Tip Income – Employer Responsibilities


The Internal Revenue Service is acutely aware of the volume of tip income generated in the United States. Therefore they are shifting the compliance aspect of this income onto employers. This is a direct result of our government’s need for more revenues including Social Security and Medicare taxes.

Given this, how is the government monitoring tip income and employer responsibilities associated with that tip income? Secondly, how is the compliance element of tip income addressed? Finally, what exactly does the employer do to get in compliance and maintain good status with the IRS?

Federal Monitoring

The IRS uses a program called ‘Market Segment Specialization’ to gauge the volume of sales in the bar and restaurant industry. Based on this information and a code entered on your business’s tax return alerts them to the fact that you operate a bar or restaurant business. 

With the tax return’s information and using an audit technique guide to calculate the total estimated amount of tips paid to employees, the restaurant’s employment taxes that should be paid is calculated. If the amount calculated and the amounts paid are not within a reasonable amount, the IRS determines the employer is underpaying the taxes and therefore will fine the restaurant for the difference.

There was a famous case that made it to the Supreme Court related to a restaurant’s failure to pay adequate taxes.  In Fior D’Italia, Inc. v. United States the IRS assessed an underpayment amount of $23,262 for Social Security and Medicare taxes on the tip income of their employees. The lower courts ruled in favor of the restaurant, but the US took the case to the Supreme Court. The Court ruled that … we cannot find that the aggregate method is, as a general matter, so unreasonable as to violate the law.’

Compliance

To assist the IRS in getting as much of the tip income reported and the corresponding taxes paid, the IRS requires restaurants to file Form 8027 – Employers Annual Information Return of Tip Income and Allocated Tips. This is an end of the year report and is required for those restaurants having 10 or more employees. Note:  this isn’t 10 or more tipped employees; this is 10 or more employees.

The report basically highlights charged receipts and charged tips. In addition, the restaurant reports on the dollar amount of tips directly and indirectly reported to them by employees. Then all food and beverage receipts are reported. The form generates an 8% baseline for expected tips and subtracts those actually reported tips from the baseline calculation. If the dollar amount of tips is less than the 8% baseline, the difference must be paid to the Internal Revenue Service. 

The employer is then allowed to subtract the employee’s share of insufficient paid tax on the next paycheck to that employee.

The key to this is that the IRS is in effect using the restaurant owner as the compliance agent for them. If you fail to comply with the law, you will be forced to pay the associated taxes and this can get expensive. The IRS provides alternatives to you so that you can avoid this additional tax.

Employer Cooperation and Reporting

The primary goal as the owner or manager of the restaurant is to ensure taxes are paid to the government. The best tools are education, systematizing the data, reporting the data and a formal tip agreement. 

Education – the restaurant may participate in the Tip Rate Determination and Education Program.  Publication 531 explains the responsibilities of all the parties. The key for employees is:

1. Keep a daily tip record.
2. Report tips to your employer.
3. Report all your tips on your income tax return.

The key for the employer is to conduct a short education class with the employees that receive tips on a regular basis reminding them of their responsibility in the program. In addition, have them sign a participation document for the class.

Systematize the Data – as the owner or manager of the restaurant, the best tool is the cash register. By assigning an employee identification code to each patron’s ticket, it is easy to figure out the dollar value associated with that respective employee to determine the total tax due. 

In addition, the employees should keep a tip log. The recommended form is Form 4070A. The employee turns this log into you each month and your job is to pay the associated taxes related to their respective tip income. This includes your matching tax and the estimated income taxes for both federal and state purposes.

Reporting – on an annual basis, file Form 8027 as explained in the section above. In addition, your quarterly 941 reports should tie back to the information reported to you by those employees turning in their respective tip reports.

Tip Agreement – a final tool for the employer is to obtain a signature on a Tip Agreement Contract with the employees. This agreement basically exempts the restaurant from the underpayment of tax due to under reporting of tip income unless the IRS examines all those employees who under reported first. In effect, it shifts the tax obligation to the employees where it belongs in the first place.

Summary – Tip Income and Employer Responsibilities

The Internal Revenue Service has established the basis via the legal system to require the employers of tipped employees in the bar and restaurants industry to collect the income and Social Security/Medicare taxes. The employer uses Form 8027 to determine the minimum threshold amount of tax due and to determine those employees that have underpaid the tax. 

The IRS advocates employers use the Tip Rate Determination and Education Program to educate, systematize data, report information and use a tip agreement to avoid paying under reported taxes and the associated penalties. Act on Knowledge.

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