Understanding IRS Guidelines on Tip Reporting
Explore the history of tax rules on tip income and delve into the new IRS guidance regarding tips versus service charges. Learn about the distinctions, employer responsibilities, and the impact on FICA taxes and Federal income tax withholding. Gain insights into key factors that differentiate tips from service charges.
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Tip Reporting Update What You Need to Know About New IRS Guidelines Mary Burke Baker, K&L Gates LLP Marianna Dyson, Miller & Chevalier Chartered October 16, 2012
Topics Brief history of tax rules on tip income What does the new IRS guidance say? Why did the IRS issue new guidance? What does the new IRS guidance really mean? How does the new IRS guidance affect the employer? What should the employer be doing about it? 3
Tips v. Service Charges - History 4
Distinction Between Tips and Service Charges Tips reported to employer are subject to FICA taxes and Federal income tax withholding (FITW) if sufficient regular wages from which to withhold Employer must pay its share of FICA taxes Employer reports underwithheld FICA taxes and FITW on employee s Form W-2, not secondarily liable Service charge is a regular wage subject to FICA taxation and FITW Employer remains secondarily liable for failing to withhold! 5
Tips v. Service Charges - History 1957: Gratuity amount required by union contract, distributed by hotel to waiter WAGES 1959: Amount negotiated by customer with hotel to use dining facilities WAGES SIGNIFICANT: Four factors to distinguish tips from service charges 1) Customer free from compulsion 2) Customer determines amount 3) Amount not subject to negotiation or employer policy 4) Customer decides who receives the amount 6
Tips v. Service Charges - History 1964: Voluntary payments for services are compensation, not gifts 1966: I.R.C. 3121(q) enacted, deeming tips to be remuneration paid by employer and subject to employer FICA tax 1969 & 1995: IRS guidance explaining the rules 2012: Rev. Rul. 2012-18; Ann. 2012-25 7
What Does the New IRS Guidance Say?
Rev. Rul. 2012-18 Covers 3121(q) notice and demand procedures, Form 941 reporting of tips and 45B FICA tax tip credit Technically, not much new--same Q&A format as Rev. Rul. 95-7 Clarifies calling a payment a tip is not determinative of treatment Clarifies credit and debit card payments are treated as cash wages for purposes of triggering FICA taxation, as are shared tips Clarifies section 45B tip credit available in year of notice and demand, not year employee received unreported tips Reaffirms the 4 factors from 1959 to test whether gratuity is a tip or service charge 9
Rev. Rul. 2012-18 Repeats previous guidance of Rev. Rul. 95-7 Reporting in writing to employer by 10th day of month Employer withholds from wages of employee, reports on Form 941; uncollected employee FICA taxes reported on W-2 Employee files Form 4137 to pay FICA taxes on unreported tips; subject to penalty unless reasonable cause Employer not liable for FICA taxes on unreported tips until receipt of 3121(q) notice and demand No formal notice and demand forms or procedures; must mention notice and demand ; 3121(q) ; state amount of tip income and tax period 10
New Q&A 1 of Rev. Rul. 2012-18 Example A: Menu specifies that 18% will be added (unclear whether convenience of the customer language on menu would be viewed as specifying a service charge Amount is included on the tip line of the bill in the amount specified by the menu The gratuity is included in the total, i.e., the system or the server totals the bill Conclusion Service charge subject to FICA taxes and FITW 11
New Q&A 1 of Rev. Rul. 2012-18 Example B: Sample calculation of tip rates (15%, 18% and 20%) beneath signature line on charge receipt Tip line is left blank Customer selects the amount, inserts it on the time line and totals the bill Conclusion -- Tip 12
Announcement 2012-25 Provides interim guidance to IRS examiners on how to apply Rev. Rul. 2012-18 when auditing tip and service charge income Renewed focus on characterization of tips and service charges Examiners must note in workpapers that service charges are not included in tip rate computations 13
Announcement 2012-25 General rule: Effective immediately and retroactively Allows prospective (beginning January 1, 2013) treatment under very limited facts and circumstances Were facts and circumstances directly addressed in prior guidance? Does business need additional time to change business practices and make system changes? All prospective changes must be approved 14
Announcement 2012-25 Existing voluntary tip (e.g., TRAC) agreements are not voided BUT, IRS may contact businesses with a tip agreement to conduct a tip rate review If service charges were treated as tips by employer, the agreement will be modified This review will not be considered an audit 15
Announcement 2012-25 Also warns taxpayers the IRS is considering changes to existing TRAC and similar agreements IRS wants to update voluntary tip agreements to rely less on employee reporting and more on POS data and credit/debit card settlement information Public comments by September 24, 2012 16
Why Did the IRS Issue New Guidance?
Rev. Rul. 2012-18 Stated reason: clarify and update previous guidance FICA taxes on tips 3121(q) notice and demand procedures Practical reason: put taxpayers on notice that IRS plans to intensify enforcement of payroll tax treatment of gratuities to determine whether service charges are being treated as tips POS technology Credit card information reporting Less reliance on TRAC, other agreements 18
What Does the New IRS Guidance Really Mean?
Expanded Tip Examinations by IRS In addition to auditing to determine whether tips were underreported, IRS will examine gratuity practices (e.g., banquets, large parties, and other auto-gratuity settings) If gratuities previously treated as tips are retroactively recharacterized as service charges (i.e., wages), employer will be liable for any underwithheld employee FICA taxes and for failing to withhold income taxes at 25% Payroll tax assessment could be applied to all open years 20
Tip Examination by IRS (contd) The TRAC agreement only applies to tip reporting does not protect against recharacterization of tips as service charges Recharacterization of tips as service charges will affect 45B credit calculation 21
Changes to Payroll Treatment Service charges are regular wages that must be counted for: Benefit contributions (e.g., 401K, health care) Minimum wage calculations Overtime calculations Determining whether regular wages are sufficient for purposes of withholding payroll taxes on tips Service charges do not qualify for 45B credit State sales tax implications 22
How Does the New IRS Guidance Affect the Employer?
Secondary Liability for Payroll Taxes Because service charges are wages, employer must withhold FICA taxes and FITW before cashing out these amounts Employer must handle tip out distribution of service charges to indirectly tipped employees (and include those amounts as wages in payroll, and withhold payroll taxes) Employer must report service charges as wages on Forms W-2 24
Procedural and System Changes Revisions to POS system Changes to tip out policies Effect on tip reporting rates Evaluation of auto-gratuities, such as: Large parties Bottle service charges Mandate delivery charges (e.g., pizza or other deliveries) Room service charges and contracted luggage assistance changes (hotels) 25
What Should the Employer Be Doing?
Next Steps Review auto-gratuity practices to determine whether treatment as tips would be challenged, in the event of a payroll tax audit Banquets, large parties, menu language Establish a team with Operations, Legal, IT, Accounting, Payroll, Tax, Finance, etc., personnel to evaluate auto-gratuity and tip reporting practices and to determine any needed changes to treatment 27
Next Steps (contd) Customize electronic point-of-sale system to properly code the treatment of the gratuity (i.e., tip or service charge) at the time of sale and to integrate the data with payroll software to ensure proper payroll tax treatment, including reporting on Forms 941 and 8027 Educate both managers and employees of any changes to characterization of gratuities and related procedural/system changes 28
Contact Information Marianna Dyson Miller & Chevalier Chartered (202) 626-5867 mdyson@milchev.com Mary Burke Baker K&L Gates LLP (202) 778-9223 mary.baker@klgates.com 29
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