Before Plager, Schall, and Bryson, Circuit Judges.
The opinion of the court was delivered by: Schall, Circuit Judge.
Appealed from: United States Court of Federal Claims Judge Marian Blank Horn United States Court of Appeals for the Federal Circuit
Opinion for the court filed by Circuit Judge SCHALL. Dissenting opinion filed by Circuit Judge PLAGER.
This litigation arises out of a tax dispute between a restaurant owner, the Bubble Room, Inc. (the "Bubble Room"), and the Internal Revenue Service ("IRS"). The principal issue presented is whether the IRS has authority under the Internal Revenue Code ("I.R.C." or "Code") to assess the Bubble Room's share of Federal Insurance Contribution Act ("FICA") taxes on unreported tips of its restaurant employees on an aggregate basis, without first determining the underreporting by the individual employees and then crediting their Social Security wage earnings records. The Court of Federal Claims granted summary judgment in favor of the Bubble Room, holding that the assessment of its share of FICA taxes on unreported tips in the aggregate was invalid under the Code because the taxes did not correlate with FICA tax paid by or assessed against individual employees. See Bubble Room, Inc. v. United States, 36 Fed. Cl. 659, 679 (1996). For the reasons set forth below, we vacate the resulting judgment in favor of the Bubble Room and remand the case for further proceedings.
Some background relating to the tax scheme at issue may help the reader to better understand this case. The Social Security system has been described as "a form of social insurance" whereby "persons gainfully employed, and those who employ them, are taxed to permit the payment of benefits to the retired and disabled, and their dependents." Flemming v. Nestor, 363 U.S. 603, 609 (1960). The purpose of the Social Security Act, stated in its broadest terms, is to provide for the general welfare. See Helvering v. Davis, 301 U.S. 619, 640 (1937). To that end, the Act covers a wide range of programs, including retirement (old-age) insurance, survivor's insurance, disability insurance, hospital and medical insurance for the aged and disabled, supplemental security income, and a variety of other public assistance services. See 42 U.S.C. § 301 (1988) *fn1 (to "furnish financial assistance to aged needy individuals" and their survivors); 42 U.S.C. § 1351 (to "furnish financial assistance . . . to needy individuals eighteen years of age and older who are permanently and totally disabled"); 42 U.S.C. § 1381 ("to provide supplemental security income to individuals who have attained age 65 or are blind or disabled"); 42 U.S.C. §§ 1395i to 1395i- 2a (to provide hospital insurance benefits to aged and disabled individuals); 42 U.S.C. § 1395j ("to provide medical insurance benefits . . . for aged and disabled individuals"). These programs are largely financed out of taxes paid by employers and employees under the provisions of FICA. *fn2 See 42 U.S.C. § 911. FICA tax proceeds are paid into the United States Treasury, and each year an amount equal to the proceeds is appropriated to the Federal Old-Age and Survivors Insurance Trust Fund, the Federal Disability Insurance Trust Fund, the Federal Hospital Insurance Trust Fund, and the Federal Supplementary Medical Insurance Trust Fund, from which benefits and expenses of the Social Security System are paid. See 42 U.S.C. § 911; see also Flemming, 363 U.S. at 609.
A. Employee and Employer FICA Taxes
I.R.C. § 3101 establishes the employee's FICA tax obligation. *fn3 Under I.R.C. § 3101, every employee is required to pay a FICA tax, which is calculated as a percentage of his or her "wages" earned during the tax year. "Wages" are defined to include, with certain exceptions, "all remuneration for employment." I.R.C. § 3121(a). The employer is responsible for collecting the employee FICA tax from each of its employees "by deducting the amount of tax from the wages as and when paid." I.R.C. § 3102 (a)-(b); see also 26 C.F.R. § 31.3102-1 (1989). *fn4
The obligation to pay FICA tax is imposed on employers independently of their employees' obligation. Compare I.R.C. § 3101 (establishing employee FICA tax) with I.R.C. § 3111 (establishing employer FICA tax). I.R.C. § 3111 imposes a FICA tax on every employer "having individuals in his employ." The employer FICA tax is computed as a percentage of "the wages . . . paid by [the employer] with respect to employment." *fn5 Id. The employer tax attaches "at the time that the wages are paid by the employer." 26 C.F.R. § 31.3111-3.
B. Treatment of Tipped Income
With some exceptions, tips received by employees are treated as wages for both the employee and employer's share of FICA taxes. See I.R.C. § 3121(q) ("[T]ips received by an employee in the course of his employment shall be considered remuneration for such employment (and deemed to have been paid by the employer for purposes of subsections (a) and (b) of section 3111)."). There are two exceptions to this general rule. First, I.R.C. § 3121(a)(1) provides that the term "wages" does not include any "remuneration" received by an individual employee in excess of "the contribution and benefit base," which was $48,000 in 1989. Second, under I.R.C. § 3121(a)(12)(B), the term "wages" does not include cash tips received by "an employee" in any calendar month in which such tips are less than $20. The parties refer to the two exceptions collectively as defining a "wages band." Thus, as far as both employer and employee FICA tax liability are concerned, tips received by an individual employee are treated as "wages" only if the employee received at least $20 of tips in a particular month (the low end of the "wages band") and the employee has not already received tips and other remuneration during the year in excess of the annual wage limitation (the high end of the "wages band").
Tipped employees must "report all . . . tips [received in the course of employment] in one or more written statements furnished to [their] employer on or before the tenth day of the month following the month in which the tips are received." I.R.C. § 6053(a); see 26 C.F.R. § 31.6053-1. *fn6 In that regard, unlike the situation where a tip is charged to a credit card, no record exists of the amount of a cash tip. Cash receipts at restaurants, such as those operated by the Bubble Room, indicate only the cost of the underlying transaction, not any additional gratuity left by a satisfied customer. Thus, only the satisfied customers and the tipped employees know the exact amount of cash tips received by the employees. The tipped employees are in effect bound by an honor system when it comes to reporting to their employers cash tips that they have received.
Special rules apply for the purpose of collecting and calculating FICA taxes payable by employees with respect to tips. As indicated above, pursuant to I.R.C. § 3102(a), an employer must collect from each of its employees the employee tax on tips received by the employee which constitute wages. See 26 C.F.R. § 31.3102-3(a). I.R.C. § 3102(c) instructs the employer on how to perform this obligation and reads as follows:
(c) Special rule for tips.-
"(1) In the case of tips which constitute wages, subsection (a) shall be applicable only to such tips as are included in a written statement furnished to the employer pursuant to section 6053(a), and only to the extent that collection can be made by the employer, at or after the time such statement is so furnished and before the close of the 10th day following the calendar month (or, if paragraph (3) applies, the 30th day following the year) in which the tips were deemed paid, by deducting the amount of the tax from such wages of the employee (excluding tips, but including funds turned over by the employee to the employer pursuant to paragraph (2)) as are under control of the employer.[ *fn7 ] (Emphasis added)."
Thus, in 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)." 26 U.S.C. § 3102(c); see 26 C.F.R. § 31.3102-3. Unlike the employee FICA tax, however, there is no parallel provision which limits the employer's FICA tax liability to tips that are included in the written statement furnished by the employee.
As noted, I.R.C § 3121(q) defines tips as remuneration for both the employer and the employee FICA tax. It also sets calculation dates for when those tips are to be considered paid. The time at which tips are considered paid is important for the statute of limitations. Under most circumstances, once a return is filed, the IRS has three years to assess the amount of any tax. See I.R.C. § 6501(a). *fn8 I.R.C. § 3121(q) reads:
"For purposes of this chapter, tips received by an employee in the course of his employment shall be considered remuneration for such employment (and deemed to have been paid by the employer for purposes of subsections (a) and (b) of section 3111). Such remuneration shall be deemed to be paid at the time a written statement including such tips is furnished to the employer pursuant to section 6053(a) or (if no statement including such tips is so furnished) at the time received; except that, in determining the employer's liability in connection with taxes imposed by section 3111 with respect to such tips in any case where no statement including such tips was so furnished (or to the extent that the statement so furnished was inaccurate or incomplete), such remuneration shall be deemed for purposes of subtitle F[ *fn9 ] to be paid on the date on which notice and demand for such taxes is made to the employer by the Secretary." (Emphasis added).
Tips were not always subject to FICA tax liability. In 1965, Congress amended the law to require employers to withhold FICA taxes based on tip income and to allow employees' Social Security wage earnings accounts to be credited for tip income earned. See Social Security Amendments of 1965, Pub. L. No. 89-97, Title III, § 313, 79 Stat. 286, 380-85 (1965). Tips, however, were not considered remuneration for employment for purposes of the employer's share of the FICA tax.
The Social Security Amendments of 1977 established the duty of an employer to pay FICA taxes on some of the tips received by its employees. See Social Security Amendments of 1977, Pub. L. No. 95-216, Title III, § 315(a), 91 Stat. 1509, 1536 (1977), repealed by Pub. L. No. 100-203, Title IX, § 9006(b)(2), 101 Stat. 1330-289 (1987). Employers were required to pay FICA tax on tips received by employees up to the amount of the federal minimum wage. See H.R. Rep. No. 95-702, at 11 (1977), reprinted in 1977 U.S.C.C.A.N. 4155, 4168. As a result, employees were subject to FICA taxes on all tips, but employers were exempt from FICA taxes for the amount of employee tip income in excess of the federal minimum wage. In 1987, Congress established an employer duty to pay FICA taxes on all tips that fall within the definition of "wages." See Omnibus Budget Reconciliation Act of 1987, Pub. L. No. 100-203, Title IX, § 9006, 101 Stat. 1330-288, 289 (1987).
C. Indirect Formulas to Estimate Tip Income
In previous cases, the IRS had used an indirect method of computation to determine the amount of tips received by an individual employee. The authority to do so was held to derive from I.R.C. § 446(b). See Mendelson v. Commissioner, 305 F.2d 519, 521 (7th Cir. 1962); Meneguzzo v. Commissioner, 43 T.C. 824, 831 (1965) ("If a taxpayer fails to keep the required records, or the records do not clearly reflect income, respondent is authorized by section 446 to compute income in accordance with such method as in his opinion does clearly reflect income."). Under that provision, if the method of accounting used by the taxpayer "does not clearly reflect income, the computation of taxable income shall be made under such method as, in the opinion of the Secretary[ *fn10 ], does clearly reflect income." I.R.C. § 446(b).
One indirect method that has been approved by the Secretary with respect to tip income is the McQuatters formula. The formula takes its name from a Tax Court case, McQuatters v. Commissioner, 32 T.C.M. (CCH) 1122 (1973). The McQuatters formula works as follows: (1) total sales of the employer are reduced by a percentage to account for sharing tips and for customers who leave little or no tip; (2) the resulting amount is divided by the total number of hours worked by all servers during the year to determine a sales-per-hour average; (3) that average is multiplied by the number of hours worked by each server to determine the server's yearly sales; and (4) the yearly sales of each server are multiplied by an average tip rate to determine the yearly tip income of each server. See id. at 1125. The formula uses the charged tip rate (i.e., the tip rate computed on bills charged by customers to credit cards) as a reference point for the average tip rate. See id.
In the McQuatters case, tipped employees contested the assessment of additional taxes due on unreported tips for the 1967 and 1968 tax years. After determining that the tip income reported by the tipped employees on their tax returns was unrealistically low, "(from $0.17 to $1.18 per hour)," the IRS used the above-described indirect formula to estimate the amount of tip income that the employees had actually received in 1967 and 1968. Id. at 1125. The McQuatters court held that the IRS was allowed to use the indirect method to assess a FICA tax against individual employees. In so holding, it stated:
"Petitioners complain that their tips did not average anything close to 12 percent of their sales and that seven percent is a more realistic figure; however, their evidence in support of such claims has little relevance or credibility since a sparse effort was made in 1970 and 1971 to determine actual tips and there were inconsistencies in these efforts. In the absence of adequate record keeping by the [tipped employees], the [IRS] was justified in reconstructing their tip income by an indirect method, and the method employed was logically and factually sufficient." Id.
Similarly, in Mendelson, the IRS used the same formula to estimate the unreported tip income of an employee who had understated her tip income for the tax years 1957 and 1958, (reporting only $200 in tip income in 1957 and $0 in tip income 1958). See 305 F.2d at 521-22. The Mendelson Court held that:
"the method used by [the Commissioner of Internal Revenue] in determining [the tipped employee's] income from tips was within his statutory power and was not arbitrary, excessive or without rational foundation, as urged by the taxpayer. His method has the support of a presumption of correctness, and the petitioner had the burden of proving it to be wrong." Id. at 522.
Continuing, the court stated:
"Obviously, where a taxpayer keeps no records disclosing his income, no method can be devised which will produce an exact result. The law does not require that much. It is sufficient if the method employed produces a result which is substantially correct. All taxpayers, including the one here involved, by failure to keep records of their income assume the hazard that they may be called upon to pay a tax based on an income which cannot be determined to a certainty. Such a situation, however, arises from the fault of the taxpayer and not that of the Commissioner." Id. at 523.
To the extent relevant to our Disposition of the case, the facts are undisputed. During 1989, the tax year in question, the Bubble Room operated two full-service, family restaurants in Maitland and Captiva, Florida. It employed 87 tipped employees at its Maitland restaurant and 72 tipped employees at its Captiva restaurant. In addition to receiving hourly wages from the Bubble Room, the tipped employees received tips from the customers they served. Under an informal "tip-out" system, waiters and waitresses, directly tipped by customers, shared their tips with other employees (busboys, bartenders, and dessert servers). Because cash tips were paid directly by customers to the waiters and waitresses and there was no record of the amount of the tip, the Bubble Room did not know whether a cash-paying customer paid a tip and, if so, the amount of the tip.
As noted, employees at the Bubble Room were required under I.R.C. § 6053(a) to report all tips constituting wages to their employer, using IRS Form 4070, by the tenth day of each month. See 26 C.F.R. § 31.6053- 1(b)(2). The Bubble Room informed its employees of this obligation. In addition, it distributed an "Employee Policy Manual" to its employees, which outlined the employees' responsibilities for complying with IRS reporting rules. Finally, the Bubble Room implemented a computerized check-out process, in which tipped employees were required to report their tip income to the Bubble Room on a daily basis.
On February 26, 1990, the Bubble Room filed an IRS Form 8027 ("Employer's Annual Information Return of Tip Income and Allocated Tips") for the 1989 calendar year. *fn11 Based on the information supplied by its employees, the Bubble Room reported from its two restaurants gross receipts in the amount of $7,336,685.81; charged receipts in the amount of $3,667,927.28; charged tips in the amount of $597,242.21; and total reported employee tip income in the amount of $647,159.50. The Bubble Room also filed IRS Form 941 ("Employer's Quarterly Federal Tax Return") for the four calendar quarters of 1989, and W-2 Forms ("Wage and Tax Statement") for 1989 for each of its tipped employees. On these forms, the Bubble Room reported wages actually paid and cash tip income reported to the Bubble Room by its employees. The reported figures reflected a tip rate of approximately 16.4% on charged receipts and a tip rate of 1.4% on cash receipts.
By letter dated December 31, 1990, the IRS notified the Bubble Room that it had been selected for a compliance check focusing on tip income reporting. The compliance check was performed by the IRS on January 7-8, 1991, and related to tax year 1989. By a "Notice and Demand" letter dated October 28, 1991, the IRS notified the Bubble Room that it had determined that the Bubble Room's "tipped personnel were not reporting all of the tips they [had] received." The letter also indicated that the IRS had computed the additional employer FICA taxes on the allegedly unreported tips to be $31,790.
The FICA tax assessment was based on an estimate of the aggregate tip income earned by all of the Bubble Room's tipped employees during 1989. To calculate the employer FICA tax liability on the aggregate estimated tip income, the IRS used the McQuatters formula. The IRS computed the charged tip rate by dividing the total charged tips for a random sample of 28 days in 1989 by the total charged sales for the sample 28 days. *fn12 Based on this sample, the IRS calculated the charged tip rate to be 14.6% of the cost of a meal. The IRS assumed that the cash tip rate was the same as the charged tip rate. *fn13 After adjusting the total gross receipts to account for non-paying customers, the IRS applied the 14.6% tip rate for charged meals to the adjusted total gross receipts to calculate a total cash and charged tip amount for 1989. By subtracting the total reported employee tip income from that figure, the IRS calculated that the Bubble Room's tipped employees received $423,298 in additional unreported tips in 1989. Multiplying $423,298 by 7.51% (the employer FICA tax rate for 1989), the IRS determined that $31,790 of employer FICA taxes were due from the Bubble Room.
As noted, the IRS did not assess the Bubble Room's FICA tax liability based on the sum of individual assessments and collections of additional FICA taxes from the Bubble Room's tipped employees. Neither did the IRS perform, as part of its compliance check, any audits of individual tipped employees who worked at the Bubble Room during 1989. In addition, there was no attempt to levy assessments against any individual employees. As a result, the additional FICA tax assessment made ...