Know Your Tip Reporting Rights

RH Staff

Congress is considering the IRS' power to estimate tip income.

Should the Internal Revenue Service be permitted to estimate the amount of tips workers receive, thus allowing the agency collect income taxes on those amounts? The U.S. Supreme Court said "yes," but federal lawmakers aren't quite as certain. The House Ways and Means Committee's Subcommittee on Oversight recently criticized the IRS's enforcement of tip income reporting, and legislation has been proposed to halt the practice.

Tips received by restaurant employees may be gratuities, but they are definitely not "gifts" in the eyes of the ever-vigilant IRS. Tips received by any employee are taxable income and are treated as employer-provided wages for withholding tax purposes.

In 2002, the Supreme Court ruled in United States v. Fior D'Italia, Inc. that the IRS may determine (on an aggregate basis) and assess against the employer the Federal Insurance Contribution Act (FICA) tax on tips that employees did not report to the employer. In response to that ruling, U.S. Rep. Wally Herger introduced a bill last year that would prevent the IRS from estimating tip income for tax collection purposes. That bill now has 21 sponsors but remains in limbo.

The Current Law
Cash tips paid directly to an employee by a customer as well as tips paid over to the employee for charge customers must be accounted for by the employee in a written statement. What's more, that written statement must be furnished to the employer on or before the 10th day of the month following the month when the tips are received. The employee reports the tips on Form 4070, "Employee's Report of Tips to Employer" or on a similar statement.These tips are subject to withholding. The only tips that the employer must report on Form W-2, however, are those that the employee reports.

Large food and beverage establishments (defined as those with more than 10 employees on a typical business day and in which tipping is customary) are required to inform the government about tip income reported to them by their employees. They must file annual information returns (Form 8027). These returns report gross food and beverage sales receipts, employee-reported tip income, total charge receipts and total charge tips.

To ensure that it gets its share, the government has decided that eight percent of a restaurant's gross receipts is a fair percentage to allocate to tips. If it can be shown that average tips are not eight percent of gross sales, the employer or a majority of its employees may apply to the IRS to have the allocation reduced below eight percent but not to below two percent.

Large employers must allocate among their employees who customarily receive tips an amount equal to the excess of eight percent of gross receipts over reported tips. This allocation is not required if employees voluntarily report total tips equalling at least eight percent of gross sales.

Tip Agreements
In 1993, the IRS introduced its Tip Rate Determination/ Education Program (TRD/EP), designed to enhance tax compliance among tipped employees using education and voluntary advance agreements instead of relying on traditional audit techniques. The TRD/EP allows employers to enter into one of two types of agreements: the Tip Rate Determination Agreement (TRDA) or the Tip-Reporting Alternative Commitment (TRAC).

The TRDA requires that employees have a Tipped Employee Participation Agreement (TEPA) with the employer. With a TRDA, the IRS works with the establishment to arrive at a tip rate for the various restaurant occupations. At least 75 percent of employees must sign the TEPA and report tips received at or above the rate determined to be appropriate for that occupation. Under TRDA, if employees fail to report tips received at or above that predetermined rate, the employer is required to provide the IRS with the names of those employees, their social security numbers, job classification, sales, hours worked and amount of tips reported.

The TRAC alternative does not require the employer to establish tip rates, nor does it require employee participation agreements. In this program, the employer agrees to institute and maintain a quarterly education program for all directly and indirectly tipped employees. The employer must also agree to establish formal tip reporting procedures as outlined by the IRS. Employers assume responsibility for having their employees report tips, and the IRS agrees not to assess the business employment taxes on unreported tips unless the employees are audited first. This method is available for food and beverage employees only.

In 2000, the IRS introduced a modified version of the TRAC, the Employer-Designed Tip Reporting Alternative Commitment (EmTRAC), available only to employers in the food and beverage industry that have employees who receive both cash and charged tips. EmTRAC retains many of the provsions contained in the TRAC agreement. The employer must, for instance, establish an educational program to explain how the law requires employees to report all their cash and charged tips to their employer. The educational program must be furnished to newly hired employees and repeated each quarter for existing employees. The EmTRAC program provides an employer with significant latitude in designing an educational program and tip reporting procedures.

The Court Decision
On June 17, 2002, the Supreme Court ruled that the IRS may legitimately determine (on an aggregate basis) and assess against the employer the FICA tax on tips that the employee did not report to the employer. In essence, the Supreme Court case reaffirmed the IRS's authority to assess employer FICA taxes on unreported tip income without having to audit the individual employee.

The restaurant in the case argued that the IRS was not authorized to use this method of aggregate estimating; instead, the restaurant argued that the IRS was required to develop individual estimates for each employee's tip income to calculate the total FICA liability of the employer. The Supreme Court, however, decided that the IRS was clearly authorized to estimate FICA tax liability and found that the restaurant failed to show that the method the IRS used to estimate such liability was unreasonable.

Current law provides a unique tax credit equal to an employer's FICA tax obligation (7.65 percent) attributable to certain tips treated as paid by the employer for FICA tax purposes (regardless of whether the tips are reported). The credit is available only on "tips received from customers in connection with the providing, delivering or serving of food or beverages for consumption if the tipping of employees receiving such tips is customary."

Employers use Form 8846 to claim the Section 45B credit. 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.

The credit is available whether the tips were reported to the employer or not. Thus, it is available for employer FICA tax paid under an IRS assessment.

Because it is a general business tax credit, it is claimed on the income tax return to offset any income tax liability—but not employment tax liability. Naturally, the deduction for FICA taxes must be reduced by the amount of this credit.

In the wake of the Supreme Court's decision that allowed employers to be held liable for the payroll taxes due on employees' unreported tip income, several bills have been introduced in Congress. H.R. 2034 prohibits the Secretary of the Treasury from issuing a notice and demand to an employer for FICA taxes with respect to tips received by an employee until the amount of tips has been resolved.

Another proposed bill, H.R. 118, would require the Internal Revenue Code to be applied, ignoring the Supreme Court's decision in United States v. Fior D'Italia Inc.

Although the tax laws and even the IRS's own policy manuals prohibit the threat of an audit to coerce taxpayers into signing a tip reporting agreement, participation is motivated because of the audit protection these agreements provide.

Obviously, the IRS does not have the resources to audit the thousands of tipped employees who fail to report all of their tip income. Now the IRS has the Fior d'Italia decision allowing it to go after the employers of those tipped employees—unless legislation emerges to prevent that.