IRS Issues Guidance on Unreported Tip Income from "Tip Boxes"

(Parker Tax Publishing May 2018)

The Office of Chief Counsel advised that cash amounts distributed to individuals from "tip boxes" are properly classified as tips under the rules of Rev. Rul. 2012-18 and are wages subject to FICA tax. In addition, the cash amounts distributed to individuals from "tip boxes" are subject to notice and demand procedures under Code Sec. 3121(q). CCA 201816010.

Background

In CCA 201816010, the Office of Chief Counsel was asked about the tax treatment of cash distributed from a "tip box." The scenario presented involved a taxpayer who engages individuals to perform services at the taxpayer's request and on the taxpayer's premises. The taxpayer treats the individuals as volunteers and does not directly pay the individuals any form of compensation or benefits for their services. The taxpayer acknowledged, however, that the individuals receive cash payments from amounts contributed by customers. The cash amounts are deposited by customers in "tip boxes" placed by the taxpayer in the vicinity of where the individuals perform services.

The taxpayer places the "tip boxes" to encourage customers to contribute cash amounts to the individuals, but does not require customers to make cash contributions. Customers have discretion on how much cash to contribute (including zero contribution).

The amount of cash in the "tip boxes" is distributed at the end of each shift. Individuals who performed services during a shift determine how to allocate the tip box amount between all of the individuals who performed services during that shift. Although the taxpayer is aware that customers place cash in the "tip boxes" and that the individuals working each shift distribute the cash among themselves, the taxpayer does not have a system in place for individuals to provide written statements reporting the cash amounts received to the taxpayer, and there is no evidence that the taxpayer has knowledge of the specific amount of cash received by each individual. The taxpayer does not issue Forms W-2, Wage and Tax Statement, to the individuals and has not included any wages or taxes in connection with their services on Form 941, Employer's QUARTERLY Federal Tax Return.

During the course of an audit, the IRS determined that the taxpayer has the right to direct and control the individuals as they perform services and that the individuals should be classified as employees of the taxpayer for purposes of FICA taxes. In addition to its worker classification determination, the IRS proposed a FICA tax liability related solely to the unreported cash amount received by the individuals. The IRS issued a Letter 3523 to the taxpayer at the conclusion of the audit, notifying the taxpayer of its worker classification determination.

The IRS asked the Office of Chief Counsel whether the cash amounts are "tips" subject to notice and demand procedures under Code Sec. 3121(q) or whether tax on the tip box amounts should be included in Table 3 of Letter 3523, which lists the proper amount of employment tax, additions to tax, and penalties with respect to payments made to individuals who are being reclassified as employees.

Analysis

Code Sec. 3102(a) requires employers to deduct from wages and pay over the employee portion of the FICA tax. However, Code Sec. 3102(c)(1) provides a special rule applicable to tips. The employer's obligation to deduct employee FICA tax from tips which constitute wages is applicable only to such tips as are included in a written statement furnished by the employee to the employer pursuant to Code Sec. 6053(a), and only to the extent that collection can be made by the employer by deducting the amount of the tax from wages of the employee (excluding tips) as are under control of the employer, or from other funds made available by the employee for this purpose.

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 portion of the FICA taxes imposed by Code Sec. 3111(a) and (b)). For purposes of determining the timing of the employer's FICA tax liability, the remuneration is deemed to be paid when a written statement including the tips is furnished to the employer by the employee pursuant to Code Sec. 6053(a). However, if the employee does not furnish the statement, or if the statement furnished is inaccurate or incomplete, the remuneration is deemed to be paid on the date on which the IRS issues a notice and demand under Code Sec. 3121(q) for the taxes to the employer.

Tips are not defined in the Code or regulations; however, published guidance addresses how to determine whether a payment is a tip. Rev. Rul. 2012-18 reaffirms the factors first stated in Rev. Rul. 59-252 which are used to determine whether payments constitute tips. 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:

(1) payment must be made free from compulsion;

(2) the customer must have the unrestricted right to determine the amount;

(3) the payment should not be the subject of negotiation or dictated by employer policy; and

(4) generally, the customer has the right to determine who receives the payment.

The Office of Chief Counsel advised that, under the facts presented, the four factors set forth in Rev. Rul. 2012-18 are satisfied. The fact that the cash contributions are collected by the individuals who work during the shift and pooled for purposes of distribution among them satisfies the fourth factor, the Chief Counsel's Office said. The customers generally have the right to determine who receives the payment when the tipped amounts are pooled and the individuals working each shift distribute the cash among themselves.

According to the Chief Counsel's Office, once the amounts have been properly identified and characterized as tips, the timing of the FICA rules for employer tax liability purposes are applied. Because the tips have not been reported to the taxpayer under Code Sec. 6053(a), the Chief Counsel's Office said, they are deemed to be paid on the date on which the IRS issues a notice and demand under Code Sec. 3121(q) for the taxes to the taxpayer. Thus, the tips are not subject to the employer share of FICA tax until the IRS issues a notice and demand under section 3121(q).

The Chief Counsel's Office concluded that the IRS should issue Letter 3523 to the taxpayer based on the worker classification determination, and should identify in Table 1 of Letter 3523 the individuals the IRS determined should be reclassified as employees. However, tax on the cash amounts received by the individuals should not be included in Table 3 of Letter 3523 because the tips are deemed paid only after the IRS issues a notice and demand under Code Sec. 3121(q). According to the Chief Counsel's Office, the only issue that would be subject to Tax Court jurisdiction would be the proper worker classification of the individuals listed in Table 1.

The Chief Counsel's Office noted that, if an amount properly characterized by an employer as a tip was reported by the employee to the employer in accordance with Code Sec. 6053(a), it would be deemed to be paid at the time the written statement was made and tax on the amount should be included in Table 3 at the time Letter 3523 was issued. Similarly, if an amount characterized by an employer as a tip was determined not to be a tip (for example, it was a service charge) tax on the amount should be included in Table 3 at the time Letter 3523 was issued.

For a discussion of the payroll tax treatment of tips by an employer, see Parker Tax ¶124,120.

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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