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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
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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?
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Tips v. Service Charges History
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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 to5 withhold!
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
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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
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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
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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
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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
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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
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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
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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?
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• All prospective changes must be approved
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
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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
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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
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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%
20 years
– Payroll tax assessment could be applied to all open
Tip Examination by IRS (cont’d)
• 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
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Changes to Payroll Treatment
• Service charges are regular wages that must
be counted for:
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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
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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
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wages on Forms W-2
Procedural and System Changes
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Revisions to POS system
Changes to “tip out” policies
Effect on tip reporting rates
Evaluation of auto-gratuities, such as:
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Large parties
Bottle service charges
Mandate delivery charges (e.g., pizza or other deliveries)
Room service charges and contracted luggage assistance
changes (hotels)
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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
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Next Steps (cont’d)
• 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
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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
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