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IRS Issues New Guidance and Audit Procedures on FICA Taxes on Tips (Plus Client Letter)
(Parker's Federal Tax Bulletin: June 06, 2012)
SUMMARY: IRS issues guidance on FICA taxes on tips and provides administrative guidelines to examiners auditing a business where tipping is customary and/or where a business adds service charges to customers' bills, and then distributes the service charges to employees
For practitioners with clients in service industries, a recent IRS ruling and announcement provide updated guidance relating to tips and service charges. In Rev. Rul. 2012-18 and Announcement 2012-25, the IRS clarifies and updates guidance on FICA taxes on tips and provides administrative guidelines to examiners auditing a business where tipping is customary and/or where a business adds service charges to customers' bills, and then distributes the service charges to employees. Services charges are properly characterized as regular (i.e., non-tip) wages and not as tips, and thus are not subject to the special reporting rules that apply to tips. The ruling states, for example, that if a restaurant adds an 18 percent gratuity to a check for a table of six or more, that amount is a service charge and not a tip. As a result, some businesses that have been treating such amounts as tips may have to change automated or manual reporting systems in order to comply with the proper treatment of service charges.
Practice Aid: See ¶320,697 for a client letter on service charge reporting.
In addition, in a separate memorandum, the IRS said it is considering significant changes to the Tip Reporting Alternative Commitment (TRAC) program and other variations of TRAC agreements.
Background
Code Secs. 3101 and 3111 impose FICA taxes on employees and employers, respectively, equal to a percentage of the wages received by an individual with respect to employment. FICA taxes consist of two separate taxes, the Old Age, Survivors, and Disability Insurance (social security) tax and the Hospital Insurance (Medicare) tax. The amount of wages subject to social security tax is limited by an annual contribution and benefit base; however, all wages are subject to Medicare tax.
Code Sec. 3121(a) defines wages for FICA tax purposes as all remuneration for employment, with certain exceptions. Subject to certain exceptions (e.g., noncash tips and tips under $20 in a month), tips are considered wages.
Employer FICA Obligations
Under Code Sec. 3121(q), tips received by an employee in the course of the employee's employment are considered remuneration for that employment and are deemed to have been paid by the employer for purposes of the employer share of FICA taxes imposed by Code Sec. 3111(a) and (b) that is, social security tax and Medicare tax, respectively. The tip amount is deemed to be paid when the employee gives the employer a written statement reporting the tips.
The employer is required to pay social security tax on the amount of cash tips received by the employee up to and including the contribution and benefit base and to pay Medicare tax on the total amount of cash tips received by the employee. However, if the employee either did not furnish the statement under Code Sec. 6053(a) or if the statement furnished was inaccurate or incomplete, then, in determining the employer's liability for FICA taxes with respect to the tips, Code Sec. 3121(q) provides that the remuneration is deemed to be paid on the date on which the IRS sends the employer a notice and demand for the taxes.
Employee FICA Obligations
Under Code Sec. 3121(q), for purposes of the employee share of FICA taxes, tips that are properly reported to the employer under Code Sec. 6053(a) are deemed to be paid at the time a written statement is furnished to the employer. Unreported tips received by the employee are deemed to be paid to the employee when actually received by the employee.
Code Sec. 6053(a) requires every employee who, in the course of the employee's employment by an employer, receives in any calendar month tips that constitute wages (as defined in section 3121(a) for FICA tax purposes or Code Sec. 3401(a) for federal income tax withholding purposes) to report all those tips in one or more written statements furnished to the employer on or before the 10th day of the following month. The employee is to furnish the statements in the form and manner prescribed by the IRS.
Credit for Employer Share of FICA Taxes Paid on Tips
Code Sec. 45B(a) provides that, for purposes of the general business credit, the credit for employer social security and Medicare taxes paid on certain employee tips is an amount equal to the "excess employer social security tax" paid or incurred by the employer. The term "excess employer social security tax" means any tax paid by an employer under Code Sec. 3111 (both social security tax and Medicare tax) on its employees' tip income without regard to whether the employees reported the tips to the employer pursuant to Code Sec. 6053(a). Consequently, the Code Sec. 45B credit is available with respect to unreported tips in an amount equal to the "excess employer social security tax" paid or incurred by the employer. No credit, however, is allowed to the extent tips are used to meet the federal minimum wage rate. The credit is available with respect to FICA taxes paid on tips received from customers in connection with the providing, delivering, or serving of food or beverages for consumption, if it is customary for customers to tip the employees.
New Guidance Relating to Service Charges
In Rev. Rul. 2012-18, the IRS states that an employer's characterization of a payment as a tip is not determinative. For example, an employer may characterize a payment as a tip, when in fact the payment is a service charge. The IRS is advising examining agents to apply the criteria of Rev. Rul. 59-252 to determine whether a payment made in the course of employment is a tip or non-tip wages. Rev. Rul. 2012-18 provides that the absence of any of the following factors creates a doubt as to whether a payment is a tip and indicates that the payment may be a service charge:
(1) the payment is made free from compulsion;
(2) the customer has the unrestricted right to determine the amount;
(3) the payment is not the subject of negotiation or dictated by employer policy; and
(4) generally, the customer has the right to determine who receives the payment.
According to the IRS, all of the surrounding facts and circumstances must be considered. For example, Rev. Rul. 59-252 holds that the payment of a fixed charge imposed by a banquet hall that is distributed to the employees who render services (e.g., waiter, busser, and bartender) is a service charge and not a tip. Thus, to the extent any portion of a service charge paid by a customer is distributed to an employee, it is wages for FICA tax purposes.
Example: Grapeseed Restaurant's menu specifies that an 18 percent charge will be added to all bills for parties of six or more customers. Dave's bill for food and beverages for his party of eight includes an amount on the tip line equal to 18 percent of the price for food and beverages and the total includes this amount. Grapeseed distributes this amount to the waitresses and bussers. Under these circumstances, Dave did not have the unrestricted right to determine the amount of the payment because it was dictated by employer policy. Also, Dave did not make the payment free from compulsion. The 18 percent is not a tip. The amount included on the tip line is a service charge dictated by Grapeseed.
Tips that Must Be Reported to Employers
All cash tips received by an employee are wages for FICA tax purposes and, therefore, must be reported to the employer, unless the cash tips received by the employee during a single calendar month while working for the employer total less than $20. For these purposes, cash tips include tips received from customers, charged tips (e.g., credit and debit card charges) distributed to the employee by his or her employer, and tips received from other employees under any tip-sharing arrangement. Thus, both directly and indirectly tipped employees must report tips received to their employer. Non-cash tips (i.e., tips received by an employee in any other medium than cash, such as passes, tickets, or other goods or commodities) from customers are not wages for FICA tax purposes and are not reported by the employee to the employer. However, all cash tips and non-cash tips are includible in an employee's gross income and subject to federal income taxes.
The IRS notes that an employee is required to give the employer a written statement (or statements) of cash tips by the 10th day of the month after the month in which the tips are received. Form 4070, Employee's Report of Tips to Employer, is used for this purpose.
Unreported Tips
If an employee fails to report tips to his or her employer, the employee is liable for the employee share of FICA taxes on the unreported tips. The employee pays his or her share of FICA taxes by completing Form 4137, Social Security and Medicare Tax on Unreported Tip Income, and filing it with Form 1040 (or other applicable return in the Form 1040 series) for the year in which the tips are actually received by the employee.
With respect to computing the employee's FICA tax liability on unreported tips, the IRS provides that the social security and Medicare rates and the social security contribution and benefit base applicable to the calendar year in which the tips were actually received apply. Form 4137 includes the applicable social security and Medicare rates and social security contribution and benefit base. The employer is not liable to withhold and pay the employee share of FICA taxes on the unreported tips.
An employee who fails to report tips required to be reported to an employer is subject to a penalty equal to 50 percent of the employee share of FICA taxes on those tips, unless the employee can provide a satisfactory explanation showing that the failure was due to reasonable cause and not due to willful neglect. The explanation must be made in the form of a written statement setting forth all the facts alleged as a reasonable cause. This statement can be attached to the employee's Form 1040 (See Form 4137). If the statement is submitted in response to a notice regarding a proposed penalty assessment, the statement must contain a declaration that it is made under the penalties of perjury.
With respect to the employer, Rev. Rul. 2012-18 notes that if an employee fails to report tips to his or her employer, the employer is not liable for the employer share of FICA taxes on the unreported tips until notice and demand for the taxes is made to the employer by the IRS. The employer is not liable to withhold and pay the employee share of FICA taxes on the unreported tips.
The notice and demand is made under Code Sec. 3121(q). However, there is no specific form or procedure prescribed for a Code Sec. 3121(q) notice and demand. According to the IRS, notice and demand is made by the IRS when it advises the employer in writing of the amount of tips received by an employee (or employees) who failed to report or underreported tips to the employer. Although no specific form is prescribed, the IRS states that a document will constitute a Code Sec. 3121(q) notice and demand if it (1) includes the words "notice and demand" and "section 3121(q), (2) states the amount of tips received by the employee (or employees), and (3) states the period to which the tips relate. However, a document including such information will not constitute a Code Sec. 3121(q) notice and demand if it states that it is not a notice and demand.
Client Letter: FICA Tax on Service Charges
Dear [client name]:
As a taxpayer in business where tipping is customary, you should be aware that the IRS has updated its guidance on FICA taxes on tips and service charges.
The IRS has clarified that the characterization of a payment as a "tip" by the employer is not determinative. For example, an employer may characterize a payment as a tip, when in fact the payment is a service charge. According to the IRS, that the absence of any of the following factors indicates that the payment may be a service charge:
(1) the payment is made by the customer free from compulsion;
(2) the customer has the unrestricted right to determine the amount;
(3) the payment is not the subject of negotiation or dictated by employer policy; and
(4) generally, the customer has the right to determine who receives the payment.
According to the IRS, all the surrounding facts and circumstances must be considered. For example, the payment of a fixed charge imposed by a banquet hall that is distributed to the employees who render services (e.g., waiter, busser, and bartender) is a service charge and not a tip. Thus, to the extent any portion of a service charge paid by a customer is distributed to an employee, it is regular, non-tip wages for FICA tax purposes, and is not subject to the special reporting and payment rules that apply to tips. Businesses that have been treating such amounts as tips may have to change automated or manual reporting systems in order to comply with the proper treatment of service charges.
Please call me at your convenience so that we can examine in greater detail the proper FICA tax treatment of the various amounts paid to your employees.
Sincerely,
[Your Name, Your Firm]
Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.
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