for any statement
he wishes to make.
Mr. POMEROY. Mr. Chairman, thank you for convening this
hearing. We on the Subcommittee on Oversight, I think, find
today's inquiry squarely in the middle of our strike zone in
terms of what ought to be the function of the Subcommittee on
Oversight. In 1982, Congress passed legislation to provide the
IRS with new measures to identify unreported tip income, and at
that time it was estimated that about 85 percent of the income
occurring in this sector went unreported. Two decades later,
IRS reports that very significant improvement in tip-reporting
compliance has been made. In fact, we have seen tips from all
industries reported increase from $8.5 billion in 1994, to $18
billion in 2003. These voluntary compliance partnerships
between the private sector and the IRS have shown some
considerable success.
The IRS has entered into approximately 14,000 agreements
with restaurant employers because employers recognize by being
part of one of these agreements, the business can significantly
decrease the likelihood of future IRS audits of related
records. The first panel is going to bring us private sector
information in terms of how this is going, and the second panel
is the IRS responding to it. It is absolutely in reverse of how
we usually do our business, because usually we have the agency
first followed by the private sector. I think that this
morning's session can maybe be almost more of a dialog format
with putting on the record how it is working, the upsides, the
downsides, where the frustration is--and there is frustration
as evidenced by the legislation that our colleagues have
introduced. I think it is going to be very interesting for us
to get the learning curve that the first panel will bring us
and then the learning curve of the IRS response. In the end, we
want to strike a fair balance among taxpayer rights, small
businessowner needs, and tax enforcement. I hope that today's
discussion is going to bring us some advanced understanding in
terms of whether this balance is presently achieved relative to
tip-reporting income. Thank you, Mr. Chairman, for holding this
hearing.
[The opening statement of Mr. Pomeroy follows:]
Opening Statement of The Honorable Earl Pomeroy, a Representative in
Congress from the State of North Dakota
The goal of today's Oversight Subcommittee hearing is to examine
the IRS's current tax administration policies for encouraging employer
and employee compliance in the reporting of and paying of taxes on tip
income.
In 1982, Congress passed legislation to provide the IRS with new
measures to identify unreported tip income. At that time, it was
estimated that about 85 percent of tip income went unreported by
workers in food and beverage, beauty and barber, gambling, and taxicab
businesses.
Two decades later, IRS reports indicate that there has been a
significant improvement in tip reporting compliance. Tips reported from
all industries have risen from $8.5 billion in 1994 to $18 billion in
2003. This is largely attributed to the private sector working closely
with the IRS to improve tax reporting by employers and employees. It is
my hope that this coordination will continue and improve even further.
Currently, there are three voluntary IRS programs through which
employers can establish tip reporting and tax payment compliance
mechanisms. These programs--the Tips Reporting Alternative Commitment
(TRAC), the Tip Rate Determination Agreement (TRDA), and the Employer-
designed Tip Reporting Alternative Commitment (EmTRAC)--have had some
success operating on a volunteer basis. The IRS has entered into
approximately 35,000 agreements with restaurant employers, for example,
because employers recognize that by being part of one of these
agreements, a business can significantly decrease the likelihood of
future IRS audits of related records.
The first panel of witnesses today, representing the restaurant,
cosmetology, and gaming industries, will discuss the successes and
failures of these programs from their experiences. I hope that, as a
result of this hearing, we will bring to light some of the problems
these types of businesses are facing in complying with the law and that
additional dialogue between the parties and the IRS may take place to
resolve these issues.
On the second panel, we will have the senior IRS official in charge
of tax reporting compliance. Among other issues, he will discuss how
the various tip-reporting programs operate to the benefit of employers,
employees, and efficient tax administration. In addition, for firms
that have not chosen to enter into voluntary agreements with the IRS,
he will discuss the importance of the recent U.S. Supreme Court
decision supporting the IRS's practice of estimating unreported tip
income for purposes of calculating an employer's liability for Social
Security and Medicare taxes.
I thank and commend Chairman Houghton for holding this hearing.
This is an issue that clearly has significance to small businesses as
well as their employees, and I know this is the case in North Dakota
where I represent thousands of small business owners and employees. In
discussing this issue, we need to ensure that we strike a fair balance
among taxpayer rights, small business needs, and tax enforcement. I am
pleased that the Oversight Subcommittee is examining the matter.
Thank you Mr. Chairman.
Chairman HOUGHTON. Well, thank you. Now, Mrs. Johnson,
would you like to make a statement or make any introductions?
Mrs. JOHNSON. Thank you very much, Mr. Chairman. I will not
be able to stay for your hearing, but I really wanted to come
and thank the Committee for holding a hearing on this issue
because it is important that everyone pay their fair share of
taxes. I have been working for several years now with the salon
industry because of the unevenness with which the IRS is
functioning in their industry, creating, really, disparities of
impact on small businessowners. I am very glad to welcome Frank
Zona here from Massachusetts, who is representing the salon
industry. What struck me was the difference between how we are
dealing with that issue in hairdressing versus how we have
dealt with it in res-
taurants. While it took us many years to get to some kind of
reasonable agreement with the restaurant industry, I think this
hearing and the relationships that this Committee has developed
with the IRS will give us an opportunity to work with these
small businesspeople to create a better not only communication
system and better understanding, but some better solutions.
Thank you very much, Chairman Houghton and Mr. Pomeroy and all
the Members of the Committee, for holding this hearing, and I
wish you well and look forward to working with you. Thank you,
Frank, for coming.
Chairman HOUGHTON. Thank you very much. Mr. Tanner, would
you like to say something?
Mr. TANNER. Thank you very much, Mr. Chairman. I want to
just welcome you all here. Mr. Herger and I have been working
together on this issue for what, Wally, 3 years now, 4 years?
We are interested in it. We look very much forward to what you
have to say to try to help us straighten this thing out. Thank
you.
Chairman HOUGHTON. All right. Mr. Herger, would you like to
make any comment?
Mr. HERGER. Thank you, Mr. Chairman and Ranking Member, for
scheduling this hearing. This is an issue of great importance
to millions of restaurant employees and employers across
America. Our interest in Congress is making sure that
employment taxes are paid on tip income and that the IRS is
enforcing the law in a manner fair and equitable to both
employers and employees. I believe the question we should be
asking ourselves today is: how do we create the proper
environment for employers, employees, and the IRS to best
manage this admittedly difficult issue? Like many small
business restaurant owners, I am troubled by the IRS aggregate
assessments based on an assumed amount of unreported tips.
Along with Congressman Tanner and others, I have introduced
legislation that would prohibit the IRS from imposing these
aggregate assessments with the hope of moving the IRS toward a
more accurate determination of taxes owed. I am hopeful that
this hearing will serve as a forum to discuss with Congress and
the IRS what we can do to improve the collection of taxes on
tip income. Again, I thank you, Mr. Chairman.
[The opening statement of Mr. Herger follows:]
Opening Statement of The Honorable Wally Herger, a Representative in
Congress from the State of California
I want to thank the Chairman and Ranking Member for scheduling this
hearing. This is an issue of great importance to millions of restaurant
employers and employees across America. Our interest in Congress is
making sure that employment taxes are paid on tip income, and that the
IRS is enforcing the law in a manner fair and equitable to both
employers and employees.
I believe the question we should be asking ourselves today is how
do we create the proper environment for employers, employees, and the
IRS to best manage this admittedly difficult issue. Like many small
business restaurant owners, I am troubled by IRS aggregate assessments
based on an assumed amount of unreported tips. Along with Congressman
Tanner and others, I have introduced legislation that would prohibit
the IRS from imposing these aggregate assessments, with the hope of
moving the IRS toward a more accurate determination of taxes owed. I am
hopeful that this hearing will serve as a forum to discuss what
Congress and the IRS can do to improve the collection of taxes on tip
income.
Chairman HOUGHTON. All right. Now, let me introduce the
first panel. Tracy Power, Partner at Power & Power; Edward
Rosic, Vice President and General Counsel of Marriott
International; Edward Tinsley, Chief Executive Officer (CEO),
K-Bob's USA, Inc., and Treasurer of the NRA; Joseph Jablonski,
Executive Director of Aztar Corporation in Phoenix; and Frank
Zona, whom Mrs. Johnson introduced, Government Affairs Co-
Chair, TSA. We would appreciate if you would begin your
testimony Ms. Power.
STATEMENT OF TRACY J. POWER, PARTNER, POWER & POWER
Ms. POWER. Thank you, Mr. Chairman and Members of the
Subcommittee. I am honored to be here and pleased to have an
opportunity to comment on the IRS' tip-reporting enforcement
policy. I would like to give you a little bit of insight into
my familiarity with this issue, briefly mention precisely what
the IRS is doing, and then talk about what is right and what is
wrong with it. I am a tax attorney representing the restaurant
industry on a variety of issues. I have been counsel of record
for seven of the cases that have been brought on the IRS'
aggregate estimate method in the courts. I represented Fior
d'Italia before the Supreme Court along with my partner and
father. I am one of the principal authors of the IRS' Tip
Reporting Alternative Commitment (TRAC) agreement. I have also
advised and consulted with well over 50 companies on how they
should institute and implement tip-reporting procedures in
order to comply with the TRAC agreement. I have some
familiarity with the broad spectrum of IRS' response on this
issue and with the differing operational problems that
restaurateurs face in dealing with this problem.
I would like to briefly comment on what the IRS does. The
IRS reviews the data on the Form 8027, which is a one-page form
that the restaurateur files each year with the IRS. That form
contains information as to sales, charge sales, charge tips,
tips reported. The IRS will look at that information and, for
instance, if a restaurateur has sales of $1 million, it will
assume that there is a 15-percent overall tip rate, that 8
percent of the tips are being reported, 7 percent is
unreported, and the IRS will assess the employer the employer's
share of Federal Insurance Contributions Act (FICA) taxes on
that 7 percent of unreported tips, or $70,000. The IRS goes
further and now claims that they can go back 16 years on that
assessment.
For a unit that grosses about $2 million a year, not an
atypical amount, that is $170,000 which has to be deposited
within 3 days after being served the notice and demand because
it is FICA taxes. For a 500-unit chain, that is $86 million
that has to be deposited within those 3 days. The IRS uses this
amount or the published potential for exposure to this
liability to require the employer to track, monitor, and police
the reporting of employees' tips. There are a number of things
wrong with this aggregate assessment approach.
First, the potential exposure is devastating. It is ongoing
and it continues to grow. The employer is blindsided by it. He
had no clue when the last was passed in 1988 that this was the
potential exposure. Second, the employer does not have and
never has had the records to defend against this type of
assessment. Most small operators would not even know where to
begin to challenge it. Third, the assessment is inherently
inaccurate. The IRS often fails to acknowledge that there is a
significant difference between charge tips and cash tips. Gross
receipts on the Form 8027 include amounts that often are not
subject to tipping, such as carry-outs, employee meals, manager
meals. Even the charge tip rate on the 8027 is not an accurate
indication of the true charge tip rate.
Next, this is wrong because it is used to push the employer
into doing something he just simply is not capable of doing:
monitoring and policing the reporting of tip income by
employees. Tips vary by employees. In one of the cases that we
litigated, the tips ranged from 7 to 23 percent. An employer
has no way of knowing which employee received which amount.
Employees tip out. They tip out at their own discretion in
varying amounts to varying different indirectly tipped
employees, such as busboys, bartenders, and hostesses. The
employer cannot force the employee to report, and there are
many logical reasons and legal reasons for why the employee
might not report his tips to the employer. The employer also
runs the risk of significant penalties under section 7434 of
the Tax Code if the employer does attempt to make the employee
report what he does not earn. Ultimately, the employee is
harmed if the employer throws up his hands and says everyone
will just simply report at 15 percent.
Last, this aggregate assessment procedure is unnecessary.
The significant increase in tip-reporting since the IRS has
adopted and implemented the TRAC agreement is indicative of the
fact that the aggregate assessment procedure is unnecessary.
The entire amount of that increase from 1994 to 2002 was
generated without an aggregate assessment threat because the
IRS during the course of this time had a moratorium against the
aggregate assessment threat. For these reasons, we encourage
the Committee to adopt the proposed change to section 3121(q).
Thank you very much.
[The prepared statement of Ms. Power follows:]
Statement of Tracy J. Power, Partner, Power & Power
Thank you Mr. Chairman and Members of the Subcommittee. I am
honored to be here and pleased to have the opportunity to speak with
your committee about the IRS enforcement policy with respect to the
reporting of tip income. I believe IRS's current enforcement policy
with respect to tip reporting is unfair to employers, unfair to tipped
employees, and unnecessary. Today's testimony will highlight some of
the reasons why.
By way of introduction I have represented the restaurant industry
and its individual members on tip reporting matters for over 20 years.
I filed the first lawsuit challenging IRS's aggregate estimation method
for assessing the employer share of FICA taxes on unreported tips ten
years ago. I represented Fior d'Italia on that issue before the U.S.
Supreme Court in 2002 and many other taxpayers in the various circuits
in between time. In 1994, I approached IRS on exploring alternatives to
employer only aggregate assessments and authored, with several other
representatives of the industry and the Service, IRS's Tip Reporting
Alternative Commitment (TRAC). Over the last 10 years I have consulted
with more that 50 industry leaders on tip reporting and TRAC
compliance. I hope my experience with such a broad cross section of the
industry will shed some light on the array of problems that employers
face with respect to employee tip reporting and what's wrong with IRS's
aggregate assessment method so that realistic and workable expectations
can guide the Committee's consideration of this issue.
The collection of taxes on tip income has presented a serious
administrative difficulty for the IRS. For more than 50 years, Congress
and IRS have been grappling with the problem.
Since under state and federal labor and common law, tips are the
sole and exclusive property of the employee, paid by customers directly
to employees, and shared among employees in varying unknown amounts,
Congress has repeatedly and consistently refused to permit the employer
to become involved in the tipping transaction or to hold the employer
responsible for the accounting of tip income. Instead, Congress placed
the responsibility for reporting tip income squarely on tipped
employees. In turn, Congress armed the IRS with the power and means to
investigate employee underreporting of tip income and to enforce
accurate reporting by employees.
IRS has not been happy with the arrangement, however, and has
continually attempted to shift its own burden of determining unreported
tip income to the employers of tipped employees on the basis of a
misconception that the restaurant is ``in an inherently better position
than the IRS to determine what its employees actually earned in tips.''
(See the Brief for the United States before the Supreme Court in United
States v. Fior D Italia pg. 38). This fundamental misunderstanding has
led to numerous clashes between IRS and the restaurant industry,
manifested in the history of the relevant statutes.\1\ At every turn
however, Congress has intervened and rejected IRS's attempts to place
this onus on employers, affirming that the admittedly difficult job of
determining unreported tip income rests not with the employer, but with
IRS.
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\1\ The Supreme Court brief of Fior d' Italia (pg 2-12) sets forth
the history of IRS's enforcement efforts with respect to tip income and
Congress's response.
---------------------------------------------------------------------------
IRS's current enforcement policy with respect to tip reporting, the
cornerstone of which is the threat of an assessment based upon an
estimate of aggregate unreported tips of all employees collectively, is
simply IRS's latest re-invention of its efforts to effectively force
the employer into undertaking obligations for, verifying,
investigating, monitoring, and policing compliance by its employees--
responsibilities which Congress has considered, evaluated, and
steadfastly refused to transfer from IRS to the employer. The Supreme
Court's holding in Fior d'Italia, sanctioning IRS's aggregate
assessment authority, overturns Congress's long standing policy
considerations underlying the respective roles of employers and IRS
with respect to the policing of the reporting of tip income by
employees.
Armed with the Supreme Court's blessing, IRS has re-instigated it's
long dormant aggregate estimate assessment policy and is currently
actively using the threat of a potential assessment for employer FICA
taxes on an aggregate estimate of unreported tips of all employees
collectively, against which employers have no defense in the absence of
the necessary employee information as to actual tips received,to
effectively force the employer to be responsible for the accurate
reporting of employee tip income through IRS's tip compliance program.
The potential assessment is financially devastating, inherently
inaccurate, and inconsistently assessed. The alternative, for the many
reasons Congress has considered over the last 50 years, is unrealistic
and virtually unworkable. The ultimate harm is to the employee and the
entire process is unnecessary to increase the compliance of tip
reporting.
The IRS's threatened assessment is for the 7.65% employer share of
FICA taxes on the difference between reported tips and the actual
tipping rate of the establishment as determined by IRS for the now 16
year period since the employer first became liable for FICA taxes on
all tips received, whether reported or not, by virtue of the 1987
amendments to IRC Sec. 3121(q). For a unit with a tipping rate of 15%
and a reporting rate of 8%, the assessment for the 16 year period would
equal 8.6% of sales (7 % unreported tips X 7.65% FICA X 16 years). On a
not atypical sales volume of $2 million the potential assessment is
$172,000. For a 500 unit chain with $1 billion in sales the potential
assessment is $86 million. Since these are FICA taxes, the amount would
have to be deposited with the next regular payroll tax deposit (e.g. 3
days) after the notice and demand is issued. While the 45B credit for
FICA taxes paid on tips may be available to offset some or eventually
all this amount, it is unlikely to do so immediately as average
industry profits are only 4% of sales and the potential assessment is
more than twice this amount. If annual taxes are 30% of annual profits
of 4% or 1.2% of sales, it would take more than 7 years before the 45B
credit would fully offset a potential FICA tax assessment of this
magnitude.
The assessment, based upon an estimate of tips earned by all
employees in the aggregate from data provided annually to IRS by the
employer on Form 8027 is also inherently inaccurate. For example, there
is no way to determine under IRS's aggregate calculation how much, if
any, of the aggregate unreported tip income was tip income received by
an individual employee amounting to less than $20.00 a month, 26 U.S.C.
3121(a)(12), nor how much of the aggregate unreported tip estimated by
IRS was received by individual employees which when added to such
individual employee's other wages paid by the employer exceeded the
wage base, 26 U.S.C. 3121(a)(1). This is information only the employee
has.
Nor does use of the Form 8027 data tell one whether individual
employees received tips net of credit card fees often charged by many
employers or whether employees received any tips on ``employee meals''
or ``carry-out'' sales, figures often included in a restaurant's gross
receipts on Form 8027 but upon which tips are seldom received. Nor
would such a methodology provide information about a company's policy
with respect to ``walk-outs'' or ``stiffs,'' figures often included in
gross receipts for financial purposes then expensed, but upon which
tipping is unlikely. Nor would an aggregate assessment based on Form
8027 data give any information as to whether a portion of a
restaurant's sales are self-service or buffet at different times of the
day, factors which would vastly affect the tip rate.
IRS does not even know whether the amount designated as a tip on a
charge receipt was in fact a tip. For example, IRS does not know to
what extent customers use the tip line to procure cash to purchase
cigarettes or to pay for valet parking or, as in some establishments,
to feed video games--information which can obviously only be procured
from the employee himself. IRS does not know whether the aggregate tips
reported on Form 8027 included credit card amounts which were
uncollectible for which the employer sought reimbursement from the
employee.
The IRS's assessment is also based on the charged tip rate even
though IRS takes no steps determine if other factors such as the use of
coupons, gift certificates or two for one offers artificially inflate
that rate and even though IRS's own studies show that cash tips are
significantly less than charged tips. These flaws permeate IRS's
aggregate estimating methodology and for the most part the employer is
wholly without the information (which he was not privy to in the first
place) to challenge them. The actual amount of tips retained by
employees and the data and records to substantiate that amount is
solely within the employees' control and has never been available to
the employer. Indeed, many state labor laws prohibit the employer from
having any involvement in the tipping process whatsoever.
IRS nevertheless uses the threat of this inherently inaccurate and
financially devastating assessment to effectively force the employer to
ensure full and accurate reporting by employees to the employer.
However, since tips are most often given to employees directly from
customers in varying amount based upon an individual employee's ability
and personality and then split with indirectly tipped employees (e.g.,
hostess, busboys, bartenders, bread girls, etc.) in varying amounts at
the discretion of the directly tipped employees, without any
involvement of the employer, it is virtually impossible for the
employer to know the amount of tips received by individual employees
and assure accurate reporting of that amount.
In addition, reporting to the employer is not the only means by
which an employee may declare his tipped income. An employee may
declare his tips directly on his income tax return through the use of
Form 4137, a form specifically designed for this purpose. There is no
penalty for an employee's failure to report his tips to the employer
and instead report his tip income directly to IRS on his tax return by
use of Form 4137 as long as his failure is due to reasonable cause and
not wilful neglect. 26 U.S.C. 6652(b). There are many legitimate,
logical, practical, and lawful reasons why an employee may not report
all his tips to the employer pursuant to 6053(a), yet still declare
them for income tax purposes on Form 4137 when filing his income tax
return.
The restaurant business is a very transient business with employee
turnover rates of 200-400%. Many employees cease working for the
employer long before the time to report even rolls around--certainly a
legitimate reason for not reporting to the, now ex-, employer.
There are also many reasons an employee may not want the employer
to know the total amount of tips retained. An employee may be afraid
that if the employer knows the total amount of tips he receives, the
employer may reduce his station or hours in favor of other employees,
thereby reducing his income. A directly tipped employee may share a
substantial portion of his tips with a hostess in return for seating
the better tipping customers in his section or with a chef for giving
his favored customers the best cut of meat--practices which neither the
directly nor indirectly tipped employee would be keen about the
employer discovering.
For these reasons and many others there would be nothing unusual in
the total amount of tips reported by employees to employers being less
than total credit card tips or less than expected. Similarly, for these
reasons and many others the employer is not in a position to ensure the
accuracy of employee reporting.
The only practical solution to an employer forced to do so, and
secure protection from an IRS threat of a financially devastating tax
assessment, is to find a way to force its employees to report at the
level IRS seeks. Satisfying IRS's stated goals of average industry tip
reporting at 14\1/2\%, when industry statistics indicate the actual
figure is substantially less, but employers are without the necessary
data to support a lower amount, will inevitably mean that many
employees will be required to report more in tips than they actually
earn, making their effective tax rate one of the highest in the
country. The fact that the aggregate estimate assessment fails to
credit employees with a wage earning history for social security
benefit purposes for the tips IRS claims they make and that it does
nothing to further the collection of the employees share of taxes on
the tips received should also not be overlooked as an inherent flaw in
this enforcement methodology.
Despite the flaws in the enforcement policy, the potential harm it
poses to employers and employees alike and the fact that it leaves 75%
of the tax dollars at issue on the table, IRS insists the aggregate
assessment method is an essential component of its enforcement effort.
IRS argues that in it absence it would be required to conduct
individual audits of employees at considerable expenditure of agency
resources with little results.
The significant increase in tips reported from 1994 through 2002
when IRS had a highly publicized self-imposed moratorium on the use of
the aggregate assessment method, belies IRS's contentions and
demonstrates that the threat of an aggregate assessment is wholly
unnecessary to assure tip reporting compliance. Moreover, IRS has many
options available to it short of individual employee audits to increase
employee tip reporting.
Certainly IRS could collect a substantial amount of its alleged
shortfall by simply sending employers a bill for their share of FICA
taxes on the additional tips their employees report on Forms 4137 (see
infra pg. 6). Additional amounts could also readily be collected by
pursuing by letter, the list of employees provided IRS annually to whom
an allocation was made, as intended by Congress in enacting the 8% tip
allocation provision. To the extent perceived additional unreported
amounts warrant further pursuit, ``desk'' audits could be undertaken by
sending the identified employees computer generated assessments for
amounts in excess of the allocation. At least then, employees could
defend against such proposed assessments and employers could avail
themselves of the defenses employees have brought to bear against IRS
assessments.
All of these options are available to IRS at minimal time and
expense with the crucial distinction of identifying individual
employees and amounts of any additional tip earnings of individual
employees so their wage earnings records for social security benefit
purposes could be credited for such additional amounts with greater
assurances that the amounts assessed were actually received by the
individual employees.
Aggregate estimate assessments are unfair to employees because
without the necessary employee records, employers are deprived of an
effective means to defend against inflated assessments. The historical
practices of tips being received directly from customers and tip
sharing among employees make it impossible for the employer to assure
the accuracy of employee tip reporting. Requiring the employer to do so
will effectively mean requiring all employees to report at a flat,
administratively workable rate--grossly unfair to the employees who do
not make that amount. These results can not be sanctioned when the
aggregate estimate method has proved to be totally unnecessary to
increasing tip reporting compliance and when IRS has many more
palatable options at its disposal to solve unreporting problems.
For these reasons we support HR 2034 and urge its passage.
Chairman HOUGHTON. Thanks very much, Ms. Power. Mr. Rosic?
STATEMENT OF EDWARD A. ROSIC, JR., VICE PRESIDENT AND ASSISTANT
GENERAL COUNSEL, MARRIOTT INTERNATIONAL, INC., BETHESDA,
MARYLAND
Mr. ROSIC. Good morning, Mr. Chairman and Members of the
Subcommittee. Thank you for giving me the opportunity to appear
today. I am Ed Rosic, testifying on behalf of Marriott
International. Marriott is a leading worldwide hospitality
company with over 2,700 lodging properties and over 128,000
employees. In the mid-nineties, Marriott joined a group of
hotel and restaurant industry members to work with the IRS to
develop a program that would be an alternative to the IRS'
enforcement strategy for reporting tip income. The result was
the TRAC program, that Ms. Power referred to. The TRAC program
is an outstanding example of the IRS working with the taxpayer
community to produce a viable alternative to address the
concerns of both the U.S. Department of the Treasury and many
in the business community. For many employers, it has provided
a framework for improved compliance with the tax rules
governing tip income.
The development of the TRAC program with the IRS was a very
significant undertaking, and the implementation of TRAC
required a major commitment on Marriott's part. The change to
comply with the TRAC requirements involved Marriott investing
significantly in systems; revamping procedures in payroll
accounting and the food and beverage operations; production of
new human resources operating procedures and development of
communication and educational materials. The decision to
implement TRAC also required taking risks in employee relations
and in the company's ability to compete in the labor market for
talent. As you can imagine, some individuals might think it
more attractive to work for a company that is not interested in
compliance.
Under TRAC, the employer makes a series of substantial
commitments: to establish procedures for tracking all of the
tip reports by the employees; to educate and periodically
update the employees as to their tip-reporting obligations; to
file all the required employment tax and information returns
and timely pay the taxes; and to maintain certain tip-reporting
records and submit to compliance reviews of those records at
the IRS' request. The IRS in turn makes commitments under the
TRAC program: to assess the employer for its share of
employment taxes on unreported tips only based on employee data
gathered by the IRS from individual employee tax returns or
audits of those employees; to revoke the TRAC agreement
retroactively only if the employer fails in the two main
commitments it makes on education and recordkeeping; and to
revoke the TRAC agreement prospectively in the event the
employer fails to satisfy the reporting and payment
requirements, and then only on the basis of employee unreported
tips if the IRS determined based on an examination that there
has been substantial and collective underreporting by employees
for two continuous quarters.
These substantial commitments on the part of employers and
the IRS under TRAC form the basis for cooperation and effective
improvement in the reporting of tip income. Under this program,
Marriott has been given positive marks by its IRS examination
team because since we joined the TRAC program, the dollar
amount of reported tips has nearly tripled on a sales increase
of only 47 percent. As part of Marriott International's tip-
reporting education efforts, the company has produced a number
of tools, including brochures, managers' guides, posters,
paycheck stuffers, and most recently, online tutorials. While
Marriott has found the TRAC program to be worthwhile and
successful, there are some aspects of the rules relating to
tip-reporting that could be improved to ease the burden on
employers and make tip-reporting compliance efforts more
efficient and effective for both the IRS and employers. The
current information reporting requirements are fairly rigid and
are unnecessarily burdensome to some employers. The tip and
sales information is required to be maintained on the basis of
individual food or beverage outlets. For many employers who
operate multiple outlets at a single location, maintaining the
data at the outlet level is expensive, can interfere with
business operations, and produces records with no incremental
value to the compliance effort. Many employers would find it
more practical if the option were provided to maintain tip and
sales information by business location rather than on an
outlet-by-outlet basis. This option would substantially reduce
the recordkeeping burden but preserve the integrity of the
information and compliance effort.
It would also be useful for employers participating in the
TRAC program, or variations of it, if uniform education and
training materials were available through the IRS in a user-
friendly manner but with content that has broad acceptance and
that employers would be able to adopt or adapt to their
particular situation. In conclusion, the TRAC program has been
a real success for both Marriott International and the IRS and
demonstrates that cooperative efforts by industry and
government can yield positive results. It is our hope that the
IRS extends the program beyond the end of 2005, hopefully
indefinitely. Thank you.
[The prepared statement of Mr. Rosic follows:]
Statement of Edward Rosic, Vice President and Assistant General
Counsel, Marriott International, Inc., Bethesda, Maryland
Thank you for the opportunity to submit this statement. I am Edward
Rosic, testifying on behalf of Marriott International, Inc. Marriott
International is a leading worldwide hospitality company with over
2,700 lodging properties in the United States and 68 other countries
and territories. The company is headquartered in Washington, D.C., and
has approximately 128,000 employees and was ranked as the lodging
industry's most admired company and one of the best places to work for
by FORTUNE.
In 1994 and 1995, Marriott International joined a group of hotel
and restaurant industry members to work with the Internal Revenue
Service to develop a program that would be an alternative to the
Service's enforcement strategy for reporting of tip income. The result
was the Tip Reporting Alternative Commitment or TRAC program. The TRAC
program is an outstanding example of the Service working with the
taxpayer community to produce a viable alternative to address concerns
of both the Treasury Department and many in the business community. For
many employers, it has provided a framework for improved compliance
with the tax rules governing tip income.
The development of the TRAC program with the IRS was a very
significant undertaking, and the implementation of TRAC required a
major commitment. The change to TRAC required our company's investment
in systems; revamping of procedures in payroll accounting, and food and
beverage operations; production of new human resources operating
procedures and development of communication processes and materials.
Moreover, the decision to implement TRAC required taking risks in
employee relations and in the company's ability to compete in the labor
market for talent as individuals might think it more attractive to work
for a company not interested in compliance.
Under TRAC, the employer makes a series of commitments:
To establish procedures for tracking all tips reported by
employees to the employer;
To educate and periodically update directly and
indirectly tipped employees as to their obligation to report all their
tips;
To file all the required employment tax and information
returns and to timely pay the taxes; and
To maintain certain tip reporting records and to submit
to compliance reviews of those records at the Service's request.
The IRS also makes commitments under TRAC:
To assess the employer for its share of employment taxes
on unreported tips only based on employee data gathered by the IRS from
individual employee tax returns or audits of the individual employees;
To revoke the TRAC agreement retroactively only if the
employer fails to substantially comply with the employer's commitments
on education or tip-reporting procedures; and
To revoke the TRAC agreement prospectively in the event
the employer fails to satisfy the reporting and tax payment commitment
or, on an establishment-by-establishment basis, if the IRS determines
that the employees of an establishment have collectively and
substantially underreported tip income for at least two continuous
calendar quarters.
These substantial commitments on the part of employers and the IRS
under a TRAC agreement form the basis for cooperation and effective
improvement in the reporting of tip income. Under this program,
Marriott has been given positive marks by its IRS examination team
because since we joined the TRAC program the dollar amount of reported
tips has nearly tripled, while applicable sales increased 47%.
As part of Marriott International's tip reporting education
efforts, the company has produced a number of tools, including:
``100% Tip Reporting'' brochures in English and Spanish;
A leader's guide to conducting tip reporting educational
meetings at new establishments or for newly hired employees;
Posters and paycheck stuffers highlighting the tip
reporting obligation;
A form for employees to sign acknowledging attendance at
a tip reporting training meeting (English and Spanish versions);
An on-line tutorial for newly hired employees or as a
refresher course for existing employees to teach the tip reporting
requirements; and
An on-line tutorial about tip reporting compliance for
managers and human resources professionals.
While Marriott International has found the TRAC Program to be very
worthwhile and successful, there are some aspects of the rules relating
to tip reporting that could be improved to ease the burden on employers
and make tip reporting compliance efforts more efficient and more
effective for both IRS and employers:
Current information reporting requirements are rigid and
can be unnecessarily burdensome to some employers. The tip and sales
information is required to be maintained on the basis of individual
food or beverage outlets. For many employers who operate multiple
outlets at a single location or in close proximity, maintaining the
data at the outlet level is expensive, interferes with business
operations and produces records with no incremental value to the
compliance effort.
Many employers would find it more practical if the option
were provided to maintain tip and sales information by business
location rather than by individual food & beverage outlet at a given
business location. This option could substantially reduce the
recordkeeping burden, while preserving the integrity of the information
and compliance effort.
It would be useful to employers participating in the TRAC
program, or variations of it, if uniform education and training
materials were made available through the IRS in a user-friendly manner
and with content that has broad acceptance and that employers would be
able to adopt or adapt. Now that the program is nearly 9 years old, a
renewed effort for industry-IRS cooperation on education and training
materials could be useful.
In conclusion, the TRAC program has been a real success for both
Marriott International and the IRS and demonstrates that cooperative
efforts by industry and government can yield positive results. It is
our hope that the IRS extends the program beyond the end of 2005,
hopefully indefinitely.
Chairman HOUGHTON. Thank you very much, Mr. Rosic. Mr.
Tinsley?
STATEMENT OF EDWARD R. TINSLEY, CHAIRMAN AND CHIEF EXECUTIVE
OFFICER, K-BOB'S USA, INC., ALBUQUERQUE, NEW MEXICO, AND
TREASURER, NATIONAL RESTAURANT ASSOCIATION
Mr. TINSLEY. Thank you, Chairman Houghton and distinguished
Members of the Committee, for allowing me to testify on behalf
of the NRA. My name is Ed Tinsley, and I am Chairman and CEO of
the K-Bob's steakhouse chain. We are located in Texas,
Oklahoma, Colorado, and New Mexico. We employ about 1,000
people system-wide in our steakhouses, of which about 40
percent are tipped employees. I am also the current Treasurer
of the NRA.
In addition to representing the industry and urging the Tip
Tax Fairness Act, the passage of this is offering some insights
into the problems faced by restaurant operators in complying
with tip agreements, and I also would like to share some
personal perspectives on a program that we have developed in
our company to help encourage tip-reporting. I have had the
honor of testifying before Congress on one other occasion, so I
know the rule: be brief and get to the point. I think
Congressman Pomeroy can relate to this because he is--I already
mentioned he represents some ranchers. If you have a long rope,
it will get you in trouble. You need a short rope and a fast
horse.
The reason we are supporting the Tip Tax Fairness Act is
when the Supreme Court upheld the IRS' ability to conduct
employer-only audits and aggregate assessments, they indicated
in that opinion that they felt like Congress would ultimately
need to decide this. In most cases, aggregate assessments
inflate the employer's liability and leave employers with
little to no choice or recourse of how to challenge an
assessment. Employers cannot prove or disprove whether
employees receive a certain amount of any tipped income. I know
of no other industry or business where the IRS places such an
onerous burden upon employers and managers in this manner. The
burden also adds tension and is destructive to a relationship
where we both have common goals, the IRS and business.
As an industry, the NRA and the restaurant industry, we
pride ourselves on being employers to 12 million people
nationwide. We are the largest private employer in the country.
Forty percent of all America's workforce today worked in our
industry at one time. Twenty-seven percent of all employees,
this is their first-time job through our industry, so that goes
without saying that we believe in education, and it goes down
the ranks, whether it is teaching the basic work skills of how
to show up to work, teaching hygiene, teaching serve safe, but
it also incorporates teaching tip-reporting and we are
committed on the educational side.
What is creating more concern for employers is the fact
that the Supreme Court decision has given the IRS a new license
to go forth and assess with even less responsibility to create
an accurate assessment. I would be happy to elaborate on this
during questions and answers, but it is basically what Tracy
alluded to. It is guesswork as to what the actual tips are, and
that is just not right. The precedent set by this decision has
restaurants nervous and looking for ways to minimize their
exposure to such an assessment, which brings me to the TRAC.
The TRAC was designed to improve tip-reporting among our
industry by requiring employers to implement education and
recordkeeping. However, the devil is in the details.
I chose not to sign a TRAC agreement with the IRS for two
basic reasons. One is I do not like signing a contractual
agreement with an entity that does not have my company's best
interest at heart. Second, I do not like signing an agreement
with a company that I have to do business with that has the
propensity to change personnel up and down frequently, because
it is always a new deal, it is a new date every time you go in.
I think those problems are what really stem from my decision to
create our own program in-house.
I think also, too, there is still a significant exposure
that remains even after you do sign a TRAC agreement because
there is no retroactive protection, and there is inconsistent
indications from the IRS as to how that retroactive issue will
be handled. We also understand that the TRAC program will
sunset in 2005, and there has been also no indication from the
recent Supreme Court decision also, too, that this will be
extended in any manner. That also is pretty much of a
disincentive to the IRS to continue with the TRAC program.
There are instances in our industry and in our association
where certain companies have been held to higher standards once
they have signed the TRAC agreement, performance standards that
go beyond what the TRAC agreement actually says. I will expound
on that in questions and answers if you would like.
Last, the due process issue with TRAC agreements is almost
like this: the IRS serves as the prosecutor, the judge, and the
jury, and that makes it very difficult. Our program that we
implemented was based on a lot of these concerns. What we did
is we set up an employee benefits program that addresses tip-
reporting, but it addresses a program that we wanted to show
our employees that we care about their future and their
welfare, and that is called K-Care. What we do as a company is
we match 5 percent of all reported tips into a mutual fund that
is shared then across-the-board with all employees in the
steakhouse, whether they are the dishwasher, the hostess, or
what, based on the hours that they work.
We also have a vacation earnings module that is pertinent
to K-Care that enables a server, when they report more tips,
their hourly wage is more, so they earn more vacation earnings
each quarter. We have seen a 25- to 30-percent increase in our
tip-reporting over the last 4 to 5 years because of this. I
feel like that if industry can come up with a solution and
implement it through proper marketing efforts and assistance
from the IRS, that could be an answer. Employers struggle with
how to balance the issues with the IRS and those challenges
that we have in maintaining a positive relationship, at the
same time how to manage and operate a small business. We do not
wake up every morning patting our fingers saying, how can we
help the IRS collect their taxes? We are worried about payroll.
We are worried about leases. We are worried about food costs
and all of those things and providing jobs.
I think the only method that we have left is for Congress
to help clarify this issue and get away from what aggregate
assessments have done in deteriorating the intent of the TRAC
agreement. We do not want to be the IRS police any more than
you would in your previous businesses back home, or if you do
have a business back home. I do not think it is our
responsibility, nor should it be the employer's, to be the IRS
police. I thank you for this opportunity to testify.
[The prepared statement of Mr. Tinsley follows:]
Statement of Edward R. Tinsley, CEO, K-Bob's USA, Inc., and Treasurer,
National Restaurant Association, Albuquerque, New Mexico
Chairman Houghton and distinguished Members of the committee, thank
you for inviting me to testify today on behalf of the National
Restaurant Association about the restaurant industry's ongoing concerns
with the Internal Revenue Service's enforcement practices with regard
to tipped income.
I am the President and CEO of K-Bob's USA, Inc., a steakhouse chain
with locations throughout New Mexico, Texas, Oklahoma and Colorado.
Systemwide we employ roughly 1000 people, of which 40 percent are
tipped employees. Currently, I am the Treasurer for the National
Restaurant Association.
Although I am here today to represent the National Restaurant
Association, I have also been asked to talk about the K-Care program, a
unique initiative I created that has resulted in increased tip
reporting among my employees.
By way of background, we want to remind the committee on the
history of this issue.
In 1988, Congress required employers to begin paying FICA payroll
taxes on all employee tips. Congress concluded that tipped employees
earn a substantial portion of their income through tips. Therefore,
Social Security benefit payments should be determined with respect to
the entire amount of tips, and Congress determined that employers
should be subject to tax on all tips, so that the employees' wage
earnings records can be properly credited.
In 1993, Congress enacted a federal tax credit to provide some
relief from paying a matching FICA tax on tips given by customers to
restaurant servers. The so-called 45(B) credit allows employers to
claim a federal income tax credit for the FICA taxes they pay on any
tips above the minimum-wage tip credit. In regulations, the IRS limited
the scope of this credit to (1) tips reported by employees and (2) tips
received after January 1, 1994.
Congress further clarified the law, rejecting the IRS'
interpretation, in the 1996 minimum wage/tax bill by allowing
restaurateurs to claim the credit for FICA taxes paid after January 1,
1994, on both reported and unreported tips, and regardless whether
those tips were received before or after January 1, 1994. This
clarification was necessary because many employers are made to pay
additional FICA taxes based on IRS's tip audits and assessments, as a
consequence of employee underreporting of tips.
In determining tax liability on unreported tips, the IRS uses an
``employer-only'' aggregate assessment method, whereby the agency looks
at a restaurant's records, primarily credit card tips' receipts, to
come up with a total amount of tips it thinks all employees should have
reported. The IRS then bills the restaurant-operator for the employer's
share of FICA taxes (currently 7.65%) on any allegedly unreported tips,
but does not examine individual employees' records or credit employer
FICA tax payments to individual employees' Social Security accounts.
The IRS's approach has been challenged in a number of court cases.
In June, 2002 the U.S. Supreme Court took up the issue and upheld the
practice based on the Court's inability to find a definite expression
of congressional intent to prohibit the IRS from conducting such
``employer-only'' audits and aggregate assessments. In its opinion, the
Court invited the industry to seek legislative action to clarify
congressional intent behind the law.
The National Restaurant Association believes Congress never
intended to grant the Internal Revenue Service (IRS) the authority to
use aggregate assessments to bill employers for FICA payroll taxes on
allegedly unreported tips. The Association believes statutory language
is needed to clarify Congressional intent for the following reasons:
1. The purpose of paying FICA taxes is to create a wage history
for individuals to draw future Social Security benefits. When the IRS
issues an aggregate assessment for FICA taxes owed on unreported tips,
the amount paid by the employer is never credited to the employee's
social security wage records.
2. Aggregate estimates inaccurately inflate an employer's tax
liability. In making these aggregate estimates, the IRS assumes--quite
often, incorrectly--that (1) customers who pay cash for their meals tip
at exactly the same percent as customers who pay by credit card; (2)
all tipped employees fail to report their tips; (3) all tipped
employees fail to report the same amount; (4) customers never ``stiff''
their servers--i.e., leave them no tip.
3. The IRS's ``employer-only'' approach puts the burden of
enforcing tip-reporting laws on employers, rather than the IRS. It
places on employers the unique burden of disproving either that
employees underreported their tips or the amount underreported. Justice
Sandra Day O'Connor asked the government attorney representing the IRS
in the Supreme Court case, Fior d'Italia v. U.S., how an employer could
disprove employees' underreporting of tips? The IRS' attorney told her
during oral argument that the only way she could imagine this being
done was for employers to hire ``honest employees.''
The Honorable Wally Herger and the Honorable John Tanner, both
distinguished Members of this committee, have introduced legislation to
help clarify congressional intent. H.R. 2034, the Tip Tax Fairness Act,
would prohibit the IRS from imposing aggregate assessments for FICA
taxes owed on allegedly unreported tips. The IRS would have to
establish the actual amount of tips that were unreported. Further, the
intent of the legislation is to ensure that the IRS credit assessments
paid by employers for FICA taxes owed on unreported tips to the
individual employee's wage credit accounts for purposes of the
employee's Social Security benefits.
The Association appreciates the effort Congressman Herger and
Congressman Tanner have put forth on behalf of tipped industries.
Passage of this legislation represents a top priority for the
Association.
Given the association's legal battles and legislative efforts, it
would appear as if we have an adversarial relationship with the IRS.
However, it is quite the contrary. Over the years, we have enjoyed a
mutually respectful working relationship. I am a witness to that,
having worked with the IRS on the concept of a non-contractual tip
reporting agreement, which the IRS later rolled out as its new
``EmTRAC'' program. The IRS has worked closely with the Association to
make improvements to the agency's tip reporting programs and IRS higher
level staff have been available on many occasions to meet with our
member restaurants to discuss problems with tip reporting programs,
such as the TRAC and EmTRAC. In return, the Association has spent a
considerable amount of resources educating members about their
employees tip reporting obligations. The Association created a tip
reporting kit for restaurateurs to use to help comply with the TRAC
agreement. And, at the request of the IRS, the Association now
recommends, and has since the year 2000 that members seriously consider
signing the TRAC or EmTRAC, as a means of protecting their restaurants
from an employer-only audit and assessment.
Until the time that our fundamental disagreement over the IRS
employer-only practices are resolved via the legislation, the
Association will work on ways to provide employers more complete
protection from their current exposure to an employer-only audit and
assessment.
It is important to point out that restaurateurs currently have
certain limited options that can minimize but do not eliminate their
potential exposure to an employer audit and assessment. First, as
mentioned, Congress passed in 1993 a tax credit for employers that pay
FICA tax on servers' tips. The so-called the 45(b) tax credit, however,
cannot be applied to all taxpayers. Like most other credits and
deductions, it cannot be taken by taxpayers filing under the
alternative minimum tax, a growing predicament for more and more
restaurateurs every year. Alternately, the credit cannot be applied
when a taxpayer has no tax liability, i.e. they did not have a
profitable year. According to National Restaurant Association
statistics, only 40 percent of restaurant companies with tipped
employees take advantage of the 45(b) tax credit. Second, and in
addition to the 45(b) tax credit mentioned earlier, restaurateurs can
enter into a tip reporting agreement with the IRS. The agreement
requires the agency to conduct employee tip examinations before
assessing an employer for back FICA taxes owed, in exchange for the
employer's commitment to educate employees about their tip obligations
and maintain records on the employee's tips (discussed below). However,
employers are not completely sheltered by this option either.
Another potential option is for an employer to enter into a tip
reporting agreement with the IRS. The most widely used program offered
to restaurant operators is the Tip Reporting Alternative Commitment or
TRAC. Under the TRAC, an employer agrees to advise his or her workers
of tip-reporting requirements, implement procedures by which employees
report tips, maintain specific records, and comply with tax reporting,
filing and payment requirements. In return, the IRS agrees to not
conduct employer-only audits and assessments against the employer for
the time period the employer is under TRAC. However, the TRAC has
numerous drawbacks.
Consider the fact that there are roughly 225,000 table service
restaurants in this country and roughly 18 percent of them are
operating under a tip reporting agreement. Clearly, the TRAC is not
providing the appropriate exposure from an audit and assessment to
entice the majority of restaurateurs to enter into a voluntary
agreement.
I chose not to sign the agreement because, like many other
restaurateurs, I do not like the idea of signing an agreement with the
IRS. I do not like executing an agreement with an entity, like the IRS,
which has no positive working relationship with our company, and an
entity which has the high propensity to change personnel in who would
be handling the relationship, thereby diminishing, or simply
eliminating, all continuity of the relationship.
The employer obligations under that TRAC are significant. The
requirements to educate employees and keep track of their tip reports,
are in addition to the basic education and training an employer must
engage in order for the employee to begin their job in the restaurant.
This is particularly onerous for an industry that deals with a large
population of young, transient and/or seasonal employees. National
Restaurant Association research shows that the 27 percent of adults
found their first job in the restaurant industry. A significant job-
training responsibility, coupled with the additional educational duties
required if you sign the TRAC.
For those that do sign the agreement, significant exposure remains.
An important point that often gets misinterpreted by employers is that
under the TRAC an employer is not protected from an audit and
assessment, just an employer-only assessment. Additionally, the
employer is not given retroactive protection. The protections of the
TRAC only apply from the day it is signed forward. There have been
inconsistent indications from IRS officials that the TRAC does apply
backward beyond the date it is signed, yet no formal statements have
been made to that point, and the wording of the TRAC belies the IRS'
representation. Such a commitment would certainly be in line with the
agency's objective of attracting more companies to the program, thus
improving overall tip reporting.
The Association also believes it is important to note the TRAC
program is set to expire at the end of 2005. There is concern within
the industry that the IRS hasn't yet announced its intentions to extend
the program, and that the recent Supreme Court ruling has provided a
disincentive to do so. The uncertainty of the program's future creates
further gaps of exposure. The Association would appreciate a commitment
by the IRS that this program will continue as it helps the Association
in advising their members on the success of the program.
In addition to these concerns, I can offer the following insights
on behalf of the National Restaurant Association's larger restaurant
companies:
Proper tip reporting by employees is a matter of great importance
to larger restaurant chains, some of which have more than 1,000
restaurant units operating nationwide. These large employers are faced
with the challenges and burdens of maintaining procedures and systems
that facilitate and encourage tip reporting by employees; timely filing
the requisite tax and information returns; educating employees; and
collecting, depositing, and reporting billions of dollars in employment
taxes, including FICA taxes.
For these reasons, large restaurant chains were among the first in
1995 to embrace the opportunity to work in partnership with the IRS
through the newly issued TRAC program to increase the level of cash tip
reporting by employees. Because of their commitment to and
participation in TRAC, the program quickly became the model for how the
IRS likes to partner with stakeholders to increase compliance with the
tax laws of the United States. More importantly, the TRAC program has
resulted in a significant increase in the reporting of cash tips by
employees.
Nevertheless, following the Supreme Court's 2002 decision in Fior
D'Italia, the industry has become increasingly concerned that the IRS
may move away from its commitment to work cooperatively with large
employers. A fundamental fact remains that restaurant employers are
neither legally required nor factually able to guarantee that their
employees will voluntarily report all cash tips received. Employers are
concerned that good-faith compliance with the TRAC program,
requirements may not ultimately protect against the threat of
``employer-only'' tip audits.
Significant concerns have arisen over the IRS's administration of
the TRAC program. There are reports of uneven treatment of similarly
situated employers at the hands of local IRS personnel. That is,
employers that may have very similar educational programs and reporting
procedures may be held to different standards by their local IRS
employment tax specialists.
In some cases, IRS local teams have sought to hold large taxpayers
to compliance and performance standards that are not set forth in the
TRAC contract. For example, the IRS has argued that employers who have
entered into a TRAC agreement must somehow ensure that directly tipped
employees report ``100 percent'' of the cash tips they receive from
customers. The IRS has also attacked the practice of employee ``tip-
outs''--where a server shares part of his or her cash tips with a
bartender or bus person--even though the TRAC agreement explicitly
contemplate the sharing of tips. Moreover, the IRS has even asserted
that the restaurant employer is not in compliance with the TRAC
agreement if the tip-outs reported by servers do not reconcile with the
tip-ins reported by the employees with whom the tips are shared, even
though such reconciliation is not required by the TRAC contract, by the
Internal Revenue Code, or by IRS regulations.
Many restaurant employers are fearful that the IRS has even
predetermined a cash tip reporting percentage threshold that, if not
met, will lead to threatened or actual revocation of the TRAC
agreement. Such a position is not supported by the law or the TRAC
contract. In fact, the TRAC agreement does not set forth any requisite
level of ``effectiveness'' in terms of cash tip reporting percentage
results. Indeed, the original working group of IRS and industry
representatives that developed the TRAC framework considered--and
rejected--an approach that would have required a restaurant's cash tip
reporting percentage to be within a specified range of charged tip
reporting.
Despite their good-faith efforts to comply with the TRAC
requirements, many large restaurant chains live in fear of TRAC
revocation and a subsequent employer-only audit. This state of
uncertainty exists despite an IRS promise in 1999 that restaurant
employers would not be held liable for employee non-reporting if they
made good-faith efforts to follow the TRAC guidelines. IRS News Release
IR-1999-84 stated:
The IRS will no longer revoke TRAC agreements in cases where
employers make a good-faith effort at following the guidelines
but employees still fail to report tips. Instead of pursuing
the employers in such situations, the IRS will focus on the
employees who are not in compliance with tip reporting.
Notwithstanding this promise by the IRS, the NRA is not aware of
any cases where the IRS has initiated audits of large chain restaurant
employees where it may have observed low cash tip reporting by those
workers.
The NRA is particularly concerned that the IRS may be revoking TRAC
agreements without warning to or input from the affected restaurant
employers. This places employers in a position of being procedurally
defenseless prior to revocation, with no due process opportunity to
address, contest, or cure any asserted breaches in contractual
obligations. Moreover, an IRS decision to revoke without warning may
actually result in revocation at the very time a restaurant employer's
cash tip reporting percentages are improving dramatically--that is,
when the cash tip reporting rate is moving in the right direction. TRAC
revocation should be a last resort, a step taken where an employer is
not working in good faith with the IRS.
Unless the TRAC program is properly administered, the NRA believes
that the IRS will lose a valuable tool for fostering the intended
cooperative environment that promotes employee tip reporting compliance
over the long term. The TRAC agreement was intended to be method for
employers and the IRS to resolve disputes before they arose. With
proper administration, we believe the TRAC program can continue to be
part of a systemic tip reporting solution. The industry stands ready to
work with the IRS and Congress in that regard.
However, there are areas where progress appears to be at a stand
still. First and foremost, I have to restate that the National
Restaurant Association continues to believe that the IRS has gone
beyond its authority in conducting employer-only audits and
assessments. The Association believes employer-only audits and
assessment create inaccurate and inflated assessments that employers
are incapable of challenging. An employer has virtually no recourse
when the IRS issues an aggregate assessment. How does the employer
prove or disprove what an employee received in cash tips? In fact,
another statement by the IRS' attorney during the oral arguments in the
case Fior d'Italia before the Supreme Court, and there was audible
laughter in the courtroom during the response of the government
attorney when she acknowledged that an employer could obtain an
employee's complete tip income records only by filing a lawsuit against
the worker.
I can offer more personal insights on the newest of the tip
reporting programs, the EmTRAC. The EmTRAC provides employers
protection from employer-audits and assessments in return for employer
commitment to employee tip reporting education efforts. The EmTRAC
requires employers to design a tip reporting education program and
submit that program for evaluation by the IRS. Unlike the TRAC, the
EmTRAC allows for flexibility in the design and implementation of tip
reporting education programs. The most significant difference between
the two programs is that the TRAC requires employers to enter into a
contractual agreement with the IRS. It is the contractual agreement
aspect of the TRAC that has kept many restaurants from participating.
The EmTRAC does not require signing a contract, only complying with the
program created by the employer, as approved by the IRS.
The EmTRAC provides a more appealing option for my company, given
the tip reporting initiative I developed known as K-Care. I did not
create the K-Care program to protect my company from an audit; I did it
prior to the IRS approving the EmTRAC approach and because at one
point, K-Bob's staff turnover was more than double the average for the
restaurant industry--230 percent! I realized we had to do something to
change this pattern, not only for the sake of my company, but also for
the image of the entire restaurant industry.
K-Care began out of the desire to more tangibly show hourly
employees how much we care about them, how much they mean to the
success of our business and how much we are willing to do to help them
meet their career and financial goals. We assumed our employees knew we
cared about them, but an employee survey surprised us by revealing that
employees would recommend our restaurant for a meal but not for a job--
only 33 percent felt the chain was interested in their welfare. We knew
we had to create a more meaningful way to show we cared. And we thought
the best way to do that was to invest in our employees. We decided to
base K-CARE on reported tips, because tips are the easiest way to
measure customer service in a table service restaurant. The harder you
work, the more you earn. Good customer service is a team effort and K-
CARE rewards all team members--from the host and the dish washer--to
the server and the line cook.
Servers report their tips, and K-Bob's matches those amounts with a
5-percent contribution into a mutual fund: New England Financial's
Growth Opportunities Fund. The more tips a server reports, the higher
the matching amount. The mutual fund is split among all employees--
front-and back-of-the-house--based on the hours they worked during any
given quarter. Employees enroll at the beginning of a financial quarter
and must be employed for the entire quarter to share in the earnings
for that period. Employees can get access to their money once a year.
They also receive paid vacation days, based on a formula that converts
their reported tips into an hourly wage. Quarterly statements are
mailed to employee's homes, just like a 401(k) statement. We also post
the names of the top 10 earners on the restaurant bulletin board, to
help other employees comprehend the long-term benefit of savings.
The results of the program are more than encouraging to K-Bob's
management. What we found was that the K-CARE program not only gave
employees more money, it improved tip reporting. Reported tips went up
by 20 percent. In addition, staff turnover, which had been 230 percent,
fell to 110 percent. Employees' attitudes toward the chain exceeded the
goal. K-Bob's wanted to increase to 40 percent the number of employees
who ``totally agree'' that the chain is concerned about their welfare.
In the latest survey 61 percent answered that way. For K-CARE, the
return on investment has been undeniable.
Consider the fact that the restaurant industry is the largest
private sector employer in this country, and roughly 50 percent of our
employees are under the age of 25. In fact, the restaurant industry is
the first job for many of these individuals and I believe we can have a
significant impact on their attitudes towards savings and investment if
we can start educating them early.
Accompanying National Restaurant Association staff, I have met with
the IRS to discuss the K-Care program along with the structural outline
of a program submitted through the National Restaurant Association, as
well as my concerns with signing a TRAC. I think it is fair to say that
the concept of the K-Care program contributed to the creation of the
EmTRAC--to encourage tip reporting initiatives, without the
intimidation of a contractual agreement. At the time, I believed, based
on this experience that my program would be one of the first to qualify
under the EmTRAC, but as of today it has not been officially approved.
Many restaurant companies have expressed interest in K-CARE and I
believe we could be successful in marketing this program to a wider
audience if the program were approved under the EmTRAC. I should also
note that the K-Care program does not qualify as a 401(k).
Contributions made by employers and employees are taxable. In order to
get K-Care qualified, I would have to jump through numerous
bureaucratic hoops. Based on my previous experience, the paperwork
alone is extremely complicated and overwhelming.
I believe the EmTRAC could be a successful program and I hope the
IRS can offer some insight on its use thus far by the restaurant
industry. I would also recommend that the IRS do more to educate
employers about its existence. I am sure the National Restaurant
Association would help to distribute that information.
Mr. Chairman, I hope this extensive testimony provides useful
insights and I thank you for the opportunity to present them to this
honorable committee.
Chairman HOUGHTON. Thanks very much. Mr. Jablonski?
STATEMENT OF JOSEPH J. JABLONSKI, CHAIR, TAX AND FINANCE TASK
FORCE, AMERICAN GAMING ASSOCIATION, AND EXECUTIVE DIRECTOR,
TAXES, AZTAR CORPORATION, PHOENIX, ARIZONA
Mr. JABLONSKI. Thank you, Mr. Chairman. Good morning. My
name is Joseph Jablonski. I am Executive Director, Taxes, of
Aztar Corporation. Aztar is a casino gaming company
headquartered in Phoenix. I am appearing today as Chair of the
Tax and Finance Task Force of the American Gaming Association
(AGA), the trade association of the commercial casino
entertainment industry. Its members account for about two-
thirds of commercial gaming revenue in the United States.
The AGA members employ a broad range of workers who receive
tips from customers, including food and beverage workers,
casino gaming staff, hotel bell staff, and parking valets. Tip-
reporting in the gaming industry has taken a somewhat different
path from the other industries you have heard about today. We
use a tip compliance agreement negotiated between the industry
and the IRS. I am here today to explain how it works, the
benefits to both sides, and the lessons we have learned.
Under this approach, the employee agrees to report tips at
a set rate specified for his or her job, shift, and location.
These tips are included on the employee's W-2 along with the
employee's regular wages. Taxes are then withheld on these tips
and paid to the IRS. The employer agrees to take on the
substantial administrative burden of implementing this new
system. In exchange, the IRS agrees not to audit the employee
or the employer on these tips for the current year or for prior
years.
Once in place, a tip agreement benefits both sides. The IRS
benefits from revenue collection and dramatically reduced
enforcement and collection costs. The employee benefits from
IRS audit protection, reduced recordkeeping, and then having a
verifiable income helpful in getting auto loans, home
mortgages, and Social Security and retirement benefits. The
employer benefits from audit protection and some certainty. To
get there, you have to reach an agreement with the IRS that is
administratively workable and that uses reasonable tip rates.
These are voluntary agreements. Both the employer and the
employee must choose to participate. Hence, the agreement must
be reasonable, benefit the employee and the employer as well as
the IRS, and be built on cooperation. Insistence on capturing
every dollar of income and indifference to the employer's
administrative burden and its employee relations will make the
employers and the employees alike reluctant to participate.
The key to the success of this voluntary program is
reasonable tip rates for the employees. If the employee
believes that the rate is fair and reasonable, he or she is
more likely to sign on. The employer is in a delicate position
here, standing between the IRS and its employees. The employees
look to us to protect their interests, negotiating on their
behalf with the IRS to try to get reasonable rates. The IRS has
to be sensitive to this delicate dynamic. If the IRS seeks
excessive tip rates, it not only discourages the employees from
signing on, but it also chills relations between the workforce
and the employer who is seen then as not advocating the
employee interests with sufficient vigor. This undermines the
employer's credibility in encouraging its employees to consider
signing on to this agreement.
The IRS also has to be sensitive to the administrative
burden on the employer. The employer has to make a big
investment of time, expense, and personnel to revamp its
accounting, payroll, and computer systems to handle all of
this, as well as to educate the employees. The employer also
has to spend significant time working through tip rates with
the IRS for its hundreds or sometimes thousands of employees.
It is not feasible for the IRS to try to roll out the agreement
all over the country at once. It really just bogs down the
entire process. The gaming tip agreement has been successfully
implemented in Nevada because we were able to negotiate
reasonable tip rates with the IRS. We are hopeful for similar
success in New Jersey if the IRS is willing to give the new
agreement time to germinate. The IRS looks to expand the tip
agreement approach across other gaming markets in other parts
of the country, and potentially to other industries, success
will depend upon a continuing recognition by the IRS that this
is a voluntary program, both sides, in fact, must benefit, and
there must be an administratively workable agreement with
reasonable tip rates. Thank you for the opportunity to present
these views on behalf of the AGA.
[The prepared statement of Mr. Jablonski follows:]
Statement of Joseph J. Jablonski, Executive Director, Taxes, Aztar
Corporation, Phoenix, Arizona
Good morning, my name is Joseph J. Jablonski. I am Executive
Director, Taxes of Aztar Corporation, headquartered in Phoenix,
Arizona. Aztar Corporation, with approximately $1.3 billion in assets
and 2003 revenues of well over $800 million, operates three casino
hotels in major gaming markets in Nevada and New Jersey, as well as two
riverboat casinos.
I am appearing today in my capacity as Chair of the Tax and Finance
Task Force of the American Gaming Association (AGA). AGA is a nonprofit
trade association that represents the commercial casino entertainment
industry in addressing federal legislative and regulatory issues. AGA
also serves as a clearinghouse for information, develops educational
and advocacy programs, and provides industry leadership in addressing
issues of public concern. AGA has 19 casino members which own or
operate more than 150 gaming properties throughout the United States,
accounting for approximately two-thirds of the country's commercial
gaming revenue. AGA members employ a broad range of workers who receive
tips from customers in the course of their employment, including food
and beverage workers, casino gaming staff, hotel bell staff, and
parking valets.
Overview of the Gaming Industry Tip Compliance Agreement
As others this morning have explained, the general rule of current
tax law is that an employee who receives tips is required to regularly
submit a report of his or her tips to the employer. The employer then
withholds employment and income tax from the employee's wage and remits
the employee's share along with the employer's share of the employment
tax to the Internal Revenue Service (IRS) and reports such tips to the
employee and the IRS on Form W-2.
Tip reporting in the gaming industry has taken a somewhat different
path, beginning more than ten years ago with the negotiation of a tip
compliance agreement in the major gaming market of Nevada. This
original Nevada tip agreement worked well for the employer, the
employee, and the IRS alike for a decade. The Nevada tip agreement
expired at the end of 2002. AGA led the industry effort that negotiated
with the IRS a new tip agreement, known as the ``Gaming Industry Tip
Compliance Agreement'' issued by the IRS as part of Revenue Procedure
2003-35, 2003-1 C.B. 919. The new gaming tip agreement has been
implemented in Nevada and most recently in New Jersey.
I am here today to explain how this tip compliance agreement works
in the gaming industry and to discuss the benefits for the employer,
employee, and the IRS, as well as lessons we have learned in
negotiating and implementing the tip agreement approach.
The essence of the gaming tip agreement approach is that, if the
employer agrees to take on the administrative burden of implementing
and operating the tip reporting system and the employee agrees to
report tips at or above a rate that is determined with some specificity
by occupational category, the IRS agrees not to audit the employee and
the employer with respect to the tips.
More specifically, under this approach:
Employee Treatment
The employee signs an agreement that he or she--
will report at or above the rate specified for the
employee's particular occupational category, shift, and place
worked;
can report below that rate if substantiated, but
subject to possible IRS review; and
will file tax returns currently and for the prior 3
tax years.
In exchange, the IRS agrees that it will not audit the
employee's tip income for the current year as well as for prior years
where no tip agreement was in place.
Employer Treatment
The employer agrees to--
encourage employees to sign up;
withhold and pay the payroll taxes on the reported
tips;
maintain certain records to compute future tip rates;
report annually to the IRS information on its tipped
employees to enable the IRS to determine if they reported the
appropriate amount of tips;
In exchange, the IRS agrees that it will not audit the
employer for tip-related payroll taxes (meaning that mass ``employer-
only'' audits seeking to collect the employer's share of tax on some
IRS collective estimate of alleged underreporting of tips by the
employer's entire tipped workforce will not occur).
the IRS can still assess employer portion of payroll
taxes on a non-participating employee if an actual audit of the
employee first proves underreporting of tips by the employee.
Other Key Terms of the Agreement
Agreement runs for 3 years.
If business conditions change, rates can be redetermined
by the employer and the IRS working together.
If employee participation falls below 75%, the IRS can
come in and discuss the reasons (likely that employees view the
specified tip rates as too high and in need of readjustment).
If participation falls below 50%, the IRS can terminate
the agreement its discretion.
The employer can terminate at any time.
Lessons Learned from Negotiation and Implementation of the
Gaming Tip Agreement
The tip agreement approach is not necessarily a ``one-
size-fits-all'' approach across industries
In the gaming industry, the employer typically has a sizable
number of tipped employees working at a particular facility,
making the administrative burden of participating in a tip
agreement at least viable. The same may not be true of various
other industries in which there are a limited number of tipped
employees located in a particular market or limited number of
tipped employees scattered around the country in different
markets.
The agreement is voluntary_there must be inducement for
both the employer and the employee to participate
A tip reporting agreement provides benefits to the IRS in the
form of revenue collection and dramatically reduced IRS
enforcement and collection costs and offers the potential of
benefits to an industry and its employees in the form of
certainty and a streamlined tip reporting system. However,
whether those potential benefits to the industry and its
employees are realized in a manner sufficient to warrant
industry and employee participation depends upon the
development of an administratively workable tip agreement that
utilizes reasonable tip rates. These are voluntary agreements
in which both the employer and the employee must choose to
participate, and hence the agreement must be reasonable.
By contrast, insistence on capturing every possible dollar of
income and indifference to the employer's administrative burden
and its employee relations will produce reluctance by employers
and employees alike to participate in a voluntary tip agreement
program.
To gain employee participation, tip rates must be
reasonable
The tips rates are determined by the employer and the IRS, in
consultation with employees and employee groups, from formulas
developed in case law, information from the casino's records,
observations of tips received, and discussions with employees.
These rates are estimates of amounts received by a theoretical
employee working in that occupational category, shift, and
location in the employer's facility. The actual amount of tips
received by an employee for a particular day or week may be
more or less than the calculated tip rate and will fluctuate
depending on the season of the year, the volumes of business,
changes in the employer's business operations and staffing
levels, and the level of service perceived by the customer.
In discussions with gaming industry employees during the
recent negotiation of the new agreement, it is clear that their
acceptance of a formal tip compliance program is fundamentally
tied to the reasonableness of the tip rates. It has been the
gaming industry's experience that so long as its employees
believe the tip rates are reasonable, they are more likely to
participate in a tip compliance program because it reduces
their recordkeeping burden, gives them protection against IRS
examination, and produces a verifiable income that is helpful
in securing auto loans, home mortgages, and social security and
retirement benefits.
By contrast, as the tip rate exceeds what the employee
believes he or she has earned, the employees become
increasingly vocal in opposition to the tip agreement approach
and decline to participate in the first instance or drop out if
they are participating. In negotiating the new tip agreement
with the gaming industry for Nevada, the IRS proposed a drastic
increase in tip rates in many cases, sometimes double or triple
the tip rate currently being applied to the employee. It took
several years of hard-fought negotiations by the industry with
the IRS to reach a more reasonable level.
As the IRS looks to expand the gaming tip agreement beyond the
Nevada and New Jersey markets currently covered to other gaming
markets, it is important for the IRS to proffer reasonable
rates to induce participation by the employees who are new to
the tip agreement approach in these markets and are likely to
view it with uncertainty and a certain wariness. Similarly, as
these gaming tip agreements come up for renewal, it is crucial
that the IRS also take a reasonable approach in renegotiating
the tip rates, to maintain the success of employer and employee
participation in these voluntary agreements.
To gain employer acceptance, the administrative burden
must be workable and the IRS must be sensitive to the delicate
interplay between the employer and its workforce on this issue
The tip agreement approach effectively requires the employer
to serve as an intermediary between the IRS and the employee in
the tip agreement process, a delicate position for the employer
vis-`-vis its workforce. Accordingly, there must be a sense of
mutuality of benefit and cooperation for the IRS and the
employer under the agreement, to persuade employers to shoulder
the added responsibility of participation.
While the employer realizes some administrative gains from
simplification of the payroll information-gathering process
using a consistent hourly rate for the position rather than
obtaining tip information from each employee, the employer
faces substantial new administrative burdens in implementing
the new agreement. The employer must incur the cost and effort
of significant systems changes in the tracking of time and
attendance and its payroll system to implement the tip
agreement approach. Changing the employer's systems is an
extensive project involving wholesale revamping of existing
accounting, payroll, and computer systems and creation of new
systems, requiring significant efforts by the employer's staff
in each of these administrative areas on top of their everyday
duties in running the business. For example, we have spent well
over a year developing and putting into place these
administrative system changes at our Atlantic City facility to
implement the recent New Jersey gaming tip agreement. The
employer is absorbing all of these costs. In addition, the IRS
should be wary of heaping extensive new reporting and
recordkeeping requirements on the employer under a tip
agreement.
The employer's administrative burden of developing tip rates
is also extensive, and only exacerbated if the IRS seeks to
require frequent revisions. In this tip rate setting process
under the gaming agreement, separate tip rates are developed
for numerous job positions and outlet locations within the
employer's facility for each shift, covering hundreds or
thousands of tipped employees at each gaming property. For
example, there are different tip rates for the parking valet on
the graveyard shift, the bartender in the casino bar on the day
shift, the cocktail server on the swing shift in the quarter
slot area, the cocktail server in a high-end restaurant, to
name only a few. Special considerations must be given to tips
shared by wait staff with the busing staff. For employee
relations reasons, care must be taken across the various
positions and shifts so as not to upset the desirability of
those positions because of tip rate disparities among employees
receiving similar amounts of tips.
More fundamentally, the IRS must be sensitive to the delicate
interplay between the employer and its workforce on this issue.
The recent experience of the Nevada gaming agreement
negotiation is that the employees look to the employer to
protect their interests here--they view the employer as
negotiating on their behalf with the IRS in an effort to
achieve reasonable tip rates. If the IRS is seeking rates that
the employees view as excessive, that not only will discourage
employees from signing on, but also will chill relations
between the workforce and the employer who is perceived as not
advocating employee interests with sufficient vigor, thereby
undermining the credibility of the employer in encouraging its
employees to consider participation in the tip agreement.
In addition, the employee participation threshold required
under the tip agreement should be set at a reasonable level,
recognizing that gains to the fisc of bringing a significant
percentage of the employer's workforce into the tax withholding
system are far preferable to having no agreement at all,
particularly in light of the fact that under the agreement the
IRS will continue to have full enforcement and collection
authority with respect to tip income of nonparticipants.
Flexibility should be provided in the early stages in a new
market to permit the ramping up of participation. The causes of
drop-offs in participation should be explored in reasonable
discussions between the IRS and the employer, rather than
placing the employer in the role of ``policeman'' in a
situation where it has little practical control.
The tip agreement must provide flexibility to respond to
significant changes in circumstances
In the immediate aftermath of the 9/11 attack, air travel
plummeted and with it tourist visits to Las Vegas. Under the
old Nevada gaming tip agreement, there was no adjustment
mechanism for tip rates, and so employees continued to be taxed
at the specified rates on tip income they were not in fact
receiving. Local IRS officials, including Jack Cheskaty and
Dennis Ozment, are to be commended for responding to this
severe problem by granting temporary relief for the employees
during the slowdown. One of the major selling points of the new
gaming tip agreement to employees is the creation of a formal
mechanism for adjustments in assumed tip income during economic
slowdowns.
IRS pursuit of tip agreements in an industry must take
care to avoid upsetting competition in the market
Seeking to implement tip agreements on an employer-by-employer
basis among competitors in a particular market can create
competitive imbalances that are harmful to the employer. An
employer which agrees to implement a tip agreement program may
find its labor costs have now risen and its workforce
recruitment hindered relative to a competitor down the street
which does not operate under agreement. Accordingly, while tip
rates must necessarily be tailored to the employer's particular
circumstances and hence negotiated individually, the effective
date of tip agreements must be uniform across competitors in a
specific market.
IRS efforts to expand a tip agreement nationally must not
overextend the administrative resources of an employer operating in
several different geographical markets
As noted, the determination of tip rates is a very extensive
administrative undertaking by the employer, requiring
substantial time, expense, and commitment of personnel who have
other business responsibilities, to revamp its systems and
compute a broad range of tip rates. For an employer operating
in several different geographical markets, many of the same
personnel are involved in helping to determine the rates for
each market. The IRS's eagerness to ``roll out'' the gaming tip
agreement to different markets across the industry must be
tempered by the recognition that overextending the employer's
administrative resources and the same personnel will bog down
the entire process.
Once a new tip agreement is put in place, the IRS must
exercise patience in letting it germinate
Once a new tip agreement is negotiated and put into place, in
practical terms the burden of implementing the new system and
encouraging employees to sign up falls to the employer. There
is an inevitable ramping up period for implementation in new
markets with employees who have never seen such a thing before.
Particularly in light of the dramatic reduction that the IRS
realizes in collection and enforcement costs under the new
system, the IRS must exercise patience in letting the new
agreement germinate. For example, the gaming tip agreement
approach was put into place in the new geographical market of
New Jersey just a few months ago. With the ink barely dry on
these new tip agreements, some IRS examinations staff already
are pressing to audit compliance with the new agreements.
Conclusion
The Gaming Industry Tip Compliance Agreement, as issued in Revenue
Procedure 2003 is fair and reasonable for both the industry and its
employees and the IRS, subject to the negotiation of reasonable tip
rates by the employer and the IRS. The Agreement has been successfully
implemented in Nevada because the parties have been able to agree on
reasonable tip rates. The industry and its employees are hopeful that
similar success can be achieved in New Jersey. However, the IRS should
allow a full calendar year of operation under the new agreement--
particularly since it is being put into place in New Jersey for the
first time ever--before attempting to evaluate the program's success or
to invoke traditional audit tactics.
As the IRS looks to expand this tip agreement approach to gaming
markets in other parts of the country--and potentially to other
industries--the success of such efforts will hinge upon a continuing
recognition by the IRS that this is a voluntary program in which there
must be a mutuality of benefit for the employer and the employee as
well as the IRS, requiring an administratively workable agreement that
utilizes reasonable tip rates.
Thank you for the opportunity to present these views on behalf of
the American Gaming Association.
Chairman HOUGHTON. Thank you, Mr. Jablonski. Mr. Zona?
STATEMENT OF FRANK ZONA, GOVERNMENT AFFAIRS CO-CHAIR, THE SALON
ASSOCIATION, AND OWNER, ZONA SALONS, NORWELL, MASSACHUSETTS
Mr. ZONA. Thank you, Mr. Chairman, for holding this
hearing. Thank you to Congresswoman Johnson and to all of you
for introducing H.R. 2133. That is something that is very
important to us. My name is Frank Zona. I own a salon in
suburban Boston. I have 18 employees there, and I personally
deal with tip income, so I will come at it from a point of view
of being a voluntary government Affairs Chair for TSA, but also
as someone who is living the issue. A lot of the things I hear
on the panel are things that ring true to me.
The salon industry, when we talked about the idea of
creating a supportive environment to help compliance increase
and to help business and so forth, and I think it is important
to know what the salon industry is first. It is not just
hairdressing, although that is a big part of it. You might want
to think about it in terms of personal services. It is a big
industry, multi-billion, a lot of people working in it, a lot
of businesses working in it, so think of day spas and hair
salons and barber shops and people doing skin care and it is
growing. The personal service area is growing. We are still
kind of an emerging industry if you look at it that way. It is
becoming a little bit more formal, but it is still a lot of
mom-and-pop. There is still a lot of confusion out there on
issues such as tip income. We try to do our job as an
association to educate, work with the IRS in a cosmetology
TRAC, and so forth. I will come at it that way to try to bring
you both perspectives.
Congresswoman Johnson's bill came about because there were
salon owners in Connecticut who were struggling with the issue
of tips and contacted her. We were just beginning to hear about
it around the country, and her office contacted us and said, is
this a wider problem and is there maybe some legislative
solution? That is how we came at that. I would say it is about
5 years now dealing with the issue of tip income for us, so it
is new to our industry relative to the others. The big
difference is this: we have a split in the industry of
employment where the people who work for us are W-2 employees,
but many salons work as self-employment. If you think of this
group of chairs here as a salon, if you are cutting hair, I
might employ you and W-2. That is how I work. I also have the
choice of just saying you can just rent that chair, give me
$200 a week for renting the chair, and we have no employment.
That is really the core of our problem with the whole issue of
tip-reporting because I am under pressure to get my employees
to report their tips. If they do not like it, they can very
easily move. In the gaming industry, it is really hard to carry
a roulette table down the street and plug it in somewhere else.
It is hard in the restaurant industry to open a basement cafe.
In our industry, if you have an employee who does not want to
report their tips, or maybe does not even believe that tips are
income--and that is something that truly, if you lined up 100
employees in our industry and said, ``Are tips income?'' most
of them would say, ``No, those are mine, those are a gift.''
So, we are still struggling at that real fundamental level.
The idea of creating the environment, we need to make sure
that we do not see real significant labor shifts where people
can, if they are going to report in one place, then they can
just slide away and go somewhere else. That goes to the core of
H.R. 2133, which what it would do is, on the one hand, provide
the relief to the employer in the industry, extend the 45(b)
tax credit that the restaurant industry has, and that is
important because the costs of complying are significant. In
addition to those costs, incidentally, something that jumped
into my mind is credit cards. Credit card companies now in many
cases, if you take tips on credit cards, charge an additional
fee for it. I would say the employer cost is more than 7.65
percent. It might more approach 10 percent, what we hear from
our members, administration costs and just tracking those tips,
and so forth. Again, it is that alienation from your employees
that you get that is the bigger issue. House Resolution 2133
would extend that 45(b), provide us some financial relief in
that sense.
It would also introduce a little information reporting on
that other half of our industry, and it is about a half-and-
half split with the self-employment and it would basically
systemize that. If I am a salon owner who employs you folks,
then I issue you a W-2 every year. If it is the other way
around and I rent you those chairs, now I would issue you a
1099 with instructions on how to report your tips as a self-
employed individual. It is not an absolute cure-all, but we
think it is really reasonable, healthy legislation that would
provide the kind of support in the industry to create that
environment that we think will help tip compliance improve all
around. The IRS has a good working relationship with them. We
do owe them some thanks, I think, because hair color is a big
part of our industry, and I do not think there is a Federal
agency who has done more for the development of white hair than
the IRS, and we very much appreciate that. Thank you for the
hearing.
[The prepared statement of Mr. Zona follows:]
Statement of Frank Zona, Government Affairs Co-Chair, The Salon
Association, and Owner, Zona Salons, Norwell, Massachusetts
Chairman Houghton and Members of the Committee, thank you for the
opportunity to testify before you on behalf of The Salon Association
(TSA).
My name is Frank Zona and I am a third generation salon owner from
Norwell, Massachusetts where I employ 18 people. I currently sit as Co-
Chairman of Government Affairs for The Salon Association. Primarily, we
represent the small businesses of the salon industry, which is the
great majority of the industry. In fact, 84 percent of salon
establishments (with payroll employees) have fewer than 10 employees.
It is also important to note that over 80% of salons and spas are owned
and staffed by women. In 2002, the salon industry posted sales of $26.4
billion, with more than 750,000 employees industry-wide. There are far
many more that work in the industry, but they do so in self-employment
rather than employment-based situations; a fact that is central to our
problem.
We support Representative Johnson's bill, H.R. 2133, The
Cosmetology Tax Fairness and Compliance Act. This bill extends existing
law to permit salon employers to claim the 45(b) tip tax credit that's
currently available only to restaurant employers with tipped employees.
The legislation also provides needed assistance to the federal
government by improving tip reporting in all sectors of the industry.
The legislation came about because salon owners from Connecticut
contacted Representative Johnson about the problems associated with tip
reporting, and her staff contacted TSA in an effort to see if the
problem was widespread and if we would support a legislative solution.
The answer to both questions was yes and we are thankful for her
initiative. We are currently working with the International Chain Salon
Association in supporting her bill on a national level.
The expanded credit is a matter of simple fairness and common
sense. Like the restaurant industry, salon owners must collect and
report tip information from its employees to the Internal Revenue
Service (IRS), and pay FICA taxes on the reported tips. However, unlike
the restaurant industry, salons cannot claim the tax credit for FICA
taxes paid on tips. Given that our average wage is over $11.00 per hour
before tips, it stands to reason that we deserve equal treatment.
The credit also serves as an offset to the significant costs
related to complying with tip tax laws. We must educate employees about
tip reporting laws, pursuade our employees to comply, keep records of
reported tips, and report the income to the Internal Revenue Service.
Credit card companies are in many cases charging extra fees for tip
transactions. Therefore, although the salon employer is already paying
over $11 per hour, he or she is facing a matching FICA liability equal
to 7.65% of tips earned and the additional administrative costs. The
actual full cost is closer to 10%. The extension of the 45(b) tax
credit to salon owners will bring needed tax relief to help offset the
costs of complying.
But the greatest compliance cost of all is being put in an
adversarial position with your employees in an industry where
employment isn't the only way to receive income. Worker classification
is the issue that separates salons from other tipped industries. Unlike
most tipped industries, a significant segment of the salon industry is
classified as self-employed. While two salons may look the same, one
may classify the people behind the chairs as employees while the other
may classify its workers as self-employed (or independent contractors).
The focus on tips in employment situations is encouraging employees to
leave employment for self-employment, and leads employers to reclassify
their workers as self-employed. Submitted with this testimony is one
example of a solicitation from a salon offering a ``tax saving'' chair
rental opportunity (Attachment 1). The bottom line is that the tip-
reporting burden is greatest on employers and compliance efforts need
to be approached with these dynamics in mind.
If the IRS does not pay equal attention to both aspects of the
salon industry, it will damage employment in the industry. If casino
employees are getting pressured by their employer to report all of
their tips, they cannot unplug their roulette tables and set up down
the street. A waitress cannot just take her tables and open a basement
cafe. But a hairdresser or massage therapist can easily find a less
formal ``self-employment'' situation. Submitted with this testimony is
an overview of the salon industry that indicates the size of the non-
employed sector (Attachment 2). Self-employment is significant and
growing. And leads to this point: Where employees do not want to comply
with regulations, they can easily leave and rent a chair where there is
no employer to withhold from them. The compliance portion of the
legislation adds simple information reporting to salons that classify
their workers as self-employed.
While it is possible that some individuals working in such a manner
report all of their tips and income as self-employment income, it is
well documented that the lack of third party reporting and withholding
reduces compliance. There is no question that the greatest source of
compliance is a paycheck subject to withholding. So what's at risk here
for salons is not only the reporting of tips, but the loss of
employees. What's at risk for the Treasury is not just the reporting of
tips, but the reporting of income altogether.
These are not just statistics for me. I have lost 5 employees in
the last 18 months who are now renting chairs in other local salons.
Our insistence on complying with tip laws was a major factor in these
employees' decisions to leave, and in their conversations with one
another. It will continue to be a factor. And I can say that because I
am present during the conversations where an employee claims that tips
are not income but a gift, or that their accountant is taking care of
it and it's not my business, or that they can just go rent a chair. Put
yourselves in my shoes for a moment. You are competing with salons that
are willing to pay under the table; willing to classify the people they
work with every day as independent contractors; willing to turn their
heads on tip reporting. So while you are responsible and concerned
about paying your share of FICA on tips, you find yourself with
problems that are more pressing than a potential audit--the loss of
your people and the tax advantage of illegitimate competition. Doing
the right thing should not put people at a disadvantage to those who do
not.
Here are our suggestions:
1. Congress needs to pass H.R. 2133.
The provisions of H.R. 2133 are reasonable, have been scored
favorably by the joint committee, have received the cosponsorship of 42
members of Congress, and have been worked on diligently for 4 years. It
is the extension of existing law to an industry at a pivotal time when
long-term overall compliance could go in either direction.
2. The IRS needs to provide more information to the industry.
Since trade associations play a critical role in disseminating
information to the industry, it is critical to have statistical facts
about IRS activities. Though the IRS has made significant efforts in
outreach, TSA has experienced numerous IRS organizational changes that
still leave us without consistent relationships and without critical
information. Only in February 2004 did we learn that 1000 TRAC
agreements had been signed. We know the IRS is working with the state
boards, but we are not included in that dialogue. We are not provided
any statistical information about the number of enforcement actions
that are taking place in the non-employment sector. This is important
information for the industry so that we can inform and advocate
appropriately and effectively.
3. The IRS needs to systemize contacts with the self-employed.
It is the IRS's contact with the employers in the industry that has
increased compliance in that segment. There is not an equal level of
contact with the self-employed.
Salon owners and industry stakeholders from around the country tell
us that while they increasingly hear about employer contacts and
audits, they never hear about self-employment contacts or audits. TSA
has not received any information from within the industry of any
enforcement activity in the self-employed segment. We lack confidence
that the IRS has a clear strategy to achieve equal treatment of both
segments of the industry.
The compliance provision of H.R. 2133 would systemize taxpayer
contacts by requiring that the correct form be issued to self-employed
workers by the establishment. In a simple way, this third party action
provides a point of contact for the IRS.
Additionally, the TRAC agreement should be modified to expand the
role of the IRS in contacting departed employees. Existing TRAC
language places a clear requirement for employers to notify the IRS of
the departed employee and for the employer to provide departed
employees with tax forms within 14 days of departure. The IRS should be
required to follow this employer action with a contact.
4. EmTRAC should be offered to the salon industry.
Salons and spas each have their unique circumstances. EmTRAC allows
employers who work with the IRS to develop a customized agreement to
get the same protections the TRAC provides--i.e., protection from
employer-first audits; but with a little more flexibility to develop
tip-reporting procedures that better suit their needs. And while the
IRS must approve an EmTRAC, it doesn't require an employer to enter
into a formal written contract with the IRS.
5. The IRS needs to connect the license with the tax filer.
The most universal arm of government in the salon industry is the
state board. It's the one place where everyone in the industry meets.
Every individual needs a professional license before they begin
practicing. Every salon needs a facility license before they can open.
Licenses need to be classified according to taxpayer type. This would
provide a cross-reference link for both the individual and the
business.
6. The IRS needs to develop industry specific guidelines for worker
classification.
The IRS should work with the industry to develop industry specific
guidelines on worker classification. During a time of increased
compliance activity on tips, the risk of worker misclassification
becomes greater. No one wants to see a salon or spa flip its
classification from employment to self-employment to avoid tax
liability. We need industry specific classification criteria to reduce
misclassification and increase compliance.
I thank you for this opportunity to share some ideas, and I'll
leave you with these thoughts:
At the bottom of this problem are people who have no intention of
complying; in the middle are people who want to do things right, but
need a supportive environment; and then there are leaders. It is
damaging to the industry and the IRS's long-term compliance efforts to
work from the most compliant to the least compliant. Employers and
their employees are the most compliant. Tax code and tax policy should
reflect this in the ways indicated.
I look forward to working together toward a long-term solution and
I welcome your questions and comments.
Thank you.
__________
Salon Industry Facts July 2004
The Salon-Industry is a Collection of Small Businesses
There are more than 655,000 Salon-Industry establishments
in the United States, with annual sales of more than $26 billion. The
Salon-Industry is primarily comprised of single-unit operations, with
98 percent of Salon-Industry firms having only one establishment.
A large proportion of Salon-Industry establishments are
small businesses, in terms of their annual sales volume. Fifty-one
percent of Salon-Industry establishments (with payroll employees) have
annual sales of less than $100,000, while 84 percent of establishments
have annual sales of less than $250,000.
The majority of Salon-Industry establishments are small
businesses, as defined by the number of individuals that they employ.
Eighty-four percent of Salon-Industry establishments have fewer than 10
employees.
Eighty-seven percent of Salon-Industry establishments are
non-employers, meaning they have no payroll employees. With the
exception of unpaid family workers, individuals who work at non-
employer establishments are classified as self-employed.
Distribution of Salon-Industry Establishments
Employers versus Non-employers
[GRAPHIC] [TIFF OMITTED] T9685A.001
Source: U.S. Census Bureau; 2001-2002 data
The Salon-Industry Employs a Large and Diverse Workforce
The Salon-Industry employs more than 754,000 individuals
in the United States.
Eighty-four percent of Salon-Industry employees are
women, compared to 47 percent of employees in the overall U.S.
workforce.
A diverse workforce is a hallmark of the Salon-Industry.
Fourteen percent of Salon-Industry employees are African American,
compared to a national average of 11 percent.
Eleven percent of Salon-Industry employees are Asian,
compared to just four percent of the overall U.S. workforce.
Eleven percent of Salon-Industry employees are of
Hispanic origin, slightly below the national average of 13 percent.
The Salon-Industry is expected to continue to grow and
provide employment opportunities well into the future. By 2012, the
Salon-Industry is projected to provide employment for more than 865,000
individuals, an increase of 111,000 jobs (or 14.7 percent) above its
2002 level, according to projections by the Bureau of Labor Statistics.
Forty-six percent of all individuals in the Salon-
Industry are self-employed, according to the Bureau of Labor
Statistics.
Distribution of Salon-Industry Employees
Payroll Employees versus Self-Employed
[GRAPHIC] [TIFF OMITTED] T9685A.002
Source: U.S. Department of Labor, Bureau of Labor Statistics; 2002 data
Average Hourly Earnings of Salon-Industry Employees
Non-supervisory employees in the Salon-Industry earned an
average of $11.75 per hour in 2003, excluding tips. In comparison, non-
supervisory employees in the overall private sector earned an average
of $15.35 per hour in 2003.
Since 1990, average hourly earnings of Salon-Industry
employees have risen steadily. The average of $11.75 per hour earned by
non-supervisory employees in the Salon-Industry in 2003 represented a
strong 67 percent increase above the $7.03 earned in 1990. In
comparison, the average hourly earnings of non-supervisory employees in
the overall private sector increased at a lower 51 percent rate between
1990 and 2003.
Average Hourly Earnings (Excluding Tips) of Non-Supervisory Employees
Barber Shops, Beauty Salons, and Nail Salons
[GRAPHIC] [TIFF OMITTED] T9685A.003
Source: U.S. Department of Labor, Bureau of Labor Statistics
Note: Figures include only establishments with payroll employees
Chairman HOUGHTON. Careful on that.
[Laughter.]
Thank you very much. I would like to ask just a couple of
questions, and, by the way, thank you very much, and then I
will pass it along to Earl and then anybody else who wants to
ask questions. I do not quite understand how the TRAC system
can work for the little guy as well as the big guy. I
understand the philosophy behind the program, and I understand
how it works. Maybe you could help me on this, Mr. Rosic.
Mr. ROSIC. Certainly. The requirements of TRAC are very
costly and require a substantial commitment, no matter what the
size of the employer. Certainly we see that a small operation
may find different challenges to overcome in some respects than
a large chain. However, remember, even if there are, say, 900
food and beverage outlets throughout the country, each one of
those is itself a small operation. The implementation of TRAC
on the ground is going to be as difficult for a large chain as
it is for a small operation. However, it may be that large
employers are able to dedicate subject matter experts to
establishing the right procedures and monitoring them than
would be possible for a smaller operation.
Chairman HOUGHTON. If you run a small restaurant with four
or five employees, and you are keeping the books, cash
register, and everything else, is the TRAC possible under that?
Mr. ROSIC. Well, I guess providing training and education
materials is as hard if you have 5 employees as if you have 500
employees. The devotion of resources to that effort is
disproportionate for a small operation as you describe. The
recordkeeping is probably similar, although a large employer is
going to be able to invest in systems that make it more
automated.
Chairman HOUGHTON. Well, I would like to ask another
question, and anybody can answer this. You are really talking
about those programs from the standpoint of the ownership, of
the management. Other than wishing reporting programs would go
away, what would your employees say if they knew there had to
be some sort of a structure, regulation, and discipline? How
would they organize these programs? What would they suggest to
this panel if they were sitting in your place?
Mr. TINSLEY. Mr. Chairman, I think that is one of the
challenges that I tried to allude to earlier. We are an
industry of 12 million people, and we have so many people
joining our workforce for the very first time in their careers.
We are talking about some of the very basic educational
commitments. There are so many challenges that small business
operators face that it is hard to sum up what I would call
priorities on how you address these. Employees, I think first
of all, would want to see something that was to their benefit
of why it was beneficial, and that starts with education. That
is one of the things that we have seen in our industry, that if
you can sit down and explain to them the benefits to their
Social Security fund, to the fact that on their W-2 they are
going to have higher reported income that they can go buy a
house, buy a washer and dryer, do those things that are very
basic when they are young that they need credit for, or buy a
car. What I have seen is where you can have the time to do
that, it is successful and you put some monetary incentives
behind it. The challenges are, when you are in our industry, is
the turnover and the passing through aspect of it. It makes it
a challenge. You see a lot of new faces that you are having to
educate daily. It is a huge challenge.
Chairman HOUGHTON. I understand the importance of education
and understanding how this fits into the overall scheme of
things and the whole concept of taxation versus gifts. At the
end of the day, what would the employee like to see? Does he
want to see a straight rate recognizing that compliance is
necessary?
Ms. POWER. If I may, Mr. Chairman, I think that the
employee would want to have the flexibility to report exactly
what he does earn. I think that the employee would be able to
tell you many, many reasons for why the perceived rate, the
charge tip rate is not the rate that he walked away with when
he left the establishment at the end of the day. I do not think
the employee would want to see a flat rate because I think that
employees make tips at different levels, varying levels, and
they tip out at different levels. I think that the employee
would want to see a system that has the flexibility for them to
report what they earn and no more, and for employees who
receive less to not be penalized by reporting more than they
earn.
Chairman HOUGHTON. If there is flexibility, no rules, under
an honor system, and employees have to report tips, factor that
into their income, and employee B does not do this at all, and
that is just the way it goes. Is that right?
Ms. POWER. Well, there are significant rules in place to
overcome that. The IRS has regulations that require employees
to keep records of the tips that they receive. They are very,
very detailed recordkeeping requirements. If it appears that an
employee has not reported what he owed, then he is subject to
proving that he received less than that.
Chairman HOUGHTON. Does anybody else have any other
thoughts on this? How about a representative from the salon
industry?
Mr. ZONA. Specific to our industry, one of the things that
comes into mind--and, again, it goes to that dual way of
working--is that I think employees feel good about being able
to voluntarily report what they earn. That system works. They
are very aware of, is the person next to them reporting, and
next to them not just in the sense literally in that salon but
throughout the industry. I think that the sense that, you know,
I will pay, is everyone else paying, goes to our industry
specifically.
Chairman HOUGHTON. So, if everybody else does not pay, then
you want a different system. Is that right?
Mr. ZONA. Well, in our industry, if we have a salon down
the street--and I have lost five people to tip income, 18
months, roughly, and we required tip-reporting. We have our own
system. We are not under TRAC. They have got opportunities, you
know, to just, again, go rent a chair. If they think that the
rest of the industry is not reporting and they are somehow
foolish for being part of a small business that counts, I think
that becomes an issue. That would they want? I think they are
okay with it, but I think they look around and it matters to
them that there is an evenness to the whole thing.
Chairman HOUGHTON. Thank you very much. Mr. Pomeroy?
Mr. POMEROY. I have enjoyed the panel presentations very
much. Thank you for excellent testimony and bringing your
perspective to the Committee. For me, this is a new issue of
inquiry, and so I do not know anything about all this. Help me
along the learning curve, if you would. Starting with Ms.
Power, it seems to me that this potential of aggregate
liability is a significant incentive to employers to really
engage with the IRS and work this seriously. Is it more or less
the driver in terms of eliciting private-sector cooperation? Or
is it a significant enforcement issue with repeated IRS
activity in terms of bringing actions against the employers on
this aggregate issue?
Ms. POWER. Well, I think that the figures bear out that the
aggregate assessment was not essential to a significant, a
very, very dramatic, a doubling of the amount of tip-reporting
over the last--I think it was 8 years or so, because during
that entire period, the IRS had a moratorium against employer-
only assessments. Notwithstanding the fact that--and it was
publicly--you know, highly publicized. Notwithstanding that
moratorium, there was a dramatic and significant increase in
tip-reporting during that period in time. I also think that
there are many other reasons why the employer would facilitate,
encourage, and promote the full and accurate reporting.
Mr. POMEROY. Absolutely. Absolutely. I am just trying to
get a sense of the level of enforcement action we have on this
aggregate business. Once the moratorium lapsed--and I know you
are a lawyer, not a trade association. I am wondering if you
have a sense in terms of what has been unleashed by the IRS in
terms of actions under this aggregate.
Ms. POWER. That would be over, I believe, the last couple
of years since the Supreme Court held that they had the
authority to do this. I think that there have been maybe about
30, 40 audits on that basis since that period in time.
Mr. POMEROY. It is my sense not a lot.
Ms. POWER. No. That is correct, although that would be
significantly more than the number of audits that they had in
the early nineties when they started doing this. There were, I
believe, less than that, maybe half that, in the early
nineties.
Mr. POMEROY. Right, which is probably why tip-reporting
income was so low, perhaps. I mean, there might be some
linkages there. Thirty actions across the United States of
America over the last 2 years, this is a highly reserved
enforcement potential action, but one that is hardly bedeviling
main street businesses as they do their operations.
Ms. POWER. Well, I think in large part, the reason why tip-
reporting was so low throughout the eighties and even into the
early nineties was that the IRS did nothing to educate the
restaurant community and the employees about tip-reporting at
all. Congress passed the tip allocation provisions, the 8-
percent allocation rule, in 1982 and then the IRS did
absolutely nothing with that for more than 10 years. Most
employers thought and most employees thought and most IRS
personnel thought that the only thing that employees had to
report was 8 percent. It was news to a lot of companies that
they were required to report any more. I think that the
increase has come from employer education of employees and from
IRS education. They have made significant strides.
Mr. POMEROY. So, it does seem that there has been some
significant achievement, both private and public, and a fairly
good result there. Mr. Tinsley, I certainly appreciate your
perspective as a restaurant owner, a restaurant chain owner,
and then also on behalf of the association. In the end, you
believe that if they are going to be trying to get down to
finding how much tip income an individual has, it should be
individually determined based on the employee. Is that correct?
Mr. TINSLEY. That is correct.
Mr. POMEROY. In principle, I understand that. Just as a
matter of running a tax system, would that require individual
employee audits to wrestle that down? Is that an impossible
burden in terms of administering a nationwide tax system?
Mr. TINSLEY. No, I do not see it at all as an impossible
burden. In fact, I feel like it is the primary line or first
point that any IRS agent should go to, is the taxpayer, and
establish what is the liability of the taxpayer if they have a
question. To me it goes in concern with every other business in
the country. I do not know of any other business where the IRS
can go to the employer, to audit them first, before they go to
the employee.
Mr. POMEROY. Well, though, there are some distinctions. I
mean, basically tip revenue is in part direct compensation from
the customer to the employee; whereas, in other businesses the
employer provides 100 percent of the compensation. I think
there is a pretty important difference. You are not taking a
position of audit my employees?
Mr. TINSLEY. No. What I am suggesting is that if there is a
question on the liability, the first line of questioning or
establishment of what the tax liability should be should be
with the employee. I think that is even more important than the
distinction that you just drew because the employer has very
little to no control over what the tip amount is.
Mr. POMEROY. It seems to me this Employer-designed TRAC
(EmTRAC) is maybe a way to try and reach it--a way that has
more or less a cooperative resolution.
Mr. TINSLEY. Absolutely.
Mr. POMEROY. How have you found your participation in it?
Mr. TINSLEY. It is excellent because actually we do it all
from a company perspective. What we do is, it is re-emphasis of
what we are doing, it is education, it is repetition. It is
every payroll the tip rates come out and show what the unit is
doing as a whole. It is the camaraderie. I will re-emphasize
what Tracy was just alluding to. To me it is an educational and
a marketing obligation, and I think that is the approach that
the IRS should take in concert with our industry. When you
start talking about aggregate assessments, I think that is
where you cross the bridge from creating a working positive
relationship to a threatening relationship. That is where you
start getting destruction in the progress. I think that is
where we are headed, especially with a lot of companies that
have encountered those kind of threats.
Mr. POMEROY. It is kind of a carrot-and-stick deal, isn't
it? On the carrot side, your participation in EmTRAC protects
you from certain liabilities that the IRS will bring against
you, and for that the IRS receives your significant efforts in
trying to make this all work better. On the other hand, you
know, sometimes carrots and sticks work better than just
carrots. Do you know anyone that has ever had an enforcement
action under aggregate?
Mr. TINSLEY. Yes.
Mr. POMEROY. Do you?
Mr. TINSLEY. Yes, and I think the question becomes in the
TRAC side--and I want to not paint the IRS as totally a bad
organization, because it is not. I have had a great rapport
with some individuals there. The challenge begins, Congressman,
whenever you discuss these ideologies and the philosophies
upstairs at 11th and Constitution, something is left between
there and the field office in Albuquerque. We all face those
challenges in our businesses, but I think the IRS may face even
more of a substantial challenge. Not only their field people do
not know and understand the TRAC or the EmTRAC, but they really
do not have the same constructive--a lot of times--maybe a
better way to say it is they have an inconsistent approach on
that enforcement.
Mr. POMEROY. They tend to be cops, not partners. I got it.
Thank you very much for superb testimony.
Chairman HOUGHTON. Mr. Herger?
Mr. HERGER. Thank you very much, Mr. Chairman, and, again,
I want to thank each of you for appearing here today. My
background is from a small business, and I think about the
reasons why I ran it for as many of the concerns I am hearing
from you. Even though we have a well-meaning government, it is
not always what government is doing for you but what they seem
to be doing to you that concerns you. I think that is what our
responsibility as elected officials is, to try to be that
buffer between the two, attempt to make the system work as it
should.
I think, Mr. Tinsley, you probably mentioned some of the
challenge we have. Once you get from the top here in
Washington, to work its way down through--I am sure it is well-
meaning but, nonetheless, this great bureaucracy, to where you
get where the rubber meets the road, so to speak, is where our
problem seems to lie. I would like to ask each of you, if I
could, to respond briefly to this question: do you think the
aggregate estimation method is a fair way to determine
unreported cash tips? If not, why?
Mr. TINSLEY. I would be glad to address that, Congressman.
Initially, absolutely not do I think it is fair. First of all,
let's take the purpose of the Social Security or FICA tax is to
be attributed directly to the employee for their retirement
benefits. The aggregate assessment does not do that. It
assesses the employer, and it is no way tracked back to the
individual employee to attribute to their Social Security fund.
That is one. The other thing is it is totally inaccurate in the
fact that in aggregate assessments they take largely credit
card tips, which are established at one rate, and assume that,
one, no server has been stiffed, no walk-outs, no manager, no
take-outs, no manager meals, no comps. They also assume that
cash tips are going to be equivalent to credit card tips. That
is just not the case. Those are two very important reasons why
that does not work.
Mr. HERGER. Maybe the rest of our restaurant people, and
then I have maybe a follow-up for you, Ms. Power. Mr. Rosic?
Mr. ROSIC. Thank you. I agree with Mr. Tinsley. I would add
that it unduly shifts the burden of proof to the employer in
any attempt to defend against an aggregate estimation method
assessment rather than focusing on the taxpayer at issue, which
is the employee. Everybody is potentially subject to audit, and
the employer is not in this case failing to pay taxes that are
shown to be due. It is the employee who has not reported the
tips and the IRS has methods by which to get at that
information, which is going to be more accurate if the
recordkeeping has been done correctly by the taxpayer.
Mr. HERGER. So, it might be one thing for an employer to
educate and try to inform as much as you can these employees,
many of which are maybe in their first jobs or whatever, but it
is something else to hold them responsible for taxes that
really are not theirs. Mr. Jablonski?
Mr. JABLONSKI. Yes, I guess from a practical standpoint
since we have sort of had to go through this whole process of
negotiating actual tip rates with the IRS, from my perspective
I would just like to echo that this is exactly what happens.
What typically the IRS did--and I will speak to New Jersey
because that was the last place we put one of these tip-
reporting agreements in place. The IRS sort of makes a first
pass. They take our sales data and hours worked type data, and
they come up with tip rates based on some formulas that they
have developed and that have been developed through court cases
and then they bring those to us, and they propose these initial
tip rates, and they say, okay, well, we think your cocktail
server should make X dollars per hour.
Well, then, as employers, we go to the employees and the
employees' management, and we say here is what the IRS
proposed, now let's hear your side of the story. That is
exactly where we get into things like stiff factors, and they
talk about carry-outs or things that we are not even aware sort
of in our ivory tower approach that, you know, the employees
tell us about. Slowly but surely that tip rate gets whittled
down to something more to the actual tip rate that is being
earned. I would certainly say that, you know, this aggregate
approach is the wrong way to go. The IRS really needs to go and
look to the employees because, you know, they are the ones that
are required to keep the tip records, and they know their
story. They know the situation that is involved. I guess that
is what I would have to offer on that?
Mr. HERGER. Mr. Zona?
Mr. ZONA. Too many variables, and it then does not go to
the employees' individual funds. That does not feel right. Then
it gets to a problem of educating, if you are educating people
that you are supposed to report, and this is, you know,
supposed to be how it goes, it does not feed that education
process either. No, we are not in favor of the aggregate
approach at all.
Mr. HERGER. Do you think it is fair and equitable?
Mr. ZONA. No.
Mr. HERGER. Okay. Thank you. Maybe just a very quick
follow-up. Ms. Power, I want to thank you for representing my
good friend and constituent, Bob Larive, before the Supreme
Court on this very issue. I would like to just hear your
thoughts on what you believe is Congress's appropriate role in
this matter given the Supreme Court's decision.
Ms. POWER. Well, first off, to comment and add to the
comments that were added here, the only thing that I would add
in terms of the fairness or unfairness of the aggregate method
is that the potential cost is financially devastating, and it
grows and grows and grows each year. I think the Supreme Court
decision said, well, you know, all the employer has to do is
put aside some money in a reserve for that. At this point, it
is absurd that it continues to grow and grow and grow and
nobody should have to operate their business under that type of
threat.
As far as what I think Congress should do here, I really
think that your bill is an excellent solution. I do not think
that the aggregate estimate method is necessary. To respond to
what the IRS' biggest complaint often is, it is that, well,
otherwise, we would be forced to do employee audits. The
restaurant industry provides the IRS more information than any
other employer as to the earnings of their employees. Every
single year on that Form 8027, the restaurateur identifies
every single employee who receives less than 8 percent. The IRS
can take that form, and if the IRS wants to, it can issue
letters to those employees to collect the taxes on that amount.
No long, timely audit is necessary to do that. The same
information that the IRS uses to assess the employer, the IRS
can turn around and do the same computation for individual
employees.
Mr. HERGER. Ms. Power, thank you very much. I notice my
time is up, but thank you very much, and I want to thank each
of you for participating. Hopefully we will try to bring this
to a more equitable solution and outcome. Thank you. Mr.
Chairman, thank you very much for your generosity in time.
Chairman HOUGHTON. Thank you. I am trying to move this
along, and we have a vote in about 10 minutes. If we could have
the answers a little faster and a little briefer, I would
appreciate it. Mr. Tanner? I said the answers.
[Laughter.]
Mr. TANNER. I will have to break a lifetime here of
congressional rhetoric to be brief. I thank all of you for
being here. I just have one short question. Some of you have
indicated that the TRAC agreements work pretty well for you. I
know we have figures on some salons have agreements and some do
not. For any of you, is there an approach that Congress could
take to either give more flexibility to the IRS or to do
something to make these agreements more adaptable to the real-
world situation that you describe? It looks to me like one of
our problems is holding one entity liable for another's
actions. That is very unusual in our system for an employer to
be held responsible for the underreporting of someone else, the
employees. That is not usually the way we view the law in this
country. Is there something that you would suggest that we
could do in this regard? The bell is ringing. Thank you very
much.
Mr. TINSLEY. I do not think that giving the IRS more
flexibility is the answer. I think holding the IRS to an
accountability or a process is what is important due to the
challenges that the IRS has from the ranks, from the
Constitution down to the field offices, because we see a lot of
inconsistent treatment. I believe there is only 18 percent of
the restaurants that are subject to being eligible for TRAC are
actually on TRAC. That tells me something is broken, and I
think it has more to do with the education and understanding of
how it all works and the fear or the threat factor than
anything else.
Mr. ZONA. For the salon industry, the flexibility for the
employer would be important, so not necessarily more
flexibility for the IRS but the EmTRAC being extended to the
salon industry is, you know, very appealing. Each business is
unique in that way, and what Ed is doing with his business is
interesting.
Mr. TANNER. Thank you. I guess I misspoke when I talked
about flexibility. That was flexibility for both parties. When
you say one, ordinarily you mean both. Thank you.
Chairman HOUGHTON. Thank you very much. Mr. Ryan?
Mr. RYAN. I will wait for the next panel.
Chairman HOUGHTON. Okay that is fine. Mr. Sandlin?
Mr. SANDLIN. Following your direction, Mr. Chairman, I will
try to be brief. I think the questions are more accurately
directed to the IRS. I would say I am in support of all the
testimony given this morning by the witnesses we have had thus
far, and I think it is important in many ways to note that I
think we are missing the point. While there may be ways to
negotiate reporting and tip rates and those sorts of things, I
think it ignores the underlying problem. The employers and the
employees are required under the law to report income--income
that they actually earn and that they receive. I know there is
a statute about the estimated income, and I am very familiar
with all that. I have a problem with it when you are paying tax
and the government is requiring employers and employees to
report on estimates. I certainly would not want to be pooled--I
would hate to be pooled with you, Mr. Chairman, and have to pay
based on that. I just think that is wrong.
The industry is not the secret police of the IRS, and I
think if the IRS thinks there is a problem, then the IRS needs
to take care of their business and they need to do it in a way
that is consistent with the Constitution and with the Fifth
amendment, and maybe they should get a good book on privacy and
read that. If we are going to target the restaurant industry
and the salon industry and the gambling industry, then we need
to target the doctors and the lawyers and the bankers and the
candlestick makers, just like us. I was looking yesterday at
some of the issues on the IRS. The taxpayers overpay taxes by
an estimated $1 billion a year because they fail to claim an
itemized deduction. A quarter of the taxpayers who are eligible
for the earned income tax credit (EITC) fail to claim it
because it is too complicated. Small business overpaid their
taxes by $18 billion in 2000 and 2001 because of return errors.
Tens of thousands of farmers paid an average of $500 too much
in tax because they failed to take care of income averaging.
The Deputy Treasury Secretary told the Senate Finance
Committee that the IRS walked away from more than 2 million
delinquent tax accounts last year totaling $16.5 billion. The
agency pursued just 18 percent of abusive tax shelters. Mr.
Chairman, when the IRS takes care of those and when they go
after those tax shelters and when they start going after the
accounts that are delinquent, I think then we can look at the
poor waiters and waitresses and salon owners and hairdressers,
and we can look at trying to do something to collect their tax.
Until such time as they take care of this stuff, I think it is
absolutely ridiculous to go after single mothers with three
children that are wait staff in a restaurant trying to pay
their bills. I yield back the balance of my time.
Chairman HOUGHTON. Does anybody have any comments on that?
Mr. TINSLEY. Mr. Chairman, the only thing that I would like
to add is on the question from the Congressman on the
flexibility issue. A follow-up to that is I feel like the
flexibility is so important in the restaurant industry from the
owner-operator's side because of the variation in the types of
businesses that we have. We know from geographic location to
style of the restaurant, where there is casual dining, fine
dining, we know what works best. We do need the flexibility to
put our programs in, educate our employees.
Mr. SANDLIN. I think it is great to educate your employees,
and I understand flexibility. The real truth is the law
requires you to pay tax on income, income received, and that is
just the bottom line. If the IRS thinks there is a problem and
people are not paying tax on their earned income, then the IRS
can darn well find out how to do it. Putting restaurant owners
and gambling operators and salons in the position of being
their police and ratting out and reporting on their employees
is just absolutely ridiculous. It is ridiculous, and we do not
do it in any other industries. If they say, well, we do not
have quite the problem in other industries, well, I do not know
what to tell them about that. They are the experts in
collecting tax and making people report. At the end of the day,
you have to say everyone in America, no matter what your job
is, is responsible for reporting his or her income accurately,
period. That is the law, and if people are breaking the law,
then we need to find some way to take care of it. It is not by
putting an added expense and burden on the employers or making
them be the secret police for the IRS.
Chairman HOUGHTON. All right. Well, thank you very much. We
certainly appreciate your wisdom and your thoughts. That is all
for this panel, and when we come back, we are going to have
three votes. Mr. Conlon, who is the Director of Reporting
Compliance at the IRS, is going to be our next witness. Thank
you very much.
[Recess.]
Well, ladies and gentlemen, if we could reconvene our
Committee, we have had our three votes. I do not know when the
next series will be, but we will go right ahead and I think we
will be okay. I would like to introduce Mr. William Conlon, who
is Director of Reporting Compliance at the IRS. Mr. Conlon,
will you please start your testimony? We are delighted to have
you here.
STATEMENT OF WILLIAM F. CONLON, DIRECTOR, REPORTING COMPLIANCE,
INTERNAL REVENUE SERVICE
Mr. CONLON. Mr. Chairman, Ranking Member Pomeroy,
distinguished Members of the Subcommittee, I appreciate the
opportunity to appear before you to discuss some of the key
issues of IRS enforcement of the reporting of tip income. A
more complete statement of my remarks has been provided in
written form. The law requires all employees who receive tips
to keep contemporaneous and accurate records of the tips
received, to report the tips received to their employers in a
written statement at least monthly, and to report those tips on
their Federal income tax returns. As 1990, which is the latest
tip study available, using 1984 data and the results of our
compliance efforts, we estimated that restaurant employees were
reporting less than 50 percent of their true tip income. This
study showed that employees working at the then-existing 69,000
restaurants were underreporting tips by over $2 billion.
Chairman HOUGHTON. Could I interrupt a minute? I know this
is unusual doing it, but what is the source of that
information, estimating 50 percent.
Mr. CONLON. Again, sir, that would be based on the taxpayer
compliance measurement data that we had, plus our own
experience. Clearly that is an estimate, but we felt that that
was fairly objective. I would have to go back into the
archives, but we could certainly do that to justify it.
Chairman HOUGHTON. No, please proceed. I just did not know
whether you had that on the tip of your tongue.
Mr. CONLON. Again, the study did show a fair degree of
noncompliance. There are now over 255,000 food and beverage
establishments in existence employing over 12 million workers.
In addition, there are many businesses where tipping is the
norm, such as those involving gaming, taxi cabs, limousine
services, golf clubs, cosmetology, and others. Along with the
study, the IRS considered its examination programs which
created burdens on the employers, the employees, and the cost
of significant compliance resources by the IRS. Accordingly,
the IRS began to explore new methods to achieve voluntary
compliance. Those efforts resulted in the IRS tip compliance
initiative. The initiative emphasizes voluntary agreements
between establishments and the IRS regarding the reporting of
tip income. While more detail is provided in my written
comments, I would like to offer a few comments.
Our initiative emphasizes education of employers as well as
their employees, simplification of the reporting process, and
reducing burden by minimizing the possibility of a tip
examination. While the initiative applies to all industries
where tipping is customary, differing products have been
developed to address specific needs. The Tip Rate Determination
Agreement applies to--or actually models examination procedures
to determine tip rates to be reported based on past experience.
A review of employer books and records is required. For TRAC
agreements, while no specific tip rate is determined, the
employer institutes its own program or actions to bring itself
and its employees into compliance. A limited review of records
is normally performed. For the EmTRAC agreements, the
opportunity is provided an employer to have their currently
existing procedures reviewed by the IRS and accepted as meeting
the requirements of the TRAC process. Finally, the Gaming
Industry Tip Compliance Agreement is very similar to the Tip
Rate Determination Agreement, but modified to meet situations
unique to the gaming industry.
Tip income voluntarily reported from all industries on
employment tax Forms 941 has increased from $8.5 billion in
1994 to $18 billion in 2003. While a range of factors has
contributed to this, I believe a significant portion of this
increase reflects the presence of the IRS in the tipping
industries, either through our education efforts, voluntary
agreement programs, or enforcement activities. Within the
tipping industries, there has been much discussion of the
opinion of the Supreme Court which affirmed the ability of the
IRS to use an aggregate estimation method for determining an
employee's tip income and assessing the employer for its share
of taxes due. Effective tax administration occasionally
requires the IRS to use reasonable estimates when a precise
determination is not practical. The Court's opinion confirmed
the reasonable use of the authority granted to the IRS.
We believe that employers decide to participate in a tip
agreement primarily because of the authority granted to the IRS
to take appropriate enforcement actions when needed and the
audit protection these agreements provide. The IRS does not
have the resources to individually audit the many thousands of
tipped employees who may not report all of their tip income. We
must take a balanced approach which fully leverages education
front-end voluntary agreements as well as enforcement efforts.
Collectively, this will achieve compliance in the most
efficient manner. We recognize that consideration has been
given to possibly restricting the enforcement authority
currently available to the IRS. In keeping with my previous
comments, I would urge the Committee to work with the Treasury
Department regarding any changes to current law.
We also understand consideration is being given to
extending the application of the section 45B income tax credit.
I would like to point out that a critical component of that
credit for the IRS is the companion requirement to file a Form
8027. The IRS uses this form to assess the accuracy of income
reporting in those industries. Tax administration could be
difficult or costly if additional applications of the credit
did not also include a means for efficiently determining its
accuracy. Mr. Chairman, thank you again for allowing me to
testify. I would be happy to entertain any questions.
[The prepared statement of Mr. Conlon follows:]
Statement of William F. Conlon, Director, Reporting Compliance,
Internal Revenue Service
Good morning Mr. Chairman, Ranking Member Pomeroy, and
distinguished Members of the Subcommittee. I appreciate the opportunity
to appear before you this morning to discuss the issue of IRS
enforcement of the reporting of tip income.
Improving the compliance behavior among tipped employees continues
to be a focus of IRS employment tax initiatives.
The law requires all employees who receive tips (1) to keep
contemporaneous and accurate records of the tips received, (2) to
report the tips received to their employers in a written statement at
least monthly, and (3) to report those tips on their federal income tax
returns.
Employers are required to withhold income tax, social security or
railroad retirement tax, and Medicare tax on the tips employees report
to them in a written statement. The Internal Revenue Code provides that
the employer is responsible for deducting and depositing the employee's
FICA and federal income tax on tips included in the written report
furnished by the employee to the extent that collections can be made
from the employee's wages (under the employer's control, excluding
tips) on or after the time the written statement is furnished.
Under section 3121(q) of the Code, tips received by an employee are
remuneration for employment. The remuneration is deemed to be paid when
the tips are reported to the employer by the employeepursuant to
section 6053(a). If the employee failed to report tips, in determining
the employer's FICA tax liability, the remuneration is deemed to be
paid when notice and demand for the taxes is made to the employer by
the Secretary.
As of 1990 \1\ (latest tip study available), using 1984 data, we
estimated that restaurant employees were reporting less than 50% of
their true tip income. This study showed that employees working at the
existing 69,000 restaurants were under-reporting tips by over $2
billion. There are now over 255,000 food and beverage establishments in
existence, employing over 12 million workers. In addition, there are
many businesses where tipping is the norm, such as gaming
establishments, taxi cabs, limousine services, golf clubs, cosmetology
and barbering establishments, nail salons, health and beauty spas, tour
guide establishments, cruise ships, and many more.
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\1\ Tip Income Study, IRS Research Division Publication 1530 (8-90)
---------------------------------------------------------------------------
In the past, the IRS performed resource intensive examinations on
the returns of tipped employees and determined that the vast majority
of these employees were not properly reporting their tips. Significant
tax assessments were being made against those employees being examined.
The results of these examinations created significant financial burdens
on the employees and the employer. They were also an inefficient
approach to this compliance problem for the IRS. Accordingly, the IRS
began to explore new methods to achieve voluntary compliance and, at
the same time, reduce the burden for employees and employers. These
efforts resulted in the IRS tip compliance initiative, the Tip Rate
Determination and Education Program (the Tip Program).
Tip Rate Determination and Education Program (TRD/EP)
The IRS initiated the Tip Program in 1993 to improve and ensure tax
compliance by employers whose employees receive tip income. The program
was originally offered to the food and beverage industry, and
subsequently to the Cosmetology and Barber and gaming industries. In
December, 2000, we further extended this program to all other
industries where tipping is customary.
The IRS initiated the Tip Program for various reasons, including:
Education--To help tipped employees and their employers
improve their understanding of the laws regarding the federal tax
treatment of tips and enhance tax compliance through the use of advance
voluntary compliance agreements,
Simplification--To make it easier for tipped employees to
calculate their tips, report their tips, and pay their taxes, and
Burden Reduction--To reduce the likelihood of a tip
examination and ease the financial burdens associated with a tip
examination.
The program offers employers options to help employees more
accurately report their tip income. These options include:
Tip Rate Determination Agreement (TRDA)
Tip Reporting Alternative Commitment(TRAC)
Employer Designed TRAC Agreement (EmTRAC)
Gaming Industry Tip Compliance Agreement (GITCA)
Other employers that can now participate in either a TRAC or TRDA
include taxicab and limousine companies, airport skycap companies, car
wash operations, tour guide companies, and many more.
Taxpayers in the food and beverage industry expressed interest in
designing their own TRAC program. Notice 2000-21, 2000-19 I.R.B. 967,
set forth proposed requirements and procedures for obtaining approval
of an employer-designed EmTRAC.
The GITCA retains many of the features of the TRDA. However, since
it is now offered through a revenue procedure, it now has the
enforceability tool and safe harbor provisions that the industry
requested.
The Tip Program is totally voluntary. An employer can choose not to
enter into the program but, instead, institute its own program or
actions to bring itself and its employees into compliance.
TRDA (Tip Rate Determination Agreement)
TRDA requires the business to work with the IRS to arrive at a tip
rate for the various occupations within the restaurant.
Participating employees report tips to their employer at or above
the rate determined in the agreement. However, if the employee actually
receives tips below the determined rate, the employee is then required
to report only the actual tips received. If an employee fails to report
at or above the determined rate, the employer will provide the IRS with
that information and the IRS may audit that employee's tax return.
Employers and employees then pay the appropriate taxes on this income,
including social security and Medicare taxes (FICA) and income taxes.
The following requirements apply to TRDAs:
At least 75% of tipped employees must sign a
participation agreement with the employer.
The tip rates are determined using financial and
operating information available to the employer, historical information
provided by the IRS, and generally accepted accounting principles.
The TRDA does not have any specific education requirement
but IRS provides assistance to help employees understand their tax
responsibilities and emphasizes benefits for complying.
TRDA is available for all industries where tipping is
customary. TRDA is available to those businesses that operate primarily
with cash receipts.
TRAC (Tip Reporting Alternative Commitment)
The food and beverage industry wanted to participate with the IRS
to develop an alternative to TRDA to improve the compliance of their
tipped employees. A coalition of both large and small food and beverage
industry representatives worked together with the IRS to create the
TRAC agreement.
TRAC requires employers to:
Establish a reasonable procedure for accurate tip
reporting by all tipped employees,
Institute a training program to educate employees of
their tax reporting obligations as they relate to tips, and
Comply with all federal tax requirements regarding the
filing of returns, paying and making tax deposits, and maintaining
required records.
TRAC was originally offered only to the food and beverage industry
but has now been extended to all industries where tipping is customary.
A specific TRAC agreement is available for the Cosmetology and
Barbering Industry. This agreement has characteristics unique to this
industry.
The IRS will only terminate a TRAC agreement if the employer fails
to meet one of the three commitments noted above.
EmTRAC (Employer Designed TRAC agreement)
The EmTRAC retains many of the provisions of the TRAC agreement.
Employers commit to:
Establish a reasonable procedure for accurate tip
reporting by all tipped employees,
Institute a training program to educate employees of
their tax reporting obligations as they relate to tips, and
Comply with all federal tax requirements regarding the
filing of returns, paying and making tax deposits, and maintaining
required records.
The EmTRAC program provides an employer with considerable latitude
in designing its educational program and tip reporting procedures.
Restaurant and bar owners must apply to have the IRS approve their
program. Once approved, these employers will receive the same benefits
and protections as afforded under the IRS administered TRAC agreement.
The IRS has approved all seven EmTRAC applications received.
Gaming Industry Tip Compliance Agreement
The new Gaming Industry Tip Compliance Agreement (GITCA), while
still voluntary, is offered through Revenue Procedure 2003-35. The
agreement allows a gaming industry employer, its employees, and the IRS
to work together to determine tip rates for specified occupational
categories. The agreement prescribes a threshold level of participation
by the employer's employees, and reduces the compliance burden for the
employer and enforcement burdens for the IRS.
The Gaming agreement was originally offered through a Gaming TRDA.
The new agreement, offered through Revenue Procedure 2003-35, was
created in direct response to concerns raised by representatives from
the Gaming Industry. As a result of these concerns, the IRS in joint
cooperation with representatives from this industry, created the new
agreement.
Indian Tribal Gaming
The Office of Indian Tribal Governments, under the Tax Exempt and
Governmental Entities Operating Division (TEGE), serves as the
coordinating office for all federal tax administration needs with
Indian tribal governments, which includes tax administration in
connection with Indian tribal gaming.
There are 566 federally recognized tribes across the country. There
are 310 gaming facilities within these tribal units, approximately 65%
of which have occupations where significant tipping occurs. The
remaining 35% consist principally of bingo or video lottery terminals,
and do not lend themselves to having tipped employees.
Between entities where agreements are in place, and entities where
compliance actions are currently underway, tip reporting compliance is
being addressed with nearly 90% of the applicable customer base. We
expect to reach 100% within the next 12-18 months, and will then focus
primarily on maintaining compliance in the tip reporting area.
Level of Compliance
Various indicators show that voluntary compliance has significantly
increased in industries where a tip agreement has been implemented.
IRS has secured 15,759 tip agreements that cover 46,596
establishments, as follows: (Indian Tribal agreements discussed
earlier)
1,176 Restaurant TRDA agreements, covering 1,440
establishments \2\
---------------------------------------------------------------------------
\2\ A Restaurant TRDA is generally with a single-property Employer.
---------------------------------------------------------------------------
12,871 Restaurant TRACs, covering 37,788 establishments.
2 Cosmetology TRDA agreements, covering 2 establishments
1,388 Cosmetology TRAC agreements, covering 5,470
establishments
322 gaming tip agreements, representing 1,896
establishments.
12 TRAC agreements with a transportation employer that
represents 12 establishments.
Since the Tip Program was introduced, tip wage reporting from all
industries on Forms 941 Employer's Quarterly Federal Tax Return has
increased substantially. In 1995, tip wages voluntarily reported from
all industries were $9.45 billion. They exceeded $18 billion for 2003.
Correspondence Examinations
To make this program successful, it must be balanced with
enforcement activity. Industry representatives have voiced approval of
the Tip Program but stated that the IRS needs to focus enforcement
efforts more on the tipped employee and not solely on the employer.\3\
---------------------------------------------------------------------------
\3\ Comments received during Restaurant and Bar Industry Meeting
held April 2, 2003 at the Treasury Executive Institute in Washington,
DC.
---------------------------------------------------------------------------
The IRS does perform examinations of those employees who do not
agree to become participating employees and report their tips at or
above the established tip rate.
The Wage and Investment (W&I) Campus in Fresno processes the Form
1040 examinations for employees identified to have unreported tip
income. Over 5,000 tipped employees' returns were examined this year.
Section 3414 of the IRS Restructuring and Reform Act of 1998
Section 3414 of the Internal Revenue Service (IRS) Restructuring
and Reform Act of 1998, prohibits the threat of an audit to coerce
taxpayers into signing a Tip Reporting Alternative Commitment (TRAC)
Agreement.
Section 4.23.7.4 of the Internal Revenue Manual (IRM) outlines
procedures for soliciting tip agreements. The IRM prohibits the use of,
or implication of, a threat of an audit to secure participation in any
voluntary tip agreement. Examiners must provide the necessary
educational material to any employer seeking information on the Tip
Program whether or not a tip agreement is secured.
To avoid any implication of a threat of audit, the IRM requires an
interval of at least six months between the last contact to solicit a
tip agreement and when an examination letter is sent to the taxpayer.
The six-month policy applies only to tip examinations and not to
general income tax examinations that may warrant an audit under normal
examination procedures.
United States vs. Fior d'Italia, Inc.
On June 17, 2002, the Supreme Court rendered a decision in favor of
the Internal Revenue Service, in the case of United States v. Fior
d'Italia.\4\ The Supreme Court affirmed that the IRS has the authority
to assess an employer's share of FICA taxes due on employees' tip
income using an aggregate estimation method.
---------------------------------------------------------------------------
\4\ U.S. v. Fior D'Italia, Inc., 536 U.S. 238 (2002)
---------------------------------------------------------------------------
In essence, the Supreme Court case reaffirmed IRS authority to
assess employer FICA taxes on unreported tip income without having to
audit individual employees. Employer-only FICA tax assessments are
implemented only where other methods would not be appropriate.
Participation in a tip agreement is motivated primarily because of
the audit protection these agreements provide and the employer-only
authority that the Supreme Court case grants the IRS. Simply stated,
the IRS does not have the resources to audit the thousands of tipped
employees that do not report all their tip income. Reversal of the Fior
d'Italia case would require the IRS to do tens of thousands of
individual examinations in order to maintain the current compliance
levels.
The following shows our audit activity for the past three years:
------------------------------------------------------------------------
FY 04
FY 01 FY 02 FY 03 (Estimated)
------------------------------------------------------------------------
Employer Audits 239 126 113 228
------------------------------------------------------------------------
Employee Audits 2553 1746 1420 5262
------------------------------------------------------------------------
Section 45B Credit
Certain food or beverage establishments may claim an income tax
credit under Section 45B of the Code for social security and Medicare
taxes paid or incurred by them on a portion of their employees' tips.
The credit is available for establishments whose employees received
tips from customers for providing, delivering, or serving food or
beverages for consumption if tipping was customary. The credit applies
only to tips received by food and beverage employees.
Employers use Form 8846, Credit for Employer Social Security and
Medicare Taxes Paid on Certain Employee Tips, to claim the credit. The
credit is available without regard to whether the tips were reported to
the employer pursuant to IRC 6053(a). Thus, it is available for
employer FICA tax paid pursuant to an IRC 3121(q) assessment.
The credit applies to employer FICA tax on tips received in excess
of the tips ``deemed paid'' by the employer for purposes of satisfying
the minimum wage provisions of the Fair Labor Standards Act (FLSA).
The credit is part of the general business tax credit. Because it
is an income tax credit, claimed on the income tax return, it may be
used to offset any income tax liability, but not employment tax
liabilities. The income tax deduction for FICA taxes must be reduced by
the amount of this credit.
Form 8027 Employer's Annual Information Return of Tip Income and
Allocated Tips is an information return that employers who operate a
large food or beverage establishment must file with the IRS. There are
certain criteria for filing this return, as explained below:
Food and beverage is provided for consumption on the
premises;
Tipping is a customary practice; and
More than 10 employees, who work more than 80 hours, were
normally employed on a typical business day during the preceding
calendar year.
If the employer owns more than one establishment, generally, a Form
8027 must be filed for each establishment. Restaurants where tipping is
not customary, such as cafeteria and fast food restaurants, are not
required to file a Form 8027.
Total tips reported on Forms 8027 increased by more than $2 billion
dollars between 1993 and 1996. In 2002, total tips reported on filed
Forms 8027 were $8.89 billion.
We recognize that the food and beverage industry has expressed the
concern that the law, in its present form, has created an inequity in
industries where tipping is customary. The IRS has developed a program
to establish tip agreements with businesses in the casino and
cosmetology industries (includes barbering and nail salons) and
agreements to encompass all other tipping industries.
We understand that the cosmetology industry is supporting
legislation extending the 45B credit to their industry. At present,
when monitoring compliance in the food and beverage industry with the
requirements for the 45B credit, the Service uses information from the
Form 8027. Under current law, comparable information would not be
available for businesses in the cosmetology industry as they are not
required to file Form 8027 or any other form containing specific
information on charged tips.
In a study prepared by the Office of Research entitled, ``The
Effect of Tip Compliance Efforts on Tip Reporting,'' participants in
the TRD/EP program reported charge and cash tips at a higher rate than
non-participants.
Conclusion
Mr. Chairman, thank you again for allowing me to testify. I will be
happy to entertain any questions.
Chairman HOUGHTON. Thank you very much. I just have a brief
question, and then I will turn it over to the rest of the
panel, particularly Mr. POMEROY. I am searching for what is the
fair and practical approach. You obviously have improved the
IRS regulations and the education system and the
simplification, in terms of doubling the amount of revenue over
the last--what is it, 10 years? Is that right?
Mr. CONLON. Yes, sir.
Chairman HOUGHTON. So, as you look to the next 10 years, do
you continue on that program or do you not? The TRAC program is
set to expire at the end of 2005. Do you want to renew that?
What are your views on this?
Mr. CONLON. Mr. Chairman, we have had no discussions about
stopping the TRAC program. Frankly, based on the comments and
the sensitivity around that, I think it would probably be
appropriate for the IRS to issue a notice and publicly go on
record that we intend to continue to pursue that program in the
future and remove any doubt or concern that there may be about
that. In the gaming tip agreements that we initiated about a
year ago and are currently signing, actually there is no back-
end cessation of those agreements. What there is is a 3-year
period, and we envision that every 3 years we should come in,
have a session, determine whether the rates are still
appropriate; and if they are, continue with the agreement in
place; and if they are not, make any appropriate adjustments.
We have had progress over the last 10 years. The battle is
not won yet, but I think we still have a high degree of
noncompliance. I believe personally that voluntary agreements
are the methodology that we are going to need to use to be able
to get to a much higher level of compliance than we currently
have. Everything that it takes to support that is, I believe,
necessary. Behavior of taxpayers being what it is, if there is
no compliance presence, I believe we would find it difficult to
get people to come forward to sign voluntary agreements with
us.
Chairman HOUGHTON. We have always had problems with the
IRS, particularly in evaluating its budget, and determining if
we have enough agents enforcing the laws. The whole tax system
is based on trust and understanding and the belief that there
is fairness. If some people are cheating and others are not, it
really undermines the system. Let me ask just one final
question. Is there evidence of a better solution to increasing
tip-reporting compliance? For example, are any States involved
in different approaches? Are there any foreign countries such
as in England or in Germany? What programs are used in Japan?
Is there any information which could help you think through
what you are going to be doing in the next 10 years?
Mr. CONLON. Well, Mr. Chairman, I do not know that there is
an easy answer to that one. The biggest hurdle that we have in
the tipped income arena is that really the responsibility rests
on the employee to track their income and to report that to the
employer. That is almost unique. Most of us have a
responsibility to an organization or other responsibilities
that are required to keep books and records and accurately
report that as well. We usually have some checks and balances.
A tipped income individual does not have perhaps all of the
checks that other wage earners would have in other arenas, and
it makes it much harder for us. I do believe that we can
achieve additional compliance. I am not sure that there is an
easy answer to that. I do not believe that it would be
tolerable or advisable for us to institute mass volumes of
individual examinations. I believe certainly we need to do
some. We need to do some employer examinations in order to have
a reasonable presence out there.
Chairman HOUGHTON. All right, thank you. Mr. Pomeroy?
Mr. POMEROY. During my question period, I did not get to
the cosmetology industry, so let me start there with you. If I
heard right, they do not have the EmTRAC opportunity, do they?
What are the distinctions between the IRS handling of tip
income relative to that industry versus the restaurant
industry?
Mr. CONLON. The TRAC forum is a vehicle that we could use
for the cosmetology industry as well, so there is no reason why
we cannot move into that arena. We have had a number of
discussions about having additional discussions with them. From
a practical standpoint, we started with the population of
tipped employees that we believed was the largest, which was
the food and beverage industry.
Mr. POMEROY. Right.
Mr. CONLON. We are trying to move into other arenas, such
as gaming and cosmetology. What we have found, I believe, is
that as we go into it industry-by-industry, there are nuances
that we need to consider because the essence of a voluntary
agreement is that it must be reasonable for the employer, the
employee, as well as the U.S. Government. All three of those
interests need to be considered. It would not surprise me that
we need to make further modifications or adjustments in order
to have a vehicle which is appropriate for cosmetology.
Mr. POMEROY. Discussions have been described to me as
proceeding in a constructive way toward this end. Do you
envision administrative action in this area within the near
future?
Mr. CONLON. Well, I do, Congressman, and I believe that
would model the discussions we have had with the restaurant
association as well as with the gaming gssociation. It is,
realistically, resources which have kept us from doing that up
until now. As we have had additional progress in those areas, I
do believe we have the capability to now move forward.
Mr. POMEROY. Great. Now, the effect of H.R. 2133 that would
bring to the salon industry the 45B non-refundable income tax
credit for employer-paid Social Security taxes, can you
describe what that is about?
Mr. CONLON. Well, what it would do is offer to those
employers the same credit that is in food and beverage, which
is to the extent that they pay a wage--not tips but wages--
which exceed whatever is the stated minimum tax, they have the
ability to get a refund for the employer portion of their FICA
taxes.
Mr. POMEROY. Does the IRS have a position on that
legislation?
Mr. CONLON. Sir, to my knowledge, you would really need to
address that with the Treasury Department, since I see that
more as a policy decision than an administrative one.
Mr. POMEROY. In terms of underlying circumstances, the
circumstances within the restaurant industry that created the
rationale to have that law probably also exists in fairly
similar fashion, albeit in a different industry context, in the
cosmetology industry?
Mr. CONLON. I would not have any argument with your
statement. Again, I believe Treasury, though, would be the best
organization to perhaps comment on that.
Mr. POMEROY. All right. There is a lot of concern in the
enforcement area, as evidenced by the prior panel, on this
aggregate responsibility and the potential exposure toward the
IRS by individual employers. How do you see the IRS using its
potential enforcement actions under that authority against
individual enterprises?
Mr. CONLON. Well, the authority that we are resting on is
not unlike other situations in administering the Income Tax
Code, where if you get into a situation where the appropriate
books and records have not been kept, we are left with trying
to reconstruct the appropriate amount of income. In the absence
of books and records, we will perform estimates using the
information that is available. To the extent that we have--I
mean, the more information we have, the better our estimates
are going to be. I think some of the representations that we
take charge sales and end there are far and away overly
simplistic. That is merely a starting point. Actually, the many
adjustments they have talked about in terms of stiff rates, tip
pooling that may be taking place, whereas a waiter may take a
portion of their tips and that may go on to the bus staff or
even the cooks, all of those are factors that we try to take
into account when we are preparing our estimates. Again, it is
the absence of books and records which are requiring us to do a
reconstruction and doing it to the best of our ability. I think
in the final analysis, when you look at our estimates, for the
most part they are deemed to be reasonable. Certainly there are
a number of healthy discussions that we have with the employer
or employee, but there are actually very few situations where
someone has taken our proposed assessments and gone to, you
know, a legal front and have it be found that those estimates
were unreasonable.
Mr. POMEROY. In the prior panel--and I know I am out of
time, but I think you can respond to this, perhaps with the
Chairman's leave--30 actions brought over the last 2 years. Is
the enforcement piece of the EmTRAC relationship between the
IRS and the employer, in your view, basically to be a rarely
used enforcement authority triggered where there is
particularly egregious conduct that has merited this kind of
IRS response?
Mr. CONLON. Well, actually, we have clear guidance to the
field that would indicate that this should be a rarely used
tool and it should be the last option that an examiner would
avail themselves of. There are actually no situations where the
IRS has gone back to 1988 to compute, you know, what may be
deemed an excessive FICA tax adjustment. Our internal guidance
is that normally one would not go past 2 years and then go
forward. Of course, those determinations are up to the field.
There could be situations where they do a current-year
assessment and go forward, all of that based on facts and
circumstances. We certainly do not have a policy of exercising
perhaps all the latitude that in theory is there by the Code,
and we have clear parameters which would equate those
adjustments to other income tax type decisions we are making.
Mr. POMEROY. Thank you.
Chairman HOUGHTON. Mr. Herger?
Mr. HERGER. Thank you. Director Conlon, I want to thank you
for being with us here today. As you may know, I introduced
legislation in 2002 in response to the concerns of restaurant
owners following the Supreme Court case. Let me be clear that
the intent of my legislation is not to stop the IRS from
collecting FICA taxes on unreported tip income. The intent of
the legislation is to make sure that the system is fair to
restaurant owners and that unreported tip income is determined
in the most accurate way possible. I want to ensure that
restaurant owners are not put in the untenable position of
being the tip police. This is not the small business man's or
businesswoman's job. Their job is to run their businesses in
the best way that they can. It is the IRS' job to enforce our
tax laws. We need to be fostering a spirit of cooperation
between tip businesses and the IRS. My concern is that the
aggregate assessments undermine this spirit of cooperation.
My question is this: what is the IRS doing to make sure
that your determination of unreported tip income is more
accurate? How can a restaurant owner have confidence that if he
follows the law and educates his employees, he will not be
subject to an aggregate assessment on the estimated amount of
unreported income over which he has no control? Remember,
restaurant owners can only report to the IRS the cash tips that
are reported to them by their employees.
Mr. CONLON. Well, Congressman, I believe that we have a
system in place certainly that if the appropriate amount of tax
is being paid, any estimation method we would take would
confirm the accuracy of what has been reported, and there would
be no additional assessment. The difficult situation, again, is
when we have pockets of noncompliance, what is practical and
reasonable for the IRS in terms of achieving the compliance
that we are all seeking. An estimation allows us to have a
platform by which we can work with the employer. We can also
take that estimate and work with the employees to get
compliance with them. Even if I had an individual examination,
I would probably still find it necessary to go into those
employer books and records in order to come up with an estimate
of an accurate tip rate. It is a challenging situation, but,
again, we do not use estimations to overturn books and records
which are otherwise kept by the employer or the employee. We
only use it when we have instances of the records actually not
being maintained as appropriate.
Mr. HERGER. Mr. Conlon, were you able to--I believe you
were present when our panel was here, and you heard some of the
horror stories that come about. During the time when I was
going to school, as is the case with many, worked in
restaurants, and I know that there are employees, those that
are working there, some of which may receive literally double--
I know of cases of that--the tips that maybe the rest of them
would. I mean, you just do not know. Likewise, there are some
who struggle and receive less than what they do.
The difficulty of coming up with these estimates--and I am
sure you heard some of the testimony of the difference. There
are carry-outs and take-outs and all the different little
nuances that are there. Again, for these employers to somehow
be held responsible for this--I know years ago now, I am a
small business man myself, and I remember looking at some of
the stats. At one time I actually considered going in the
restaurant business until I looked at some of the stats. All
small businesses are tough to make it when you start, but it is
probably three or four or five times more difficult for a
restaurant. You look at those, I think at one time, for every
15 restaurants that started every year, there is only 1 or 2
left after 3 years. I mean, this is a tough business to begin
with for so many of them that are going. Do you have a response
on how you can be working with this to correct this horrible
dilemma that we are in?
Mr. CONLON. Well, that is a tremendously challenging
question and an opportunity you have provided me, Congressman.
Unfortunately, I do not know that I have a great answer for
that. It is a difficult situation. The real challenge for the
IRS is do you walk away from a known situation of noncompliance
or do you try to take some reasonable efforts to deal with the
noncompliance that is there. We are taking approaches that I
think are reasonable. I do not think it is appropriate for us
to walk away from this, or else we are abridging the commitment
that we have to those taxpayers who are paying their
appropriate share.
We stand ready to meet and work with any industry or group
who has suggestions or methods for a better process than what
we have got now. I think we have demonstrated that in the past,
and we certainly stand ready to do that currently. If there is
a better approach, we would be glad to have some substantive
discussions and work to come up with a better product or a
better methodology. To be honest with you, short of the current
efforts we have, that represents our best thinking or certainly
my best thinking at this point in time.
Mr. HERGER. I know my time is up, and the Chairman has been
very generous. Just very briefly, and it may not even need a
response here. Another concern, even some of these agreements
that they come up with on a TRAC agreement, there is this
concern of new people in with the IRS and the fact that the
rules seem to be changing in this. Anyway, there needs to be
something done where the restaurants have some sense of peace
of mind working with the IRS. That is not there now.
Mr. CONLON. Congressman, if I could respond to that, if an
organization has a signed agreement by an executive in the IRS,
we live up to not only the words but the spirit of that
agreement. I think our track record is that if you have it from
us in writing, we do everything we can to meet our commitments.
There are actually very, very few situations of us ever taking
the effort to revoking an agreement. Out of over 46,000
voluntary agreements out there, we have 17 revocations, and
this is going over all the records that I could find going back
10 years. That is an extreme situation, and I think based on
that history, I would hope that a reasonable person could look
at that track record and understand that if they enter into an
agreement with us, we are certainly going to meet our portion
of the commitment.
Mr. HERGER. Thank you very much, Mr. Conlon. Thank you, Mr.
Chairman.
Chairman HOUGHTON. Thank you, Mr. Herger. Mr. Sandlin?
Mr. SANDLIN. Thank you, Mr. Chairman, and thank you, Mr.
Conlon, for coming today. You indicated that you have a
dilemma, and I would submit to you that you do not have much of
a dilemma. Your position that the IRS is taking is much like
you see in the movies when they find someone they think
committed a crime, and the policeman says, ``Go out and round
up the usual suspects.'' That is what you guys are doing. You
are going out and you are rounding up the usual suspects. You
say that you have data within an industry that indicates a
certain percentage of people are not properly reporting their
income. That is not the way that this country works.
You have absolutely no information as you go forward except
data, internal data from the IRS, and just because there is an
internal average--or there is an average in an industry based
upon your internal records, it does not mean a particular
person has committed any crime. I do not think you have a
dilemma. You have got a law that you enforce that says when
people earn income, they receive it, they report it, and they
pay their tax on it. Aren't employees required to pay income
tax only on the income that they receive?
Mr. CONLON. Congressman, that is entirely correct. They are
only required to report what they receive and no more.
Mr. SANDLIN. Right, and I do not have to pay tax on some
sort of income average that I did not receive, right?
Mr. CONLON. That is absolutely correct.
Mr. SANDLIN. Okay. You said that you do not have enough
resources to audit everyone, so we need a balanced approach,
correct.
Mr. CONLON. Yes, sir.
Mr. SANDLIN. Now, failure to pay income tax is a crime,
isn't it? Isn't that a crime if you do not pay your income tax?
Mr. CONLON. My wording around that is they failed to meet
their obligations under the law. Whether that meets the
definition of a crime, actually I do not know that that word is
defined in the Tax Code as such.
Mr. SANDLIN. Oh, so the IRS' position is that if someone
does not pay their income tax it is not a crime?
Mr. CONLON. I am saying----
Mr. SANDLIN. We need to get this to the bar immediately.
Mr. CONLON. Congressman, to my knowledge, the word
``crime'' is not defined in the Internal Revenue Code, and we
do not use it internally to describe----
Mr. SANDLIN. Well, I am pleased to know that. Do you think
that our constitutional rights require this balance that you
are talking about, or do you think the Fifth amendment requires
a constitutional--a balance of some sort?
Mr. CONLON. Congressman, I would actually be glad to have
that discussion, but I believe now you are into a policy rule,
which is better handled by my colleagues in the Treasury.
Again, my role is to administer the laws which are
significantly or importantly passed by this body, and to the
extent that I can, that is what I am attempting to do.
Mr. SANDLIN. Okay. That is a good answer to some other
question. Do you think that as we round up these suspects, for
example, that we should go to a bar and, as everyone comes out,
we should round them all up and maybe give them Breathalyzer
tests or charge them with public intoxication just because
there is a whole lot of them in there and we figure they have
been drinking? Do you think that would be a good position for
the government?
Mr. CONLON. Congressman, I appreciate your comments;
however, they do not describe the process----
Mr. SANDLIN. I did not ask you about----
Mr. CONLON. The policy and the procedures----
Mr. SANDLIN. What they described. You are the one that told
us that you all are going after these industries because you
think a certain percentage of the people are not paying their
tax, correct? Just because a certain percentage are not paying
does not mean that any individual is not paying. Isn't that
correct?
Mr. CONLON. I do not know how you could reasonably assume
that if--if we have a high degree of noncompliance, some
individuals, some entities are not meeting their obligation----
Mr. SANDLIN. Exactly my point, and so you are rounding up
the innocents with the guilty, and you are saying you are all
guilty by association, and we are going to come in here and
take care of you as the government because we just do not--we
do not have the assets or the information or the money to
protect your constitutional rights, so we are just going to all
round you up. Let me ask you some other things that you all are
so interested in helping people with these voluntary
agreements. As I mentioned earlier, I had found yesterday some
information that taxpayers overpay their taxes by $1 billion a
year because they fail to claim itemized deductions. Now, do
you all have a group that you work with to get some voluntary
agreements to pay that money back to them? I mean, since you
found that out, do you have some voluntary agreements that they
sign and you say we are going to give back that $1 billion?
Mr. CONLON. Well, Congressman, we do have programs to
better educate the public both on----
Mr. SANDLIN. No, I did not ask you about your education
programs. What I said, do you get them to enter into voluntary
agreements from the government, from the IRS, to give them back
the $1 billion that you know you got illegally? I guess if it
is illegal for them to not report, it is illegal for you to
take it, isn't it? That wouldn't not be right? I mean, what is
good for the goose is good for the gander, isn't it? Now, let
me ask you about the quarter of the taxpayers who are eligible
for the EITC that do not claim it because it is too
complicated. Do you go back to them and have voluntary
agreements on that? If you would like to come up and testify,
sir, we would like to have you forward. You can come up and I
will ask you some questions. Or how about the small businesses
that overpaid their taxes by $18 billion? Do you have written
agreements with them, voluntary agreements that say we are
going to pay back this $18 billion, we feel really bad about
it? You do not have that.
This entire thing, Mr. Chairman, just scares me in that we
have the government running around creating potential conflicts
between employers and employees and going after people on
criminal allegations when they have absolutely no information
and no probable cause about the individuals involved, and you
think you are going to strong-arm industries and poor
waitresses, single waitresses with children. You do not even go
and collect this money that you know is owed. You do not go and
investigate abusive tax shelters. You do not give money back
that you collect illegally. I think we are going about it the
wrong way. When you take care of those things, then I think we
can go look at our waitresses and folks that work in the
gambling industry and otherwise. It is outrageous that the U.S.
Government would go after people on criminal allegations
without any sort of information whatsoever except data on a
group. I am out of time.
Chairman HOUGHTON. I am not in Mr. Conlon's position, but I
think the theme of this hearing is that everybody in his or her
own way should be a part of the tax system, and we are trying
to make it fair. Let me pick up on this a minute. It seems that
you have got an almost impossible job, and I will tell you why
I say this, and you can comment on this. It is that you are
taking really low-wage earners, and many of them are making
minimum wage. It is a wage which is not possible to live on,
and they get a few extra dollars as far as tips. Essentially
they have that, yet at the same time they are exposed the way
the rest of us are, proportionately to their income on paying
their tax. You can see this particularly in the lack of signing
up with taxis and valets and bellhops and skycaps. They do not
comply, or they do not sign up with any of your programs. I
mean, if I was one of those operators, I think I would probably
do something like EmTRAC where I could sort of design my own
system, but they do not do it. Is it something which we can
talk about and try to adjust, tweak the system a little bit? Is
this something really which is fixable?
Mr. CONLON. Well, Mr. Chairman, there are actually, I
thought, a couple questions there, and let me try to be
responsive to that. I think from an administrative decision,
what you really need to ask yourself is: do you put all of your
attention to one program or do you try to have balance in tax
administration? I think clearly we are trying to have balance,
with the understanding that if you ever completely move away
from a noncompliant segment, the situation is going to get
rampantly worse rather than better.
From my standpoint, I have seen us take a number of
aggressive steps to deal with tax shelters and abusive
promotions, not only the promoters but the individuals who
participate in those. Again, I believe our approach, which is
to not put all of our resources in there, is appropriate,
though clearly you do need to focus on major areas of
significant noncompliance. Again, in that abusive arena, I
believe we have done so and will continue to do so. In terms of
a better approach, clearly we have had the approach in the past
of let's just audit people until we get to compliance. I think
our recognition is that that is not a winning solution for us;
that is not the most efficient use of our resources. In light
of that, we are now trying to use all of the resources
available to us, which certainly include education, voluntary
agreements with organizations, and trying to move the ball
forward using that type of an approach.
Again, I think the combination of the education, the
voluntary agreements, and compliance or enforcement efforts is
the methodology that we need to be using, and we just need to
be careful that we are not outweighing one of those. It needs
to be on a front that takes advantage of all those tools.
Certainly it is not easy, but I do not think you would be
expecting us to move away from this arena just because it is
difficult for us to pursue it.
Chairman HOUGHTON. Well, let me try to put in my own
words--and correct me if I am wrong--what I hear. The program
should be voluntary; it should be flexible; it should not put
the burden on the employer. It should help the employees; it
should set up common procedures and education and understanding
of the law and the authority and simplification and things like
that. Occasional auditing, focus on the important areas, and
just leave it at that. Tell me where I am wrong here.
Mr. CONLON. Mr. Chairman, I would not say you are wrong. I
would say we need to and we do make continual assessments as to
where we have the best application of our resources. The
situation could change, and we could decide in the future to
apply more to this program than we have in the past in light of
significant noncompliance, again, in the abusive arena. I think
that needs to be a clear focus area for us. We need to make
sure that we are devoting the resources that we have available
to meet those needs. Then we need to look at the breadth of
noncompliance that we face, and that is a constantly
challenging situation. Certainly different people can have
different thoughts as to, you know, what is best in that arena.
Clearly, that balanced approach, keeping in mind those
significant egregious situations, is the approach that we have
taken as an organization.
Chairman HOUGHTON. Okay. Mr. Pomeroy?
Mr. POMEROY. One of the presenters this morning made the
observation that they felt this whole partnership concept, as
kicked around down at the IRS headquarters, may get lost in
terms of field implementation. I can certainly understand the
management challenge of trying to basically hold the concept
consistent through an operation spread all across the country
with thousands of employees, although that seems to me a fair
evaluation. Do you make efforts to try and have your personnel
administer these TRAC agreements in the cooperative spirit that
you have spoken to today?
Mr. CONLON. Congressman, I believe whether we are talking
the tip income program or a general examination program, our
thrust is always to be up front regarding what the issues are
before us and try to work in a collaborative manner. That is
the methodology that I believe we deploy in every situation.
Certainly we have tools that if people do not choose to work
with us in that manner, we can make those available and deploy
those as needed. We need to give people an opportunity to
comply at a reasonable cost, at a reasonable burden to them. We
need to facilitate that process. Unfortunately, I believe we
need to continue to have an enforcement presence that reminds
people of their obligations and commitments.
Mr. POMEROY. Is the segment of our economy that involves
tip income growing?
Mr. CONLON. Well, industry data that we have available
would indicate that it has. Some of the numbers available to us
from the Restaurant Association talking about 10 million
waiters and waitresses; the cosmetology industry has published
over a million members of the salon industry; I think gaming
has an estimated 370,000 employees. There are other industries
for which we do not have industry data by which to come up with
an estimate. If you look at those numbers over time, I think
you will see growth there. That is why I believe the
noncompliance that we do have is something that we need to pay
attention to, so hopefully we are growing more compliance
rather than growing more noncompliance.
Mr. POMEROY. Thank you. I yield back.
Chairman HOUGHTON. Mr. Herger, do you have a question?
Mr. HERGER. Thank you. Mr. Conlon, just how effective do
you feel that your TRAC program has been in improving
compliance? Are there specific areas that you feel need
improvement?
Mr. CONLON. Well, in terms of the clear impact that has had
on compliance, actually I do not have information that would
allow me to come to you and say because we have a certain
number of TRAC agreements, compliance has improved by an
indicated percentage. The TRAC agreement is something we came
to in collaboration with the Restaurant Association. It was a
vehicle that they thought was more appropriate for them, and it
does seem on an ongoing basis to be getting us to a more
compliant environment. When we have those agreements, my belief
is we are significantly more compliant than those
establishments that we do not have them with. Again, I do not
have empirical data necessarily by which I could tell you that
it is, you know, more compliant by a stated percentage.
Mr. HERGER. Thank you. Thank you, Mr. Chairman.
Chairman HOUGHTON. Mr. Sandlin?
Mr. SANDLIN. Thank you, Mr. Chairman. Just a few questions.
You indicated and the Chairman asked about some opportunities
to tweak the system. Now, as we mentioned earlier, an employee
is required to report his received income, correct?
Mr. CONLON. Yes, that is correct.
Mr. SANDLIN. Then he is required to pay tax on that income,
correct?
Mr. CONLON. Yes.
Mr. SANDLIN. So, that is tweak the system. I mean, that is
the system, and that is what you need, and that is what the law
is. I am continually concerned about your balanced approach as
it tramples on the rights of individuals. You know, our
government is not set up to take care of the whole. It is to
protect the individuals. You said that, well, you do not think
that the Congress would want you to move away because it is
difficult to pursue this topic, correct?
Mr. CONLON. My understanding is that the balanced approach
is what we are being expected to deploy, and that is the
approach we are taking.
Mr. SANDLIN. My question was: you said that you think that
the Congress does not want you to move away from this area just
because it is difficult to pursue it.
Mr. CONLON. That is correct.
Mr. SANDLIN. My statement is to you that is exactly what I
want you to do if by ``difficult to pursue'' you mean
protecting the rights of the citizens. You know, our individual
rights are protected in this country because they are difficult
to take away. We do not condemn people and condemn industries
and condemn individuals because they are in a certain group or
class.
Now, my position is this: if you as the IRS have an
individual that you think is not complying, you should by all
means go after that individual. However, just because it is
difficult to go after the individual or it is costly or you do
not have enough staff or you do not have enough clerks, or
whatever the problem may be--I understand that is a practical
problem for you, but you do not get to go after people just
because you have some pie-in-the-sky belief or hope that they
are not reporting something. This balanced approach is the
most--that is the most dangerous attitude I have ever heard
from any government agency, that we are going to take a
balanced approach. We do not take balanced approaches with the
law. We all have individual rights that are protected
absolutely, and when we start balancing them, you have to be a
little bit concerned about who is doing the balancing and who
is weighing that.
You said that people have to have an opportunity to comply
in a reasonable way, and you need an enforcement presence that
encourages people to comply. Most people understand, don't you
think, that if they do not report the income, they can either
be charged with a crime or required to pay back taxes plus
penalty and interest? They understand there is an enforcement
part of the IRS, don't you think?
Mr. CONLON. Yes, sir, I do.
Mr. SANDLIN. People have an opportunity to comply by
reporting their income and paying their taxes, right?
Mr. CONLON. They do.
Mr. SANDLIN. It seems to me that you already have those
opportunities, and certainly I think that the IRS--I know that
you are challenged with your budget and what you need and the
growing population and problems. I hope you will take into
account the fact that we just cannot turn into a government or
a government agency that tracks down people without specific
allegations on the individual. Mr. Chairman, I think the entire
approach is improper, if not unconstitutional, and maybe we
should look at making sure they have enough assets to track
down the money that is owed. Going after entire groups is
pretty repugnant to the law. I yield back the balance of my
time.
Chairman HOUGHTON. Well, listen, I thank you very much. You
have got a tough job. You have been an excellent witness. I
would like to work with you. I think we are always going to be
facing issues because the margin of the income is so small. We
have some Members who were not here, so without objection, we
will allow Members to submit questions to be answered in
writing. Without further ado, Mr. Conlon, thank you very much
for being here. The hearing is adjourned.
Mr. CONLON. Mr. Chairman, Congressmen, thank you for your
time. I appreciate it.
[Whereupon, at 12:47 p.m., the hearing was adjourned.]
[Submission for the record follows:]
Statement of Richard J. Walsh, Darden Restaurants, Inc., Orlando,
Florida
I am writing on behalf of Darden Restaurants, Inc. (``Darden'') to
comment on the enforcement of tip reporting by the Internal Revenue
Service (``IRS'' or ``Service''), which was the subject of the
Subcommittee on Oversight's hearing of July 15, 2004. Included within
the scope of the Subcommittee's review is the progress of the Service's
Tip Reporting Alternative Commitment (``TRAC'') program, which was
officially launched in 1995. Darden, which was the first taxpayer to
sign a TRAC Agreement, is writing to reconfirm its commitment to that
partnership with the Service, but also to express concern about reports
that the Service may not be honoring the terms of the TRAC agreement.
A. Background.
Darden is headquartered in Orlando, Florida and is the largest
casual dining restaurant company in the world. We operate more than
1,300 Red Lobster, Olive Garden, Bahama Breeze, Smokey Bones BBQ and
Seasons 52 restaurants in North America. We are leaders in each of our
market segments and employ more than 140,000 employees. Consequently,
the accurate reporting of tips is of great concern to us.
The numerous discussions between the IRS and the food service
industry--which ultimately led to the launch of the TRAC Program in
1995--actually began with a small, informal meeting in March 1994.
Ernie Harper and I of General Mills Restaurants, Inc. (now Darden), Tim
Halverson of Charthouse Restaurants, and a representative of Hyatt
Hotels met with Tom Burger (then the Director of the IRS Office of
Employment Tax Administration and Compliance), Bob Cossey (an IRS
Revenue Officer from the Phoenix District), and Tony Warcholak (an IRS
Revenue Officer from Chicago). This discussion was initiated because
the Tip Rate Determination Agreements used by the gaming industry were
not being accepted by tipped employees of the food service industry
and, consequently, we wanted to explore the feasibility of restaurant
employers negotiating a different agreement with the Service. With
assurances from Mr. Burger that not only was the Service open to
working on a market segment understanding with the food service
industry, it would be willing to provide protection against retroactive
assessments of employer FICA taxes for participating employers, I was
tasked with approaching the National Restaurant Association and other
restaurant employers to encourage participation in the negotiation
process. Without the assurance from the Service on the issue of
protection from retroactive assessments of employer FICA taxes, it is
unlikely that I would have been able to persuade the industry to enter
into negotiations with the Service.
Over the next 18 months, numerous meetings of IRS and industry
representatives were held at various sites around the country to work
out the details of the market segment understanding. The working group
expanded to include other restaurant and hotel employers and
representatives of the IRS Office of the Associate Chief Counsel
(Employee Benefits and Exempt Organizations). We were most fortunate
that the IRS team was led by Tom Burger, who not only negotiated fairly
with the industry, but encouraged open discussions about the industry's
concerns with the IRS's interpretation and future administration of the
market segment understanding agreement that came to be known as TRAC in
March 1995.
B. Employer's Obligations under TRAC.
Section III. of the TRAC Agreement that both food service industry
representatives and IRS representatives agreed to in 1995 requires a
restaurant employer to:
1. establish procedures for tracking all tips reported by
employees to the employer, so that the tips may be reported to the IRS;
2. educate and periodically update directly and indirectly tipped
employees as to their obligation to report all the tips they receive as
either direct tips from customers or as tip-outs from other members of
the wait staff;
3. file all the requisite employment tax and information returns
and to timely pay the appropriate taxes; and
4. to maintain certain tip reporting records and to submit to
compliance reviews of those records at the request of the IRS.
It is noteworthy that the final version of the 1995 TRAC Agreement
does not set forth any requirement that charged or cash tips must be
reported at any particular levels, rates, or percentages, or within any
particular range of one another.
C. IRS's Commitment Under TRAC.
In exchange for the employer's commitment under TRAC, the IRS
agreed during negotiations--and as reflected in the final TRAC
agreement--that during the calendar quarters that an employer is on
TRAC, the employer could be assessed for its share of FICA taxes on
unreported tips, but solely based on employee-by-employee data gathered
by the IRS from individual employee tax returns or audits of the
individual employees by the Service (Section IV.A. of the TRAC
Agreement). In other words, the IRS agreed that an employer on TRAC
would not be subjected to an Internal Revenue Code (``Code'') 3121(q)
aggregate assessment of the employer's share of FICA taxes.
D. Working Group's Discussions Regarding TRAC Revocation.
Consistent with the concern raised during the first informal
discussion with Messrs. Burger, Cossey, and Warcholak of the IRS in
March 1994, the TRAC working group had long and extensive discussions
about the grounds for terminating a restaurant employer's participation
in the TRAC program and whether the Service's revocation could be
retroactive. The final version of the TRAC agreement, as negotiated by
our working group, provides for only one circumstance in which a TRAC
agreement may be revoked retroactively by the IRS.
Specifically, if a restaurant employer (or any of its
establishments) fails to substantially comply with the commitment to
educate employees and/or to establish and maintain tip-reporting
procedures as discussed above, the employer's (or its establishment's)
participation in TRAC may be revoked retroactively. This revocation is
effective on the first day of the first calendar quarter in which there
was substantial noncompliance. This provision does not permit the IRS
to revoke a TRAC agreement retroactively based on the rate of charged
or cash tips reported by the restaurant's employees. In other words,
the TRAC Agreement does not authorize the Service to revoke the
Agreement retroactively because the Service or one of its agents
decides that the tip reporting rates should have been higher during the
years of TRAC participation.
The TRAC working group's discussions on this point were vigorous. I
distinctly remember the question that I directed to IRS
representatives--``can the TRAC agreement be revoked retroactively, so
as to expose the employer to a section 3121(q) assessment, if the IRS
decides that the tips reported by employees during the restaurant's
TRAC participation were not high enough?''
I was again reassured by Service personnel that retroactive
revocation would not happen under those circumstances. The working
group's collective understanding that such action would not be taken by
the Service is in fact reflected in the final TRAC agreement. Moreover,
terminating a TRAC Agreement prospectively for an underreporting of
tips by employees even requires the IRS to do more than just decide
unilaterally that the tip reporting rates were too low. The TRAC
Agreement provides in Section V. that the IRS may prospectively
terminate an employer's participation (or an establishment's
participation) if an IRS audit of employees for two calendar quarters
reveals that the employees collectively and substantially underreported
tip income, despite the employer's substantial compliance with TRAC
requirements. In other words, if the Service determines through audits
of employees that they are not in ``substantial compliance'' with the
requirement to report tips in spite of the employer's commitment to
TRAC, the IRS is empowered to revoke the TRAC prospectively with
respect to the employer or a particular establishment of the employer.
The prospective revocation is effective on the first day of the first
calendar quarter after the Service notifies the employer or the
establishment that the Agreement is being terminated.
E. Concern Regarding IRS's Apparent Shift in Interpreting TRAC
Revocation Authority.
We are deeply concerned to learn that the IRS recently had
retroactively revoked a TRAC agreement of another restaurant employer
apparently on the grounds that the employer was in substantial
noncompliance, because the tip rates were not high enough. If an
employer, which has met its commitments under a TRAC agreement, can be
retroactively subjected to a Code section 3121(q) aggregate assessment
of employer FICA taxes, the greatest fear of the food service industry
members of the TRAC working group is being realized 10 years after the
TRAC negotiations were completed.
We believe that the Subcommittee and the Service should consider
whether this development puts the entire TRAC program at risk. No
taxpayer and certainly no industry is willing to negotiate cooperative
solutions with the Service and operate their businesses accordingly if
IRS examiners feel free to change the deal when it suits them.
F. Success of the TRAC Program.
As the announcement for the Subcommittee's hearing noted, tip
reporting has improved exponentially in the last decade, which is in no
small measure due to the TRAC program and the exceptional efforts of
Tom Burger and his team to work with the industry. Over 11,200 TRAC
agreements have been signed by food service employers, covering nearly
31,000 restaurant establishments. Form 8027 reporting by large food and
beverage establishments nearly doubled between 1994, the year before
TRAC was released, and 2001--$4.73 billion in reported tips to $7.86
billion. An improvement in tip reporting of one-half of a percentage
point reflects an additional billion dollars in reported tip income.
Indeed, the TRAC program has been so successful; it has become the
model for negotiating resolutions and market segment understanding
agreements with taxpayers. Therefore, the IRS should continue to
respect both the specific terms of the Agreement and the original
intent of the program to work cooperatively with taxpayers.
G. Conclusion.
Darden is proud to have proposed the idea of an industry
partnership with the Service and to have been the first signatory of a
TRAC Agreement. We are prepared to continue that partnership, provided
the Service is prepared to honor the agreement as negotiated a decade
ago. We realize that the TRAC Program is scheduled to expire in 2005
and if the Service believes that the TRAC program needs to be
revisited, we would be delighted to be a part of that discussion. In
the interim, however, we would encourage the Service to rethink its
apparent decision to revoke TRAC agreements retroactively for reasons
not articulated by the Agreement that was painstakingly negotiated with
the food service industry in 1994 and 1995. In addition, we would
encourage the Service to direct its enforcement efforts toward
improving compliance among restaurant establishments that should be
filing Forms 8027 or those with tipped employees who are not
participating in the TRAC program.