In a Tax Court Memorandum Opinion released February 26, 2015, the Tax Court held that a taxpayer had fully reported his tip income for tax years 2009 – 2011, rejecting the Service’s determination that the taxpayer had underreported his tip income based on its reconstruction of the taxpayer’s tip income.[i] During the tax years at issue, the taxpayer, who was a bartender at MGM Grand Hotel and Casino in Las Vegas, self-reported his tip income based on daily contemporaneous records that the taxpayer kept of the tips that he received. Although the Tax Court found the Service’s method of reconstructing the taxpayer’s income to be reasonable, the Tax Court held that the taxpayer’s records more accurately reflected the taxpayer’s actual tip income.
Tips that employees receive are taxable as compensation for services under Internal Revenue Code § 61(a).[ii] The Employment Tax Regulations require tipped employees to maintain a daily record or other similarly reliable evidence of their tips.[iii] A taxpayer’s daily record should include the taxpayer’s name and address, the employer and the establishment’s name, the amount of cash tips and charge tips received from customers or from other employees for each work day, the amount of any tips paid out to other employees through tip sharing or similar arrangements and the names of such employees, and the date that each entry is made.[iv]
The IRS has initiated programs to enhance compliance among tipped employees, which involve a voluntary agreement between an employer and the IRS in which the IRS and the employer determine the amount of tips that employees generally receive and should report. Participants in these programs are relieved of their recordkeeping requirements and the IRS will not challenge the tip income reported by participants under the terms of the program.[v] One such program is the Gaming Industry Tip Compliance Agreement Program (GITCA), which sets an automatic tip rate for participating employees in the gaming industry—the employer’s payroll department multiplies the number of hours worked by participating employees by the applicable tip rate to arrive at taxable tip income that is then reported on the participants’ Forms W-2.[vi]
In Sabolic v. Commissioner, T.C. Memo 2015-32, the taxpayer had opted out of the GITCA for tax years 2009 – 2011 and instead self-reported his tips to his employer and maintained a daily log of the tips he received.[vii] For tips that he earned from credit cards and room charges, the MGM Grand’s system generated a receipt stating how much the taxpayer had earned. For cash tips, the taxpayer personally kept track of his cash tips for each shift, except for leftover change that he would tip the cashier. In addition to keeping a daily personal tip diary, the taxpayer would add up his cash tips and his charged tips at the end of each shift and enter them into MGM Grand’s system when he punched out, which would then be reported to MGM Grand’s payroll department and reported on his W-2. The Taxpayer would then “tip out” a portion, generally 10% to 20%, of his tips to the barbacks who helped him during his shifts. The taxpayer’s tip diaries showed that the petitioner received tips of $21,849, $24,212, and $22,950 for tax years 2009 – 2011, respectively, and his Forms W-2 reported tip income of $18,110, $23,941, and $21,926 for tax years 2009 – 2011, respectively.[viii] When reporting these amounts on his returns, the taxpayer deducted 10% for the amount he tipped out to other employees.[ix]
The IRS issued the taxpayer a notice of deficiency, which asserted that the taxpayer underreported his tips by $19,729, $19,000, and $20,284 for tax years 2009 – 2011, respectively, based on its reconstruction of the taxpayer’s tip income using a well-established indirect method for computing tip income, and imposed an accuracy-related penalty.[x] The IRS argued that the taxpayer’s records were inadequate because (1) the logs were recorded in whole numbers; (2) the taxpayer did not keep track of how much he actually tipped the barbacks; (3) the logs appeared to be missing days; and (4) the taxpayer’s logs did not precisely match up with the information in his Forms W-2.[xi]
Finding no evidence to support the discrepancy asserted by the IRS, the Tax Court rejected each of the IRS’ arguments against the reliability of the taxpayer’s records. Although there was a small discrepancy between the taxpayer’s personal log and the W-2 amounts and the taxpayer did not maintain a record of the precise amounts that he tipped out to other employees, the Tax Court found the taxpayer’s explanations to be credible and the taxpayer’s logs to be a “substantially accurate” account of his tip income for the tax years at issue.[xii]
Although the IRS’ asserted deficiency based on its indirect method of computing the taxpayer’s income was presumed to be correct, the Tax Court held that the taxpayer satisfied his burden of proving the IRS wrong through his “habitual careful recordkeeping” and his detailed, credible testimony regarding how he kept track of his tips, the nature of the bar he worked at, and the typical tipping behaviors of his patrons.[xiii]
LACEY STRACHAN – For more information please contact Lacey Strachan at Strachan@taxlitigator.com. Ms. Strachan is a tax attorney at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and represents clients throughout the United States and elsewhere involving federal and state, civil and criminal tax controversies and in tax litigation. Additional information is available at http://www.taxlitigator.com.
[i] Sabolic v. Comm’r, T.C. Memo 2015-32.
[ii] IRC § 61(a); Treas. Reg. § 1.61-2(a)(1).
[iii] Treas. Reg. § 31.6053-4(a)(1).
[iv] Treas. Reg. § 31.6053-4(a)(2).
[v] Ann 2001-1, 2001-1 CB 277.
[vi] Rev. Proc. 2007-32.
[vii] Sabolic v. Comm’r, T.C. Memo 2015-32 at *4.
[viii] Id. at *5-*6.
[x] Id. at *8.
[xi] Id. at *12-*13.
[xii] Id. at *14.
[xiii] Id. at *10, *14-*16.