Employer's burden: reporting tax on tip income.by Zanon, Steven
Tip income has been scrutinized more than ever during the past five years. The IRS estimates that 84% of tip income, approximately $500 million each year, is never reported. TEFRA 82 was designed to provide for reporting of tips by employees of food and beverage establishments.
Tips are included under the definition of wages and considered taxable under Secs. 3121(a) and 3401(a). The IRS states that lost tax revenue from tip income ranks second to the revenue lost on illegal activities.
TIP VERSUS SERVICE CHARGE
A clear distinction should be made between a tip and a service charge, as there is a significant difference in an employer's reporting requirements for each.
A tip is a gratuity payment made by a customer to a waiter or waitress. The customer has the right to determine the amount given and is free from compulsion. The absence of any of these factors creates a doubt to whether the payment is a tip or a service charge.
A service charge is an amount added to a customer's check by management. IRS regulations state that a service charge is considered a part of the enterprise's gross receipts. In the case of catered affairs and banquets, the amount so charged is agreed upon in advance by the customer and management. Because the service charge is considered a part of gross recipts, many state tax authorities have argued that it should be subject to a sales tax. However, a discussion of that issue is beyond the scope of this article.
OBRA 87 requires that, effective January 1, 1988, the full amount of an employee's tips are subject to FICA tax for both employers and employees with a top limit that usually increases each year. Beginning in 1991, the wages for the two parts of the FICA tax, (social security and medicare), are different. Employers can no longer combine and report the withholding as a single amount. Forms 941 and W-2 will require employers to separately report these amounts. This tax is to be paid from deductions from wages, exclusive of tips under the control of the employer or from funds received from the employee for making the payment. A discussion and example of priority of the application of taxes withheld is presented in the tax withholding section of this article.
An employee must maintain sufficient evidence to establish the amount of tip income received in a tax year. Such records should include:
* Tips received directly from customers and other employees;
* Tips received on credit card receipts;
* Tips paid out to other employees; and
* Names of employees to whom tips were paid.
A daily record on IRS Form 4070A, Employee's Daily Record of Tips, or other credible or reliable evidence is usually sufficient. However, these will not constitute sufficient evidence if there are facts and circumstances indicating that an employee received a larger amount of tip income.
Each employee who receives tips amounting to $20 or more in any calendar month, considered wages under Sec. 3121(a), shall report all such tips in a written statement to the employer on or before the tenth day following the end of the month. This statement should include:
* Employee's name, address, and social security number;
* Employer name and address;
* Period covered by the statement;
* Signature of employee and date submitted; and
* Total amount of tips received.
Tips that a taxpayer must report to his or her employer are considered to be received at the time the employee furnishes the written report to the employer Sec. 451(c).
In determining the employer's liability for the FICA taxes where no statement of tips was furnished by an employee or where the statement was inaccurate or incomplete, tips will be deemed to be paid by the employer on the date on which notice and demand for tax is made to the employer by the IRS. Form 4070, Employee's Report of Tips to Employer, may be used to report the total tips on a monthly or other period to the employer.
The burden of reporting is the responsibility of both employee and employer. The type and form in which the tip is received controls who is responsible. For example, if a tip is received directly by the employee in cash, the employee must report the amount to the employer; if a tip is received by charge to a credit card, the employer is responsible for reporting this income in addition to amounts reported by the employee.
The monthly reporting of tip income by the employer is due by the tenth day of the month following the month in which the tip income was received, under Secs. 6053(a) and 3121(a) or 3231(e), unless reasonable cause is shown. Penalties for failure to report are severe; the employee shall pay an amount equal to 50% of the tax due, in addition to the tax imposed by Sec. 3101 or 3201, with respect to the amount of tips not reported.
Employers should notify employees that all tips are taxable income and that the reporting obligation of the employee is mandatory. In addition, the employee should be made aware of the severe penalties if the report is not furnished on a timely basis. An employer must keep records sufficient to substantiate any information returns, employer statements to employees, or tip allocations for a period of three years after due date of the respective return or statement to which they pertain.
Sec. 6053.3 requires that Form 8027, Employer's Annual Information Return of Tip Income and Allocated Tips, be filed by every large food or beverage establishment (defined in a subsequent paragraph) for each calendar year. Establishments filing more than one Form 8027 must include the transmittal Form 8027T with the return. These returns are due on or before the last day of February following the end of the calendar year and require:
* Employer's name, address, and tax identification number;
* Establishment's name, address, and identification number;
* Aggregate gross receipts of the establishment from the sale of food and beverage, exclusive of nonallocable receipts.
* Aggregate amount of charge receipts on which there were charged tips, exclusive of nonallocable receipts.
* Aggregate amount of charged tips shown on charge receipts;
* Aggregate amount of tips actually received by employees and reported to employer; and
* Name and social security number of each employee to whom an allocation of tips was made.
ALLOCATION OF TIP INCOME
The minimum aggregate amount the employer is required to report as tip income of employees generally is 8% of food and beverage receipts. If the aggregate amount of tips reported for any payroll period or calendar year is less than 8%, employers who qualify as large establishments must allocate the difference among tipped employees on either a "good faith" agreement, or on the allocation methods prescribed in Sec. 6053.3. See Exhibit 1 for an example illustrating the allocation of tip income.
A good faith agreement is a written agreement between the employer and at least two-thirds of the tipped employees of each occupational category (i.e., busboys and waiters). Such agreements describe the manner in which any allocated tips are to be attributed to employees. If a good faith agreement allocation is used, a copy must be attached to Form 8027.
However, the 8% allocation requirement can be reduced by filing a petition with the IRS District Director. The petition may be filed by the employer or a majority of the employees and indicate the actual amount of tips received to determine the perecentage of the establishment's gross receipts to be deemed as tips. The percentage
may not be reduced below 2% of gross receipts.
Studies have indicated that most patrons tip between 10% and 20% of food and beverage total. Congress has allowed for customers dissatisfied with the serviceprovided, who may tip less than customary, and for those who may not tip at all, to arrive at the 8% average.
Generally, employees are also paid an hourly wage in addition to their tips. Employers are permitted to take a 45% tip credit into account in paying the minimum wage. On April 1, 1991, the credit will be increased to 50%; under current law, the minimum wage is $3.80 per hour.
LARGE FOOD OR BEVERAGE
A large food or beverage establishment is defined as any trade or business that provides food or beverages, with respect to which tipping by customers of employees serving food or beverages is customary, and which during the preceding calendar year normally employed more than 10 employees or equivalent (80 employee hours) on a typical business day, exclusive of 50% or more shareholders.
In general, the employer of a large food or beverage establishment shall, during any payroll period, allocate among serving employees who customarily receive tip income, an amount equal to the excess of:
* 8% of gross receipts of such establishment for the payroll period, other than nonallocable receipts such as carryout sales or services to which a service charge of 10% or more is added, over;
* The aggregate amount reported by such employees to the employer for such period.
TAX WITHHOLDING ON TIP
As noted, tips received by an employee are considered wages and are subject to federal income tax withholding. Non-cash tips (i.e., tickets and other goods) and tips of less than $20 in any calendar month are excluded and not subject to withholding taxes.
An employer is responsible for remitting tax to the IRS on reported tips only to the extent sufficient wages of the employee are under the employer's control from which to deduct the tax, or funds are received from the employee for paying the deduction. Form 941, Employer's Quarterly Federal Tax Return, is used by an employer to report to the IRS the total amount both of wages and tips and of taxes withheld.
PRIORITIES FOR COLLECTING
TIP TAX FROM WAGES
Withholdings from wages under the employer's control are to be aplied toward previously uncollected federal income taxes on tip income in the following order:
1. Employee's portion of FICA on wage payments;
2. Federal Income tax to be withheld from wage payments;
3. Employee's portion of FICA tax on tip income;
4. Federal income tax to be withheld from tip income;
See Exhibit 2 for an example of this application.
Employers must furnish their employees with a statement indicating the amount of FICA tax due on allocated tips that exceeds the amount the employer was able to withhold. The excess must be reported on Form W-2 and the employee must report the income on his or her individual income tax return (Form 1040) and pay the uncollected tax (both income tax and FICA), even if he or she would not otherwise be required to file a return.
Employers are not required to withhold income and FICA taxes on tips that are allocated. Employers are required to withhold only on tips that are reported by their employees. Allocated tip income is shown on Form W-2 as a separate item.
The IRS now considers the employer responsible for informing employees on what their tip income should be as well as any uncollected tax on tip income. The IRS has determined that the burden of reporting must be on the employer to achieve success in collecting taxes on tip income.
One diffuculty in this area is that the standard 8% rate is used for minimum tip reporting and allocation. In practice, the IRS adjusts these rates according to local statistics and demographics. Practitioners should be alert to the reporting requirements so that clients may be aware of potential liabilities.
Enforcement of these guidelines for reporting of tip income is difficult without the absolute cooperation of employers. The burden of reporting responsibility and control has shifted more towards the employer under present regulations. Every employer must be aware of the difference between tip income and a service charge, and the reporting requirements to the IRS and to employees.
Kadir R. Karabay, CPA, is a Partner of Karabay and Tempesta, New York, NY. Mr. Karabay is a member of the AICPA, NYSSCPA, and Committees on Hotel, Club, and Restaurant Accounting and on Closely Held and S Corporations.
Steven Zanon, CPA, is a Manager in the accounting and business advisory services department of Laventhol & Horwath. Mr. Zanon is a member of the AICPA, NYSSCPA, and the Committee on Hotel, Club, and Restaurant Accounting.
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