UNITED STATES COURT OF APPEALS
FOR THE NINTH CIRCUIT
FIOR D'ITALIA, INC.,
Plaintiff-counter-
No. 99-16021
defendant-Appellee,
D.C. No.
v. CV-97-04613-CAL
UNITED STATES OF AMERICA,
OPINION
Defendant-counter-
claimant-Appellant.
Appeal from the United States District Court
for the Northern District of California
Charles A. Legge, District Judge, Presiding
Argued and Submitted
March 15, 2000--Berkeley, California
Filed March 7, 2001
Before: Alex Kozinski, Andrew J. Kleinfeld and
M. Margaret McKeown, Circuit Judges.
Opinion by Judge Kozinski;
Dissent by Judge McKeown
_________________________________________________________________
COUNSEL
Jeffrey R. Meyer, Attorney for the Department of Justice Tax
Division, Washington, D.C., for the appellant.
Tracy J. Power, Power & Power, Arlington, Virginia, for the
appellee.
Peter G. Kilgore, for amicus curiae National Restaurant Asso-
ciation in support of Appellee.
_________________________________________________________________
OPINION
KOZINSKI, Circuit Judge.
In a dispute involving a restaurant's share of Social Secur-
ity taxes on its employees' tip income, we explore the outer
bounds of the IRS's power to make tax assessments.
I
Like most restaurants, Fior D'Italia employs waiters, table
bussers, bartenders and others whose earnings come in part
2882
from tips left by customers. Although these tips are paid by
customers directly to employees, federal law deems them to
have been paid by the employer for purposes of FICA taxes.
See I.R.C. SS 3101, 3111, 3121(a) & (q). This puts employers
in an awkward position: They are "deemed" for purposes of
tax law, to have paid large sums of money that they have
never touched and whose exact amounts they have no way of
ascertaining. See I.R.C. S 3121(q). 1 Yet employers need to
know how much tip income employees receive in order to cal-
culate their own FICA taxes and withhold appropriate
amounts from the wage portion of the employees' compensa-
tion, pursuant to I.R.C. S 3102.
To make this information known to employers, tipped
employees must submit monthly statements (usually on Form
4070) reporting all tip earnings that qualify as wages under
the statute. See I.R.C. S 6053(a); Treas. Reg. S 31.6053-1(a).
Employers, in turn, must report to the government (on Form
8027) their gross sales, charged tips and the tip amounts
reported by employees. See I.R.C. S 6053(c)(1).
The dispute before us arose because in 1991 and 1992, Fior
D'Italia reported aggregate tips that were significantly less
than the tips that appeared on its credit card charge slips.2 The
Internal Revenue Service assessed Fior for additional FICA
taxes on what it deemed was unreported tip income for those
years. To determine what Fior owed, the IRS used a simple
calculation: For each year, it divided total tips charged on
credit cards by total credit card receipts, yielding an average
tip rate of 14.49% and 14.29% for 1991 and 1992, respec-
_________________________________________________________________
1 Some restaurants (not Fior) require all employees to pool cash tips for
subsequent redistribution, in which case they do know, at least insofar as
employees do not pocket some of the tips before pooling the rest. See 330
West Hubbard Restaurant Corp. v. United States, 203 F.3d 990, 993 (7th
Cir. 2000).
2 For 1991, disclosed total charged tips were $364,786, while total tips
reported by employees were $247,181. For 1992, the numbers were
$338,161 charged and $220,845 reported.
2883
tively. It then applied this "tip rate" to the restaurant's gross
receipts to get a presumed tip total for the year. The IRS
assessed Fior additional FICA taxes based on the difference
between its presumed total and the amount of tips Fior's
employees had reported.3 The IRS did not readjust the FICA
or income tax liability of the various employees who may
have understated tip income on their 4070 forms.
Fior challenged the assessment method in district court,
arguing that it exceeded the IRS's authority. The district court
agreed, Fior D'Italia, Inc. v. United States, 21 F. Supp. 2d
1097 (N.D. Cal. 1998), and the government appeals.
II
[1] Because we must decide whether the IRS's assessment
is valid, we begin by examining what exactly the IRS is
assessing. Section 3111 imposes on every employer a tax
equal to a percentage of "the wages . . . paid by him with
respect to employment." I.R.C. S 3111(a). These wages are
defined to include "tips received by an employee in the course
of his employment." I.R.C. S 3121(q). But Congress did not
treat all tips as taxable wages for this purpose. In section
3121(a)(1), it excluded all remuneration from the employer
(salary plus tips) that exceeds the Social Security wage base
for that year.4 In section 3121(a)(12)(B), it excluded all cash
tips received by an employee if that amount was less than $20
in a given month. These latter two provisions are often
described as defining the "wages band" outside of which tip
income is not taxed. See Bubble Room, Inc. v. United States,
159 F.3d 553, 555-56 (Fed. Cir. 1998) (Bubble Room II). For
the IRS's aggregate assessment method to precisely equal the
tips on which the employer's FICA tax is calculated, the cash
tipping rate must be exactly the same as the tipping rate on
_________________________________________________________________
3 The IRS concluded that unreported wages totaled $156,545 in 1991
and $147,529 in 1992.
4 This base was $53,400 in 1991 and $55,500 in 1992.
2884
charge slips, and total tips received must be distributed among
employees so that none falls outside the wages band.
[2] Neither condition will hold true in most cases. First,
experience shows that charged tips generally exceed cash tips.
See Yukimura v. Commissioner, 43 T.C.M. (CCH) 467, 470
(1982). One can think of many reasons why this would be so.
Spending credit is easier than spending cash, because actual
payment is deferred. Also, people dining on expense accounts
generally pay with credit cards, and spending someone else's
credit is even easier than spending one's own. Then there is
the convenience of being able to write a tip in precisely the
amount one deems appropriate. People paying in cash, how-
ever generous they may feel, are limited by the amount actu-
ally in their wallets and the need to keep some cash until their
next visit to Gringott's. Applying the charged tip rate to cash
receipts will thus tend to overestimate the cash tips actually
paid. And charged tips paid to employees may be less than
appears on the credit card receipts, because some employers
pass on the three percent fee assessed by the credit card com-
panies. See Bubble Room, Inc. v. United States, 36 Fed. Cl.
659, 663 (1996) (Bubble Room I), rev'd , Bubble Room II, 159
F.3d 553.
[3] The assumption that all tip income falls within the
wages band is even more problematic because Fior's employ-
ees, like those of many other restaurants, engage in tip shar-
ing. Waiters receive tips from the customers and then share
them with table bussers, bartenders and other employees.
Much like tips left by the customer, the exact amount shared
with others depends on the waiter's generosity and his evalua-
tion of how much other employees contributed to customer
satisfaction. Looking only at the aggregate tips collected, we
cannot tell how many table bussers made less than $20 in
indirect tips per month for some or all of the periods in question.5
_________________________________________________________________
5 While $20 in tips per month is not very much, employees who start
employment, leave employment, or take vacation or sick leave within a
particular month may well earn less than that.
2885
Nor is there any way of knowing how many waiters and hosts
received salaries plus tips exceeding the Social Security wage
base--something we cannot rule out for an upscale restaurant
like Fior D'Italia.
While an employer may be aware that reported tips are less
than actual charged tips, it cannot be sure that employees are
understating tips in their 4070 forms. Some or all of the dis-
crepancy could be explained by the fact that employees are
not required to report tips falling outside the wages band.
Even if the employer suspects that some employees are under-
stating their tip income, it has no way of knowing who is
underreporting or by how much. Restaurants cannot force
waiters to divulge how much they have actually received in
tips, and how those amounts were shared with other employ-
ees. Nor are employees likely to volunteer such information,
because they would be admitting that they committed tax
fraud by understating their tip income on the IRS form they
submitted to the employer.
The IRS is unimpressed. It believes itself empowered to use
any rational method for assessing the tax; the difficulties the
employer raises can be considered in determining the precise
amount of tax actually owed. If the assessment is valid, the
burden shifts to the taxpayer to prove the amount (if any) by
which the assessment overstates the tax owed. The question
remains whether the assessment is valid.
III
The IRS's authority to make assessments is a very powerful
tool. By making a valid assessment, the IRS shifts to the tax-
payer the burden of proving that it does not owe the amount
of tax the IRS has assessed it. If the taxpayer cannot persuade
a trier of fact that the amount assessed is incorrect, the IRS
wins and the taxpayer is required to pay that amount. See
Palmer v. IRS, 116 F.3d 1309, 1312 (9th Cir. 1997). So long
as the assessment is supported by a "minimal factual founda-
2886
tion," the IRS need not present any additional evidence; the
risk of uncertainty falls on the taxpayer. Id .
[4] In the income tax context, an assessment becomes even
more powerful when coupled with the IRS's authority pursu-
ant to I.R.C. S 446 to redefine the manner in which the tax-
payer computes income. Section 446 has been interpreted as
giving the IRS authority to make an assessment based on an
estimate rather than a computation. See McQuatters v. Com-
missioner, 32 T.C.M. (CCH) 1122, 1125 (1973). This means
that, in making the assessment, the IRS need not rely on the
actual records kept by the taxpayer. Where such records are
inadequate, the IRS may make an educated guess as to how
much tax is owed, and then put the burden on the taxpayer to
prove it wrong.
McQuatters also involved tip income but, unlike our case,
it involved the income taxes of the employees who had actu-
ally received the income. See also Mendelson v. Commis-
sioner, 305 F.2d 519 (7th Cir. 1962). The tipped employees
had failed to maintain adequate records of the tips they had
received, and the courts held that the IRS was authorized to
use an estimate in making its assessment. Because the
employees should have maintained records of their income
but failed to do so, it was deemed entirely appropriate to put
the burden on them to prove that the IRS's estimate overstated
their taxable income. See id. at 523 ("Obviously, where a tax-
payer keeps no records disclosing his income, no method can
be devised which will produce an exact result. The law does
not require that much."); McQuatters, 32 T.C.M. (CCH) at
1125 ("In the absence of adequate record keeping by petition-
ers, [the IRS] was justified in reconstructing their tip income
by an indirect method . . . .").
The taxpayer in our case is in a very different position from
the taxpayers in McQuatters and Mendelson. While each
employee knows how much he receives in tips, the restaurant
does not. Employees, moreover, have an obligation to main-
2887
tain records of their tip income and to accurately report such
income to their employer on a monthly basis. The restaurant
has no obligation to maintain records of tip income, except to
the extent its employees report on Form 4070. Unlike the tax-
payers in McQuatters and Mendelson, then, the taxpayer in
our case did not fail to satisfy a legal duty imposed on it by
the Internal Revenue Code, and thus did not give the IRS just
cause for resorting to an estimate in constructing its assess-
ment.
Also, unlike the taxpayers in McQuatters and Mendelson,
Fior is not in an inherently better position than the IRS to
determine what its employees actually earned in tips. Quite
the contrary: Fior lacks the IRS's power to audit its employ-
ees and has no other means of forcing its employees to
divulge how much tip income they earned during a given year.6
Forcing the restaurant to prove that the estimate is wrong puts
an impossible burden on it, making the already heavy pre-
sumption that attaches to an IRS assessment virtually conclu-
sive.
We find this particularly troubling because the IRS's esti-
mate has some serious flaws. As discussed above, the IRS's
method for estimating cash tips likely overstates the amount
of such tips received. See pp. 2885-86 supra. As to credit card
tips, the IRS method fails to take into account the three per-
cent fee imposed by the credit card companies which may be
passed on to employees by the restaurant. Nor does the esti-
mate make allowance for the statutory wages bands which
limit the restaurant's FICA tax liability.
_________________________________________________________________
6 The government suggests that the employer could know exactly how
much each employee makes in tips by adopting a tip-pooling arrangement.
See note 1 supra. But adopting such an arrangement would alter the way
a restaurant does business by undermining the incentive structures created
by discretionary tip-sharing. It would be akin to saying that a restaurant
must charge a fixed service charge in lieu of tips. Obviously, a restaurant
cannot be required to change its business practices in order to avoid pay-
ing taxes it doesn't owe.
2888
We can't ignore these inaccuracies on the theory that they
will cancel each other out in the long run; they all overstate
the base on which the FICA tax is calculated and thus will
combine to overstate the amount the taxpayer owes. As Judge
Plager noted in his dissent in Bubble Room II , "[t]hough it
may be that the excess taxes assessed in this manner against
the employer amount to a relatively small amount, a Govern-
ment demand for taxes that are not owed is unlawful on its
face and remains unlawful regardless of the amount at issue."
159 F.3d at 569 (Plager, J., dissenting).
We have held that the IRS's power to rely on estimates in
making its assessment is not without bounds; rather, the IRS
must use a "rational method for approximating the correct
amount." Palmer, 116 F.3d at 1312. Where more accurate
information does not exist because the taxpayer failed to
maintain adequate records, or where the taxpayer has much
better access to the information in question, we will generally
defer to the IRS's decision as to what is a rational method for
approximating the amount of tax due. But a case where the
taxpayer has done everything the law requires of it, where the
IRS's access to the relevant information is no worse (and
probably much better) than the taxpayer's, and where the esti-
mation method adopted by the government ignores the statu-
tory limits on what is taxable, sorely tests the limits of that
deference.
[5] Fortunately, we need not decide whether the IRS has
stretched deference to the breaking point because its assess-
ment suffers from a more fundamental flaw: It rests on an
estimate in circumstances where Congress has not authorized
the IRS to use estimation as an assessment method. McQuat-
ters and similar cases relied on I.R.C. S 446, which (as
already discussed) gives the IRS broad authority to use esti-
mates in making income tax assessments. But the IRS cannot
rely on section 446 as authority for the assessment here
because the section does not apply to the collection of FICA
taxes.
2889
While acknowledging that section 446 is inapplicable, the
Federal Circuit found it "informative" in concluding that the
IRS is authorized to construct its assessment by means of esti-
mation. Bubble Room II, 159 F.3d at 566. Like Judge Plager,
we fail to understand "exactly how that section is informative
with regard to the specific issue before us." Id. at 571 (Plager,
J., dissenting). To the extent section 446 has any bearing at
all, it suggests that the IRS here was not authorized to proceed
by estimation. Congress obviously knew how to give the IRS
the authority to use estimation in lieu of actual calculations,
and just as clearly thought it necessary to say so explicitly
when it wished to confer that power. Unlike our colleagues in
the Bubble Room II majority, we do not believe such an
important and sweeping power can be derived from the pen-
umbras and emanations of the Internal Revenue Code.
[6] The IRS points to another source of authority for its
assessment, namely I.R.C. S 3121(q). This section provides
that an employer is liable for its portion of FICA taxes even
when "no statement including such tips is . . . furnished" or
"the statement so furnished was inaccurate or incomplete."
But this section doesn't help the government. All it says is
that, where employees have not provided accurate tip infor-
mation to the employer, and the IRS finds some other means
of determining how much the employer owes, the employer
must pay its share. Nothing in the text of section 3121(q)
speaks to the method the IRS may use in making its assess-
ment. In fact, section 3121(q) is worded so differently from
section 446 that we cannot conclude they were meant to do
the same work.
The IRS points to the fact that section 3121(q) allows it to
assess the employer even after the time for assessing the
employee has passed. See Rev. Rul. 95-7, 1995-4 I.R.B. 44
(Q&A 11).7 According to the IRS, this implicitly authorizes
_________________________________________________________________
7 The Code does this by providing that unreported tips "shall be deemed
for purposes of subtitle F to be paid on the date on which notice and
2890
the use of estimates. The chain of reasoning goes something
like this: If the IRS is allowed to assess the employer when
it may no longer audit the employees, it will have no way to
conduct the assessment except by estimation. Congress there-
fore must have contemplated that the IRS would proceed by
estimation in making the assessments.
[7] We do not see this as a necessary implication. Rather,
we read section 3121(q) as saying that the IRS need not also
conduct an audit of the employer while it is auditing the
records of individual employees. Congress doubtless under-
stood that the only way the IRS can determine FICA taxes on
tips is by examining the employees' records; there's no point
in auditing the restaurant at the same time because it will have
no record of tips, other than the information provided by the
employees in their 4070 and 8027 forms. But, if the normal
limitations period applied, the IRS might have to assess the
employer before it finished auditing the employees. Section
3121(q) solves this problem by keeping the period open
indefinitely--which means for however long it takes to com-
plete the audit of the restaurant's tipped employees.8
[8] This does not mean that the IRS may assess the
employer only if it also assesses each of its employees. Three
other circuits have rejected this argument and, for reasons
well expressed in those opinions, we reject it as well. See 330
_________________________________________________________________
demand for such taxes is made." I.R.C. S 3121(q). Thus, the limitations
period for the assessment of the employer's FICA taxes only begins to run
after notice and demand is made, even if the limitations period for the
assessment of the employee's tax has expired.
8 Tying the employer's liability to the audit period for its employees also
avoids the anomaly that would arise from the fact that section 3121(q) pro-
vides no time limit for assessing the employer for additional FICA taxes,
making it theoretically possible that the employer could be assessed 10, 20
or more years after the tax year in question. If employer assessments are
tied to employee audits, the employer can only be assessed for however
long it takes to conduct audits of its various tipped employees, plus a rea-
sonable time thereafter.
2891
West Hubbard Restaurant Corp. v. United States , 203 F.3d
990, 995 (7th Cir. 2000); Bubble Room II, 159 F.3d at 565;
Morrison Restaurants, Inc. v. United States, 118 F.3d 1526,
1529 (11th Cir. 1997). As the government correctly points
out, the employer's portion of FICA is separate from the
employee's, and the IRS need not collect the one as a condi-
tion for collecting the other. Having audited an employee and
determined the precise amount of FICA wages the employee
has received, the IRS may then choose to assess only the
employer, only the employee, or both. If the IRS cannot or
will not assess the employee for additional FICA tax, this will
not jeopardize its right to assess the employer. 9
[9] That having been said, it does not follow that the IRS
can dispense with auditing the employees' records or other-
wise determining the amount each employee earned in tips.
For the reasons explained, there is no way to determine the
employer's FICA tax liability without making an employee-
by-employee determination of the taxable tips each has
earned. An aggregate assessment based on inaccurate esti-
mates, as used by the IRS in this case, is simply not authorized.10
_________________________________________________________________
9 Accordingly, our holding is entirely consistent with those of the Sev-
enth and Eleventh Circuits, both of which considered only whether the
IRS must assess the employees prior to assessing the employer and not
whether the IRS may rely upon aggregate estimates--the issue which is
the fulcrum of our ruling. See 330 West Hubbard Restaurant Corp., 203
F.3d at 994 ("On appeal, Coco Pazzo argues that the district court erred
in holding that the IRS was authorized . . . to assess employer FICA taxes
based on an aggregate estimate of the tip income received by its employ-
ees without first determining the amount of under reporting by individual
employees."); Morrison Restaurants, 118 F.3d at 1529 ("Morrison Restau-
rants contends that, in view of Congress's silence, the IRS lacks statutory
authority to assess the employer's share of FICA taxes without determin-
ing the individual employees' unreported tips and crediting the employees
with the employer's share of the tax."). The Federal Circuit's decision in
Bubble Room II is another story.
10 The dissent worries that the IRS won't be able to collect the employ-
er's share of FICA taxes, because it can't audit every waiter at every res-
taurant to determine the amount of under-reporting. See Dissent. Op. at
2892
While recognizing that "I.R.C. S 3121(q) does not fully
address the question at issue here," the Federal Circuit never-
theless found that the section "would . . . seem to imply that
an indirect method may be used to calculate the amount of
employer FICA tax in the absence of any better evidence."
Bubble Room II, 159 F.3d at 565.11 The Federal Circuit
derived this implication as follows: Section 3121(q) comes
into play only where "no statement including such tips was so
furnished (or to the extent that the statement so furnished was
inaccurate or incomplete)." I.R.C. S 3121(q). Because the sec-
tion applies where the employer's records are inadequate, the
Federal Circuit reasoned, Congress must have known that the
IRS would have no choice but to use an aggregate estimation
method. See Bubble Room II, 159 F.3d at 565.
Respectfully, we disagree with our colleagues. If the
employer's records are inadequate, it is because its employees
have failed to report all their tips. The direct and obvious way
of determining the taxable tips actually received is for the IRS
to audit the employees. Proceeding by aggregate estimate, and
thereby forcing the employer to pay the price for its employ-
ees' dereliction, is simply not the only (nor even the best) way
the IRS may proceed. We therefore cannot agree that Con-
gress must have had this in mind when it passed section
3121(q).
We are aware that auditing individual employees is much
_________________________________________________________________
2907. But if this turns out to be a problem, the IRS can solve it by promul-
gating a regulation allowing it to assess restaurants using estimates. See p.
2894-95 infra. Even without such a regulation, we are not convinced that
the IRS must audit every waiter in order to ensure effective collection of
the tax. As with other taxes, a vigorous enforcement program will encour-
age waiters to report tips more accurately, for fear of suffering penalties
if caught. Moreover, when it does audit waiters, the IRS can also assess
the restaurant for its portion of the tax.
11 The Federal Circuit used the term "indirect method" where we use the
term "estimate." Both mean the same thing.
2893
more cumbersome than slapping the employer with assess-
ments based on aggregate estimates. The fact remains that
Congress authorized the IRS to use estimates in collecting
income taxes but withheld such authority in collecting FICA
taxes. By using an estimate--and particularly one that ignores
the statutory wages bands--and putting on the employer an
impossible burden in rebutting the estimated amount, the IRS
has effectively increased the tax payable by the employer
above that provided in the Internal Revenue Code. 12
Nor is the IRS without recourse. If auditing individual
employees proves too cumbersome, it can seek to have Con-
gress extend its section 446 authority to the collection of
FICA taxes. Or, it may proceed by regulation. I.R.C.
S 6205(a)(1) speaks to this situation:
If less than the correct amount of tax imposed by
section 3101, 3111, 3201, 3221, or 3402 is paid with
respect to any payment of wages or compensation,
proper adjustments, with respect to both the tax and
the amount to be deducted, shall be made, without
interest, in such manner and at such times as the
Secretary may by regulations prescribe.
Id. (emphasis added). This provision seems to authorize the
Secretary to give the IRS authority to make assessments based
on aggregate estimates by promulgating a regulation to that
_________________________________________________________________
12 As the Court of Federal Claims rightly remarked:
Even a substantially low reporting of cash tips . . . does not jus-
tify allowing the IRS to shift its responsibility to the employer for
policing the acknowledged problem of underreporting of tips by
employees. It is the responsibility of the IRS to track down and
collect unreported income. If the IRS wishes to shift its duty to
employers to ensure proper compliance, it should do so through
a congressional enactment and continued cooperation between
restaurants and the IRS."
Bubble Room I, 36 Cl. Ct. at 678 (Horn, J.).
2894
effect. But, before imposing such rough justice, the Secretary
must follow the procedural requirements of notice-and-
comment rulemaking.
These are not idle steps. The rulemaking process, by its
very design, encourages public scrutiny of an agency's pro-
posed course of action. By giving notice of a proposed rule,
the agency provides interested parties with the opportunity to
express their views and bring their political influence to bear
on the process. See 1 Kenneth Culp Davis & Richard J.
Pierce, Jr., Administrative Law Treatise,S 6.7 (3d ed. 1994)
(noting that rulemaking enhances the "political accountability
of agency policy decisions adopted through the rulemaking
process"); Bernard Schwartz, Administrative Law, S 4.16 (2d
ed. 1984) ("Rulemaking provides the agency with a forum for
soliciting the informed views of those affected in industry and
labor before adopting a new policy.").
The political process plays a particularly significant role in
the arena of tax policy. Congress has delegated to the Secre-
tary broad regulatory powers to adjust the legal obligations of
taxpayers. See, e.g., I.R.C. S 6205(a)(1). But before the Secre-
tary can give a regulation legal force, he must endure the scru-
tiny of interested groups, legislative critics and the public at
large. Congress maintains a particularly vigilant oversight
through the Joint Committee on Taxation, whose large staff
monitors and reports on the collection activities of the Depart-
ment of the Treasury. See I.R.C. SS 8001, 8004, 8022.
Indeed, Congress has blocked at least one of the IRS's
recent efforts to enhance the collection of FICA taxes on cash
tips. In 1993, the IRS promulgated a regulation that con-
strained restaurants' ability to take advantage of a FICA tax
credit by limiting the credit to the amount of tip income
received and reported by the employee (as opposed to the
amount of FICA taxes paid by the restaurant). See Treas. Reg.
S 1.45B-1T (1994). The purpose of the regulation was to give
employers an incentive for encouraging employees to report
2895
their tips. See, e.g., Fior d'Italia, 21 F. Supp. 2d at 1103-04
(quoting Letter from Leslie B. Samuels, Assistant Secretary of
the Treasury, to Senator Trent Lott (Mar. 30, 1994)).
Responding to industry complaints, Congress rejected this
incentive scheme in 1996 and provided that the tax credit
would be available "without regard to whether such tips are
reported under section 6053." I.R.C. S 45B(b)(1)(A).
This episode demonstrates the difficulty the executive and
the legislative branches have had in reaching common ground
on the problem of collecting taxes on employee tips. This
should surprise no one, given both the substantial amount of
revenue involved and the serious administrative difficulties in
determining the amounts employees receive in tips. In the
wake of political setbacks, the IRS has tried to solve the prob-
lem by assessing restaurants based only on the rough, and
somewhat inflated, estimates that we have seen in this case.
But before it can take such a significant step, it must obtain
authorization directly from Congress or by exercising Trea-
sury's own regulatory authority. Either path involves signifi-
cant political checks on agency discretion, and we decline to
assist the IRS in avoiding the public scrutiny such a process
would entail.
AFFIRMED.
_________________________________________________________________
McKEOWN, Circuit Judge, dissenting:
The issue in this case is the authority of the Internal Reve-
nue Service to use the aggregate method of assessment for the
employer's share of Social Security taxes on unreported tip
income. The separate issue of the accuracy of the assessment
is not before us and the two concepts--authority and accuracy
--should neither be confused nor mixed and matched. In
affirming the district court's rejection of the aggregate
approach, the majority creates a circuit split on a tax issue of
2896
national importance. Unlike Quidditch or Fizzing Whizbees,
there is nothing magical about the IRS's assessment--the
employer owes taxes on the unreported tip income and the
IRS has simply devised a practical means of calculating the
tip income. In view of our respect for the decisions of sister
circuits in tax cases, our deference to the IRS in interpreting
the tax code, and the logic and practicality of the aggregate
method, I respectfully dissent.
A. OTHER CIRCUITS.
The question of whether the IRS is authorized to assess the
employer's share of Federal Insurance Contribution Act
("FICA") taxes, commonly known as Social Security taxes,
based on the aggregate method without first determining the
amount of under-reporting by individual employees is one of
first impression in this circuit. Three other circuits, however,
have already addressed this issue, and all three have held that
the tax code ("Code") authorizes the IRS to do so. See 330
West Hubbard Restaurant Corp. v. United States, 203 F.3d
990, 997 (7th Cir. 2000); Bubble Room, Inc. v. United States,
159 F.3d 553, 568 (Fed. Cir. 1998) (Bubble Room II); Morri-
son Restaurants, Inc. v. United States, 118 F.3d 1526, 1530
(11th Cir. 1997); see also LIR Mgmt. Corp. v. United States,
86 F. Supp. 2d 340, 346 (S.D.N.Y. 2000); Quietwater Entm't,
Inc. v. United States, 80 F. Supp. 2d 1323 (N.D. Fla. 1999),
rev'd in part, vacated in part without op., 220 F.3d 592 (11th
Cir. 2000).
The majority's position places the Ninth Circuit directly at
odds with our sister circuits, which is of particular concern in
this case, as "[u]niformity among Circuits is especially impor-
tant . . . to ensure equal and certain administration of the tax
system." Hill v. Comm'r, 204 F.3d 1214, 1217-18 (9th Cir.
2000) (internal quotation marks and citations omitted). Until
now, we have "hesitate[d] to reject the view of another cir-
cuit" in this area. Id. (internal quotation marks and citations
omitted).
2897
Three years ago the Eleventh Circuit was the first circuit to
address the question before us. In Morrison Restaurants, the
employer sought a refund and abatement of FICA taxes
assessed on unreported employee tips. 118 F.3d at 1528. The
employer argued that the IRS does not have the authority
under 26 U.S.C. S 3121(q) to assess its share of FICA taxes
on unreported tips on an aggregate basis without first deter-
mining the under-reporting by individual employees and cred-
iting their wage history accounts. Id. at 1529. This is precisely
the position advocated by Fior d'Italia. The Eleventh Circuit
rejected this argument, noting that S 3121(q)
clearly states than an employer can be assessed for
its share of FICA taxes on employee tips even if the
employee fails to report all tips. It also suggests that
the employer can be assessed its share of FICA taxes
even when the individual employee's share is not
determined.
Id. (emphasis added). The court concluded:
[W]e are unconvinced that Congress's silence can be
construed to mean that an employer cannot be
assessed its share of FICA taxes based on employ-
ees' unreported tips in the aggregate without deter-
mining the underreporting by the individual
employees and crediting the individual employees'
wage history accounts.
Id. at 1529-30. The Eleventh Circuit deferred to the IRS's use
of the aggregate method because its interpretation of the Code
was reasonable. Id. at 1530.
The next year, in Bubble Room II, 159 F.3d at 554, the Fed-
eral Circuit similarly addressed whether the IRS has the
authority to assess the employer's share of FICA taxes on
unreported tips on an aggregate basis "without first determin-
ing the under-reporting by the individual employees and then
2898
crediting their Social Security wage earnings records." The
court concluded that the statutes authorize the IRS to do so:
I.R.C. S 3121(q) expressly contemplates that the
employer may be liable for its share of FICA taxes
even if the records supplied by the employee are
missing, inaccurate, or incomplete. Although not
conclusive, S 3121(q) would thus seem to imply that
an indirect method may be used to calculate the
amount of employer FICA tax in the absence of any
better evidence.
However, I.R.C. S 3121(q) does not fully address
the question at issue here--whether the particular
indirect formula used by the IRS to estimate the
[employer's] FICA tax liability was illegal. I.R.C.
S 6201 speaks to this question. Under I.R.C.S 6201,
the IRS is "authorized and required to make the
inquiries, determinations, and assessments" neces-
sary for all taxes imposed by the Code, "which have
not been duly paid . . . in the manner provided by
law." I.R.C. S 6201 implicitly authorizes the IRS to
use an indirect formula in order to carry out the gen-
eral power granted in I.R.C. S 6201. For example,
the IRS would have to use an indirect formula to
estimate the amount of FICA tax owed by an
employer when there is no other way to "determine
and assess" the wages deemed to have been paid by
the employer.
Id. at 565. The Federal Circuit concluded that the statutes
authorize the IRS to use the aggregate method without first
determining the individual employees' tip income. See id. at
566-68.
Most recently, in 330 West Hubbard Restaurant , 203 F.3d
990 at 997, the Seventh Circuit addressed the issue and simi-
larly concluded that the statutes authorize the IRS to assess
2899
the employer's share of FICA taxes based on the aggregate
method without first determining the amount of under-
reporting by individual employees. The Seventh Circuit was
unequivocal:
We conclude that [the employer] has failed to dem-
onstrate that the IRS's aggregate method of collect-
ing employer FICA taxes is an impermissible
reading of the tax code. Accordingly, we uphold the
IRS's interpretation of its authority to use the aggre-
gate method of collecting FICA taxes.
Id. at 997.
Every circuit court that has addressed the aggregate assess-
ment issue has come to the opposite conclusion from the
majority. The majority's attempt to avoid the weight of circuit
authority by suggesting that its position is somehow in line
with that of 330 West Hubbard Restaurant and Morrison Res-
taurants is transparently unsuccessful. See Maj. Op. at 2892
n.9 ("our holding is entirely consistent with those of the Sev-
enth and Eleventh Circuits"). As noted above, both the Sev-
enth and Eleventh Circuits held that the IRS has the authority
to use the aggregate method with respect to unreported tip
income without determining the under-reporting by individual
employees and crediting their wage history accounts. See 330
West Hubbard Restaurant, 203 F.3d at 994, 997; Morrison
Restaurants, 118 F.3d at 1529-30. Although the majority
agrees that the IRS need not assess the employees in order to
assess the employer, the majority concludes that the IRS may
not rely on the aggregate method and must audit the employ-
ees. See Maj. Op. at 2892 & n.9. Requiring an audit is simply
another way of saying that the IRS cannot estimate and that
the only way the IRS can assess taxes on unreported or under-
reported tips is to undertake an individual accounting of
employees. This view can hardly be viewed as "entirely con-
sistent" with that of the Seventh and Eleventh Circuits. The
IRS's authority to use the aggregate method was at the heart
2900
of the cases in those circuits. The majority's recharacteriza-
tion can only pretend consistency with these cases.
B. THE IRS'S INTERPRETATION IS REASONABLE.
The Supreme Court has instructed that we must defer to an
agency's interpretation of its statutes and that our review is
restricted to determining whether that interpretation is reason-
able. See Chevron U.S.A. Inc. v. Natural Resources Def.
Council, Inc., 467 U.S. 837, 843 (1984) ("[I]f the statute is
silent or ambiguous with respect to the specific issue, the
question for the court is whether the agency's answer is based
on a permissible construction of the statute."); United States
v. Nat'l Bank of Commerce, 472 U.S. 713, 730 (1985) ("The
IRS's understanding of the terms of the Code is entitled to
considerable deference."); Bob Jones Univ. v. United States,
461 U.S. 574, 596 (1983) ("this Court has long recognized the
primary authority of the IRS . . . in construing the Internal
Revenue Code"). We have likewise limited our review of IRS
interpretations of the Code. See Walthall v. United States, 131
F.3d 1289, 1297 (9th Cir. 1997) (concluding that where the
IRS's interpretation is reasonable, "[w]e must . . . show the
IRS interpretation substantial deference"); Durando v. United
States, 70 F.3d 548, 550 (9th Cir. 1995) ("Courts give defer-
ence to IRS rulings and interpretations of the Code."); Haw-
kins v. United States, 30 F.3d 1077, 1082 (9th Cir. 1994)
(recognizing "the well-settled rule that an agency's interpreta-
tion of a statute is entitled to deference unless it contradicts
the statute's plain meaning").
In reviewing the IRS's interpretation of the Code, we "need
not find that the agency construction [is] the only one it per-
missibly could have adopted to uphold the construction, or
even the reading that [we] would have reached if the question
initially had arisen in a judicial proceeding." Chevron, 467
U.S. at 843 n.11; accord Walthall, 131 F.3d at 1297 (conclud-
ing that although "[t]he statute is not susceptible only to the
[taxpayers'] interpretation . . . the IRS's interpretation . . . is
2901
reasonable" and "[w]e must therefore show the IRS interpre-
tation substantial deference"). Moreover, we owe deference to
the IRS's interpretation of the Code even absent a formal IRS
rule. See Alexander v. Glickman, 139 F.3d 733, 736 (9th Cir.
1998) ("We owe deference to the agency's interpretation of
the statute even absent a formal agency rule interpreting the
statute.").
The IRS's interpretation of the statutes at issue here--that
is, its conclusion that the statutes permit it to use the aggre-
gate method--is reasonable in light of the statutory language.
Nothing in the statutes or regulations requires the IRS to
determine the amount of unreported tips before assessing the
employer's FICA tax liability, and nothing in the statutes or
regulations prohibits the IRS from using the aggregate
method. Rather, the IRS's use of the aggregate method is
entirely consistent with the statutes and regulations and there-
fore is entitled to substantial deference. A brief review of the
relevant Code sections reveals that the Code does not require
or bar any method, but leaves selection of the method to the
agency.
Section 3111 imposes a FICA tax on employers that is
computed as a percentage of wages paid by the employer to
its employees. 26 U.S.C. S 3111; 26 C.F.R.SS 31.3111-1,
31.3111-4. "Wages" includes all tips received by employees
except those that amount to less than $20 in any calendar
month. 26 U.S.C. S 3121(a)(12)(B), (q); 26 C.F.R.
S 31.3121(a)(12)-1. Section 3121(q) requires employers to
pay the S 3111 taxes on the total amount of tips and other
remuneration, up to the Social Security wage base. See 26
U.S.C. S 3121(a)(1). As the Federal Circuit recognized,
[i]n the case of the employee FICA tax, the employer
need only consider those tips that "are included in a
written statement furnished by the employee to the
employer pursuant to section 6053(a)." Unlike the
employee FICA tax, however, there is no parallel
2902
provision which limits the employer's FICA tax lia-
bility to tips that are included in the written state-
ment furnished by the employee.
Bubble Room II, 159 F.3d at 556 (quoting 26 U.S.C.
S 3102(c)) (emphasis added).
Although the statutes do not directly address whether the
IRS has the authority to make aggregate assessments with
respect to unreported tips, see Maj. Op. at 2890-91, they are
certainly broad enough to permit the IRS to do so. In fact, it
is precisely the statutes' silence that requires Chevron defer-
ence. See Chevron, 467 U.S. at 843. In particular, S 3121(q)
provides that, even in cases where employees do not provide
the employer with tip statements under 26 U.S.C.S 6053(a)
or where the statements are inaccurate or incomplete, the IRS
may issue a notice and demand for employer FICA taxes. See
26 U.S.C. S 3121(q). The statute does not suggest, let alone
require, that the IRS must first audit the employees to deter-
mine the amount of unreported tips.
This statutory silence is buttressed by S 6201's express del-
egation authorizing the IRS to determine and assess the
amount of FICA taxes imposed by S 3111. See 26 U.S.C.
S 6201. Specifically, S 6201(a) permits the IRS to "make the
inquiries, determinations, and assessments of all taxes . . .
imposed by this title." 26 U.S.C. S 6201(a). It is up to the IRS
to choose the method, so long as reasonable, and it is reason-
able for the IRS to conclude that the authority to determine
and assess taxes includes the authority to use the aggregate
method to assess the employer's taxes on unreported tips.
Indeed, the IRS uses estimation methods in other contexts--
specifically, to determine the amount of tips received by
employees and assess a FICA tax against them under 26
U.S.C. S 446(b). Like S 6201(a), S 446(b) does not specifi-
cally authorize estimates, but S 446(b) has been interpreted to
permit the IRS to use estimates to determine tax assessments.
See Bubble Room II, 159 F.3d at 557-58. The majority posits
2903
that use of estimates with respect to employees is permissible
but not so with employers. See Maj. Op. at 2887-88. This
dichotomy overlooks the fact that employers and employees
have independent tax obligations with respect to tips. And,
although employers arguably have a more difficult burden
than employees in documenting the actual amount of tips, the
implementation of estimates is a judgment best left to the IRS,
not the court. The majority's approach tramples the deference
owed to the IRS.
The IRS's interpretation of the statutes is also consistent
with S 3111's imposition of a single tax on the employer
based on the aggregate tips and other wages received by its
employees. See 26 U.S.C. S 3111(a)-(b); Bubble Room II, 159
F.3d at 566 ("[T]he employer FICA tax imposed by I.R.C.
S 3111 is expressed in terms of the employees' aggregate tip
income."). Similarly, the limitations period for the assessment
of employer FICA taxes is consistent with the conclusion that
the IRS need not audit employees before assessing the
employer; the limitations period does not begin to run until
after notice and demand by the IRS under S 3121(q), even if
the limitations period for assessing employees has run. See
Rev. Rul. 95-7, 1995-4 I.R.B. 44 (Q&A 11). In other words,
because the IRS can assess the employer even after it may no
longer audit the employees, the statute implicitly authorizes
the use of estimates. Although, as the majority points out,
other interpretations of the statute are possible, see Maj. Op.
at 2890-91, to be reasonable, the IRS's interpretation need not
rule out alternatives.
Congressional action in recent years suggests that Congress
believes that the IRS has the authority to use the aggregate
method as well. In 1998, Congress passed a law that prohib-
ited the IRS from "threaten[ing] to audit[a] taxpayer in an
attempt to coerce the taxpayer into entering a Tip Reporting
Alternative Commitment [TRAC] Agreement." Internal Reve-
nue Service Restructuring and Reform Act of 1998, Pub. L.
No. 105-206, S 3414, 112 Stat. 685, 755 (July 22, 1998).
2904
Under the TRAC program, the employer agrees to educate its
employees about tax reporting, establish procedures to ensure
accurate tip reporting, and fulfill various federal tax require-
ments; in return, the IRS agrees to base the employer FICA
tax liability solely on reported tips and any unreported tips
discovered during an IRS audit of an employee. See H.R.
Conf. Rep. No. 105-599 at 274 (1998); S. Rep. No. 105-174
at 75 (1998); H.R. Rep. No. 105-364 (Pt. 1) at 73 (1997). The
TRAC program is a special initiative that limits the employ-
er's liability to actual rather than estimated tips. But, in mak-
ing sure that TRAC is not used as a cudgel, Congress
acknowledged the IRS's power to make aggregate calcula-
tions of employer tax obligations, before or without making
determinations with respect to individual employees.
As the majority concedes, the IRS need not assess each
employee before it can assess the employer. See Maj. Op. at
2891. The majority stresses, rather, that the IRS need only
audit each employee before assessing the employer. See Maj.
Op. at 2892 & n.9. But, as the majority recognizes, employer
and employee tax obligations are completely separate. See
Maj. Op. at 2892. One has nothing to do with the other.
Although the employer and employee may be bound together
through an employment relationship, their tax obligations
arise separately. See Bubble Room II, 159 F.3d at 565 ("We
read SS 3101 and 3111 as imposing a separate and distinct tax
liability on employers.").1 Where the wages fall within the
wages band, the employer must pay taxes on them, regardless
_________________________________________________________________
1 Many of Fior d'Italia's arguments against use of the aggregate method
focus on employees; for example, incentives with respect to employee tip-
reporting and crediting of employee Social Security accounts. But the
employer and employee tax obligations are separate and not completely
parallel. Whether employees report their tips and receive Social Security
credit is not at issue here. If employees do not receive Social Security
credit for all of their income, it is because they under-reported their
income--not because of the aggregate method of assessing employer
FICA taxes.
2905
of whether the employees reported them. See 26 U.S.C.
S3121(q).
The employer's independent tax obligation resonates in the
structure and text of the Code. The respective employer and
employee tax obligations are set forth in different subchap-
ters. The employer's obligation is set forth inS 3111; the
employees' obligation is set forth in S 3101. As previously
noted, the employer's duty to collect and remit the employees'
share of FICA taxes applies only with respect to reported tips
--the employer's duty is not so limited. See 26 U.S.C.
S 3102(c)(1), 3121(q). Finally, as discussed above, the limita-
tions periods for the two tax obligations are different. See 26
U.S.C. S 3121(q).
The majority makes much of the IRS's lack of specific reg-
ulatory authority to use the aggregate method. But, as noted
earlier, the IRS does not need to adopt a regulation in order
to benefit from the deference owed to its interpretation of the
Code. The majority also projects the image of a rogue IRS
exercising its muscle to collect employer taxes on unreported
tips, trampling on restaurants' rights and ignoring basic pro-
cess. This characterization obscures the congressional dictate
to tax all wages, specifically including unreported tips, and
ignores the fact that the IRS's method is based on justifiable
projections, not "thin air" estimates.
The majority also intimates that Congress tried to put the
brakes on the IRS's effort to collect employer taxes on tips.
An examination of recent legislation dispels this notion. Code
S 45B generally allows an income tax credit to an employer
for employer FICA taxes paid with respect to employee tips.
See 26 U.S.C. S 45B. In 1996, Congress amended S 45B to
clarify that the tax credit is available for employer FICA taxes
paid on all tips, regardless of whether the employees reported
the tips. See 26 U.S.C. S 45B(b)(1)(A), as amended by Small
Business Job Protection Act of 1996, Pub. L. No. 104-188,
S 1112(a), 110 Stat. 1755, 1759 (1996). The majority reads
2906
this amendment as "demonstrat[ing] the difficulty the execu-
tive and the legislative branches have had in reaching com-
mon ground on the problem of collecting taxes on employee
tips." See Maj. Op. at 2896. But, rather than a rebuke of "the
IRS's recent efforts to enhance the collection of FICA taxes
on cash tips," as the majority suggests, Maj. Op. at 2895, the
amendment merely confirms that the employer's tax obliga-
tion is completely separate from the employees' obligation.
And the amendment does more--it confirms that the IRS may
impose taxes on all tips and that the employer may benefit
from a tax credit on those tips, whether reported or not.
C. PRACTICALITY OF AGGREGATE METHOD.
The majority's policy arguments against the aggregate
method are just that--the court making policy. Equally avail-
ing practical and policy considerations support the IRS's
approach and weigh against the majority's position. For
example, the majority's approach effectively prohibits the IRS
from assessing the employer's share of FICA taxes with
respect to unreported tips because the IRS cannot possibly
audit all tipped employees to determine the degree of under-
reporting. See Bubble Room II, 159 F.3d at 567 ("[A]s a prac-
tical matter, the IRS lacked the resources necessary to audit
each of the [employer's] tipped employees to determine the
unreported tip income of each tipped employee."). The major-
ity's approach thereby invites employers and employees alike
to evade their statutory tax obligations. See id. ("[R]equiring
the IRS to make an assessment against each employee for
employee FICA taxes on unreported tips before the IRS could
make an assessment against the employer for employer FICA
taxes on such tips might also provide an incentive to an
employer to discourage accurate reporting or to ignore clearly
inaccurate reporting by its employees."); Morrison Restau-
rants, 118 F.3d at 1530 ("[B]asing the employer's share of
FICA taxes exclusively on employees' reported tips would
provide incentive to the employer to discourage accurate
2907
reporting or ignore blatantly inaccurate reporting by the
employees so that the employer could pay less FICA tax.").
The IRS's interpretation--the one to which we owe
deference--requires only that employers comply with the
law; it is neither unfair nor a punishment. See Bubble Room
II, 159 F.3d at 566 ("[W]e reject the position that the
McQuatters formula [i.e., the aggregate method] is punitive in
nature and thus limited to situations where taxpayers fail to
keep adequate records."). Cf. Maj. Op. at 2887-88. Employers
are required, by statute, to pay their share of FICA taxes on
reported and unreported tips. Use of the aggregate method is
not an effort to tell restaurants how to run their businesses. It
is simply an alternate means of assessing the tax when indi-
vidual employees' records are unavailable. Restaurants can
continue to pool tips or not, to require certain reporting from
their employees or not, and to create a specialized tip system
or not. The choice lies with the restaurant, not the IRS. The
consequence is that the tax is still owed and the IRS will
impose a reasonable method to assess it. Because the IRS's
conclusion that it can assess the employer's share of FICA
taxes with respect to unreported tips based on the aggregate
method is reasonable, we should defer to that interpretation,
particularly here, in light of the need for uniformity in admin-
istering the national tax system and the views of our sister cir-
cuits.
D. USE OF THE AGGREGATE METHOD DOES NOT PRECLUDE A
CHALLENGE AS TO ACCURACY AND AMOUNT.
The majority confuses the IRS's authority to use the aggre-
gate method with the accuracy of that method. See Maj. Op.
at 2884-85, 2888-89. "[W]hether there are flaws in the indi-
rect formula used to estimate the FICA tax is a separate mat-
ter from whether the IRS has the authority to assess an
employer-only FICA tax based on an aggregate estimate of
unreported tip income." Bubble Room II, 159 F.3d at 568.
2908
Adoption of the aggregate method does not preclude an
employer from challenging the amount of the assessment by
showing, for example, that some of the tips were received by
employees who fell outside the wages band. See 330 West
Hubbard Restaurant, 203 F.3d at 996 ("[The employer's]
argument [regarding the wages band] is misplaced because it
fails to distinguish between the IRS's authority to collect
taxes and the correctness of the IRS's calculation of the
amount of those taxes."); Bubble Room II, 159 F.3d at 567
(concluding that failure to take the wages band into account
does not "make the assessment unlawful" but, rather, "merely
suggests that the amount of FICA tax assessed against [the
employer] may have been incorrect by some margin and that
it may be entitled to a refund of some portion of the FICA tax
assessed against it"). Here, however, the issue of accuracy is
not before us, because Fior d'Italia did not challenge the accu-
racy of the calculation--it challenged only the IRS's authority
to assess taxes under the aggregate method.
The IRS is not just plucking a number out of the air and
shifting the burden to the taxpayer as the majority would have
us believe. Use of the aggregate method does not shift the
normal burdens in some topsy-turvy manner. Instead, the
aggregate method is predicated on a reasonable estimate and
that may be challenged by the taxpayer. There is nothing new
or unusual in this scheme of tax assessment.
* * * * *
Our review of the IRS's interpretation of the Code is lim-
ited. Because the IRS's conclusion that it has the authority to
use the aggregate method is reasonable, we must defer to it,
as have three circuits before us. This approach preserves the
right to challenge the accuracy of the assessment resulting
from the aggregate method. Therefore, I respectfully dissent.
2909