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99–685 2005

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 

( 

ii 

COMMITTEE ON WAYS AND MEANS 

BILL THOMAS, California, Chairman 

PHILIP M. CRANE, Illinois 

E. CLAY SHAW, JR., Florida 

NANCY L. JOHNSON, Connecticut 

AMO HOUGHTON, New York 

WALLY HERGER, California 

JIM MCCRERY, Louisiana 

DAVE CAMP, Michigan 

JIM RAMSTAD, Minnesota 

JIM NUSSLE, Iowa 

SAM JOHNSON, Texas 

JENNIFER DUNN, Washington 

MAC COLLINS, Georgia 

ROB PORTMAN, Ohio 

PHIL ENGLISH, Pennsylvania 

J.D. HAYWORTH, Arizona 

JERRY WELLER, Illinois 

KENNY C. HULSHOF, Missouri 

SCOTT MCINNIS, Colorado 

RON LEWIS, Kentucky 

MARK FOLEY, Florida 

KEVIN BRADY, Texas 

PAUL RYAN, Wisconsin 

ERIC CANTOR, Virginia 

CHARLES B. RANGEL, New York 

FORTNEY PETE STARK, California 

ROBERT T. MATSUI, California 

SANDER M. LEVIN, Michigan 

BENJAMIN L. CARDIN, Maryland 

JIM MCDERMOTT, Washington 

GERALD D. KLECZKA, Wisconsin 

JOHN LEWIS, Georgia 

RICHARD E. NEAL, Massachusetts 

MICHAEL R. MCNULTY, New York 

WILLIAM J. JEFFERSON, Louisiana 

JOHN S. TANNER, Tennessee 

XAVIER BECERRA, California 

LLOYD DOGGETT, Texas 

EARL POMEROY, North Dakota 

MAX SANDLIN, Texas 

STEPHANIE TUBBS JONES, Ohio 

Allison H. Giles, Chief of Staff 

Janice Mays, Minority Chief Counsel 

SUBCOMMITTEE ON OVERSIGHT 

AMO HOUGHTON, New York, Chairman 

ROB PORTMAN, Ohio 

JERRY WELLER, Illinois 

SCOTT MCINNIS, Colorado 

MARK FOLEY, Florida 

SAM JOHNSON, Texas 

PAUL RYAN, Wisconsin 

ERIC CANTOR, Virginia 

EARL POMEROY, North Dakota 

GERALD D. KLECZKA, Wisconsin 

MICHAEL R. MCNULTY, New York 

JOHN S. TANNER, Tennessee 

MAX SANDLIN, Texas 

Pursuant to clause 2(e)(4) of Rule XI of the Rules of the House, public hearing records 

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is further refined. 

iii 

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 

(1) 

IRS ENFORCEMENT OF THE REPORTING OF 

TIP INCOME 

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:] 

2 

ADVISORY 

FROM THE COMMITTEE ON WAYS AND MEANS 

SUBCOMMITTEE ON OVERSIGHT 

FOR IMMEDIATE RELEASE CONTACT: (202) 225–7601 

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 Employerdesigned 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. 

3 

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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4 

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f 

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 sigVerDate Aug 04 2004 01:08 Aug 20, 2005 Jkt 099685 PO 00000 Frm 00008 Fmt 6633 Sfmt 6621 E:\HR\OC\A685.XXX A685
5 

nificantly. 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. 

f 

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 

6 

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. 

f 

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 resVerDate Aug 04 2004 01:08 Aug 20, 2005 Jkt 099685 PO 00000 Frm 00010 Fmt 6633 Sfmt 6602 E:\HR\OC\A685.XXX A685
7 

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. 

f 

8 

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 operVerDate Aug 04 2004 01:08 Aug 20, 2005 Jkt 099685 PO 00000 Frm 00012 Fmt 6633 Sfmt 6602 E:\HR\OC\A685.XXX A685
9 

ators 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. 

10 

1The 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. 

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. 

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 § 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 emVerDate Aug 04 2004 01:08 Aug 20, 2005 Jkt 099685 PO 00000 Frm 00014 Fmt 6633 Sfmt 6621 E:\HR\OC\A685.XXX A685
11 

ployee’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 141⁄2%, when industry statistics indicate the acVerDate Aug 04 2004 01:08 Aug 20, 2005 Jkt 099685 PO 00000 Frm 00015 Fmt 6633 Sfmt 6621 E:\HR\OC\A685.XXX A685
12 

tual 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. 

f 

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 midnineties, Marriott joined a group of hotel and restaurant industry 

members to work with the IRS to develop a program that would 

13 

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 

14 

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: 

15 

• 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-byestablishment 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. 

f 

Chairman HOUGHTON. Thank you very much, Mr. Rosic. Mr. 

Tinsley? 

16 

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 employeronly 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 tipVerDate Aug 04 2004 01:08 Aug 20, 2005 Jkt 099685 PO 00000 Frm 00020 Fmt 6633 Sfmt 6602 E:\HR\OC\A685.XXX A685
17 

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 inhouse. 

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 KCare. 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 KCare 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 

18 

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; 

19 

(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 agreeVerDate Aug 04 2004 01:08 Aug 20, 2005 Jkt 099685 PO 00000 Frm 00023 Fmt 6633 Sfmt 6621 E:\HR\OC\A685.XXX A685
20 

ment. 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 barVerDate Aug 04 2004 01:08 Aug 20, 2005 Jkt 099685 PO 00000 Frm 00024 Fmt 6633 Sfmt 6621 E:\HR\OC\A685.XXX A685
21 

tender 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 employeronly 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. 

22 

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. 

f 

Chairman HOUGHTON. Thanks very much. Mr. Jablonski? 

23 

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 

24 

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, 

25 

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 

26 

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 agreeVerDate Aug 04 2004 01:08 Aug 20, 2005 Jkt 099685 PO 00000 Frm 00030 Fmt 6633 Sfmt 6621 E:\HR\OC\A685.XXX A685
27 

ment. 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 

28 

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. 

f 

Chairman HOUGHTON. Thank you, Mr. Jablonski. Mr. Zona? 

STATEMENT OF FRANK ZONA, GOVERNMENT AFFAIRS COCHAIR, 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 

29 

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 

30 

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 testiVerDate Aug 04 2004 01:08 Aug 20, 2005 Jkt 099685 PO 00000 Frm 00034 Fmt 6633 Sfmt 6621 E:\HR\OC\A685.XXX A685
31 

mony 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 ‘‘selfemployment’’ 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 selfemployed. 

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. 

32 

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 longterm 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 SalonIndustry 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. 

33 

Distribution of Salon-Industry Establishments 

Employers versus Non-employers 

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. 


Insert offset folio 99685a.001
34 

Distribution of Salon-Industry Employees 

Payroll Employees versus Self-Employed 

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 nonsupervisory 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 

SOURCE: U.S. DEPARTMENT OF LABOR, BUREAU OF LABOR STATISTICS

NOTE: FIGURES INCLUDE ONLY ESTABLISHMENTS WITH PAYROLL EMPLOYEES

f 


Insert offset folio 99685a.002 Insert offset folio 99685a.003
35 

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 

36 

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? 

37 

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 

38 

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 

39 

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. 

40 

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 followup. Ms. Power, I want to thank you for representing my good friend 

and constituent, Bob Larive, before the Supreme Court on this very 

41 

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, beVerDate Aug 04 2004 01:08 Aug 20, 2005 Jkt 099685 PO 00000 Frm 00045 Fmt 6633 Sfmt 6602 E:\HR\OC\A685.XXX A685
42 

cause 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 delinVerDate Aug 04 2004 01:08 Aug 20, 2005 Jkt 099685 PO 00000 Frm 00046 Fmt 6633 Sfmt 6602 E:\HR\OC\A685.XXX A685
43 

quent, 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 

44 

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 

45 

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. 

46 

1Tip Income Study, IRS Research Division Publication 1530 (8–90) 

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. 

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, 

47 

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 

48 

2 A Restaurant TRDA is generally with a single-property Employer. 

3 Comments received during Restaurant and Bar Industry Meeting held April 2, 2003 at the 

Treasury Executive Institute in Washington, DC. 4 U.S. v. Fior D’Italia, Inc., 536 U.S. 238 (2002) 

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

• 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

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. 

49 

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 01 FY 02 FY 03 FY 04 

(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. 

50 

Conclusion 

Mr. Chairman, thank you again for allowing me to testify. I will be happy to entertain any questions. 

f 

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 

51 

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. 

52 

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 

53 

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 

54 

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 carryouts 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 

55 

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 

56 

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 

57 

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 

58 

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. 

59 

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. 

60 

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. 

61 

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. 

62 

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. 

63 

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. 

Æ