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Tip Reporting UpdateWhat You Need to Know About New IRS

Guidelines

Mary Burke Baker, K&L Gates LLPMarianna 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

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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 to withhold!5


• 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 compulsion2) Customer determines amount3) Amount not subject to negotiation or employer policy4) Customer decides who receives the amount

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• 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

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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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• 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 approved14


• 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


• 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

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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%– Payroll tax assessment could be applied to all open years20

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:– 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

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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 28

Contact Information

Marianna DysonMiller & Chevalier Chartered

(202) [email protected]

Mary Burke BakerK&L Gates LLP(202) 778-9223

[email protected] 29

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