Tips on Tip Reporting: Are You at Risk for Back FICA Taxes?
If you've been in the restaurant business, at least since 2002, you've likely felt the aftershock of United States v. Fior d'Italia, even if you haven't read or fully understand this landmark Supreme Court case.
In June 2002, the Supreme Court determined that Fior d' Italia, a San Francisco restaurant, was liable to the Internal Revenue Service (IRS) in the amount of $23,262. The amount represented unpaid Federal Insurance Contribution Act (FICA) tax on tip income that was unreported by the restaurant's staff.
You are responsible for your share of FICA tax on all tip income of your employees, including any tip income that your employees don't report to the IRS. If you own or manage a restaurant, you need to make sure that your employees are reporting all of their tip income.
Otherwise -- at least for now -- the IRS has an easy way to determine any reporting shortfalls, and your share of the tax on that income will come out of the restaurant's till -- with the blessings of the highest court in the land.
In this article, we'll look at the basic accounting, legal, and practical issues of tip reporting, and point you in the direction of some resources and tips that will help you monitor your employee's tip income, so that you do not get burned in an IRS audit.
Can You Say 'Aggregate Estimation Method' 10 Times Real Fast?
In United States v. Fíor d'Italia, Inc., the Supreme Court held that the IRS was authorized under federal tax law to use the "aggregate estimation" method to determine if a restaurant's employees are not reporting tip income.
How does this work? In this case, the IRS examined the restaurant's credit card slips for 1991 and 1992 -- the years, claimed the IRS, that Fior d'Italia's employees had underreported their tips. The IRS found that customers had tipped, on average, 14.49 percent of their bills in 1991 and 14.29 percent in 1992. So, the IRS assumed that cash-paying customers on average tipped at those rates also, and calculated the total tips by multiplying the known tip rates by the restaurant's total receipts -- in other words, an aggregate estimation. The IRS then subtracted tips already reported and applied the FICA tax rate to the remainder. Using this method, the IRS determined that from 1991 to 1992 the restaurant's employees had not reported $304,074. Fior d'Italia's liability for unpaid FICA taxes for those years totaled $23,262.
Proposed Legislation Could Shift Burden Back on IRS
Restaurant industry advocates, including the National Restaurant Association (NRA), point out the unfairness of the aggregate estimation method to both employer and employee. It allows the IRS to hold the restaurant owner's metaphorical feet to the fire for unpaid FICA tax, without examining the income of the individual tip earner. Furthermore, when the employer pays the FICA taxes, the IRS doesn't credit these payments to the employees' Social Security accounts. It's a lot easier for the IRS to go after the employer for underpaid FICA taxes, than to examine numerous employees to find out if they've underreported their tip income and how much.
The restaurant industry has not rolled over on this matter; the NRA and state restaurant associations are vigorously backing the "Tip Tax Fairness Act of 2003" (H.R. 2034), which was introduced in May 2003 to the 108th Congress by Rep. Wally Herger (R-Calif.).
The proposed legislation clarifies the manner in which the IRS may interpret the current IRS Code, regarding its current practice of limiting audits to employers only and using aggregate assessments. According to the language of the bill, its purpose is "To amend the Internal Revenue Code -- to provide that an employer shall be liable for Social Security taxes on unreported tips paid to an employee only after the Internal Revenue Service establishes the amount of tips received by that employee." In short, the proposed legislation would prohibit the IRS from billing an employer for FICA payroll taxes on allegedly unreported tips without first verifying that individual employees actually underreported their tips. This would shift the burden of enforcing tip-reporting laws back to the IRS. Stay tuned.
Regardless of pending legislation, you should take proactive, visible steps to show that you are doing everything possible to accurately report all of your employees' tip income. There are some actions you can, and should take to protect yourself from these assessments.
Basic Tip Reporting Requirements
The IRS requires tipped employees who earn more than $20 per month in tips to report their tips to their employer each month. Employees should maintain daily logs of all tips received. The IRS has made the process a little easier for them by making available for free on its Web site Publication 1244, an "Employee's Daily Record of Tips and Report to Employer" (www.irs.gov/pub/irs-pdf/p1244.pdf ). But, again, you need to make sure tipped employees are, in fact, doing this.
The employer must report and withhold income and FICA taxes on tip income reported by your employees. You must also pay FICA and unemployment taxes on these tips. Restaurants are required to file Form 8027, "Employer's Annual Information Return of Tip Income and Allocated Tips," with the IRS each year. On this form you must report charge tips (tips paid by credit card), reported tips (tips reported by your employees), total credit card receipts (total payments received with credit cards), and gross sales.
As noted, in the case of Fior d'Italia, the IRS discovered that its employees' "reported tips" were less than "charge tips" on Form 8027. This triggered an IRS audit. Make sure your reported tips exceed charge tips. Don't trigger an IRS audit by missing this very important detail.
Educate your Employees -- Today
There's a lot of cash floating around in many restaurant operations. And one of the appeals to working in a restaurant is the common practice of cash tipping. These are often a major source of income for many restaurant employees. Employees are prone to pocket these tips and not report them to the IRS as part of their earnings. While they might feel smug and safe from tax liability on these earnings, the IRS is looking for folks who own their own home and car, and report $10,000 or less income. That will trigger an audit of their return, and possibly yours, as their employer.
As a practical matter, requiring tipped employees to report their tips at the end of each shift makes this process easier. You may have to badger and pester your employees to get them to do this. They won't like it. But that's tough, as they say on the playground.
Have a tip reporting policy in your employee manual. Distribute copies of Publication 1872, "Tips on Tips -- A Guide to Tip Income Reporting for Employees in the Food and Beverage Industry" and IRS Publication 531, "Reporting Tip Income," to your employees. Talk to your staff about it periodically at lineup and staff meetings. Make sure they know the rules. Keep records of the dates and times that you have done this. Documenting this will help you prove that you have in good faith performed your duty to educate your employees.
'Large Restaurants' and the 8% Rule
Large restaurants must follow special tip reporting rules. The IRS defines "large restaurants" as those where tipping is customary, food or beverage is provided and consumed on the premises, and, in the preceding year, the average number of hours worked by all employees on a typical business day was more than 80. If your restaurant meets these criteria, you must allocate tips to your employees if the total tips reported are less than 8 percent of total sales (adjusted for carry-out sales, service charges and sales taxes).
Allocated tips are subject to the employer's portion of FICA taxes. Tips can be allocated based on each employee's share of gross receipts, hours worked, or another method based on an agreement with your employees. Most restaurants allocate using the gross receipts method. You only withhold income and FICA taxes on reported tips, not on allocated tips. Allocated tips are reported separately on the employee's W-2.
Although the 8 percent figure is the threshold used by the IRS for tip allocations, your employees are still required to report all their tip income. Even if your employees report 8-percent in aggregate, your restaurant may still be audited and assessed back FICA taxes on unreported tips as calculated by the IRS, particularly if, as mentioned, unreported tips are less than charged tips.
The Employer Tip Credit
The IRS allows restaurants a tax credit on the FICA taxes paid on tips. In effect, you may be able to recover a large portion of the FICA taxes you paid on tip income through the use of the credit; however, please note that the deduction you take for FICA taxes paid is reduced by the amount of the credit. In order to take advantage of this credit (reported on Form 8846), you must have income tax liability. If your current year income tax liability is less than the credit, you can carry the credit back a year or forward for up to 20 years. Also note that tips used to meet the federal minimum wage rate are not included in the calculation of the credit. Confer with your accountant to ensure that you are getting the full benefit of this allowable credit.
Agreements with the IRS
In an effort to collect these taxes, the IRS has established compliance agreements for industries where tipping is customary. Restaurants participating in these programs are protected from prior period assessments as long as the participants comply with the provisions of the agreements. If you're considering entering into one of these agreements, talk it over with your tax adviser. They will be able to assist you as you navigate through these waters and may even advise you not to enter into one of these agreements. You are under no obligation to enter into an agreement with the IRS, and many accountants will advise that it is unnecessary when you are complying with all IRS codes and regulations.
Tip Rate Determination Agreements (TRDA) -- Under this agreement, the IRS and the employer work together to establish a tip rate for employees. At least 75 percent of the employees must sign a "Tipped Employee Participation Agreement" with the employer whereby they agree to report tips at or above the established rate. The employer must report employees who do not report at or above this rate to the IRS.
Tip Reporting Alternative Commitment (TRAC) -- TRAC does not require employee agreements or assess tip rates. Under this program, restaurants must track charge and cash tips by employee and provide written notification of this information to each employee at least once a month. A system should be in place for the employees to verify or correct their tip reports. Under the TRAC program, employers are required to educate their tipped employees about their legal obligation to report all tips. This education must be done at the time of hire and repeated at least quarterly. If employees underreport their tip income, only the employees who underreport will be examined.
Employer-designed Tip Reporting Alternative Commitment (EmTRAC) -- In response to restaurant industry requests, the IRS has also developed an EmTRAC program. Only restaurants that have employees who receive both cash and charge tips may participate in EmTRACs. These programs must be similar to the TRAC programs and must include an educational program and established tip-reporting procedures. EmTRACs allow employers more flexibility in designing their programs.
The government is feeling the effects of the economy. Tax revenues are down, government expenditures are up, and as a result, more audits are being performed. Add tax reporting to your employee-training schedule. Closely monitor your employee tip reporting. Consider entering into one of the agreements offered by the IRS. Educate your employees about their responsibility to report their tips. Do whatever you can to avoid the pitfalls encountered by Fior d'Italia.
Do You Have a POS System?
If you have a POS (Point of Sale) system, you most likely have the ability to track sales and charge tips by employee. Most restaurant POS systems will also allow you to enter cash tips each day and run reports, which will analyze this information. Having such a system will make meeting your tip reporting requirements much easier.
Additional information on tip reporting requirements can be found at the Internal Revenue Service Web site at www.irs.gov. These include:
Publication 1875, Tips on Tips -- A Guide to Tip Income Reporting for Employers in the Food and Beverage Industry
Publication 1872, Tips on Tips -- A Guide to Tip Income Reporting for Employees in the Food and Beverage Industry
Publication 505 Tax Withholding and Estimated Tax
Publication 531, Reporting Tip Income
Easier Said than Done
By Patricia Luebke
"You must take a pro-active role in educating, prodding, cajoling, and annoying, if necessary, your employees to get them to accurately report their tips." That's the advice for restaurant owners of John Nessel, whose Restaurant Resource Group provides financial management tools to independent restaurant operators. The words he chooses -- prodding, cajoling, annoying -- speaks to the difficulty of getting accurate and timely tip reporting from your serving staff. It's one thing to know you must get this information, but quite another thing to actually get it.
Rodney Wedge is co-owner of Fuego Cafe & Tapas Bar, with two locations in the Atlanta, Georgia, area. Like many restaurant owners, he began his career as a server while still a teenager. "There's no financial education when you become a server -- it's as if servers belong to a secret society where no one talks about what you make or what you claim in your taxes," Wedge says. "You follow the lead of your fellow servers, and you may be lucky or you may get caught."
Wedge got caught. "I went along with the pack, and I never realized I was doing something wrong," he says. "In fact, there wasn't a lesson to be learned unless you got caught." At the time, Wedge was working for a large restaurant chain where the IRS came in and did a voluntary meeting with servers throughout the company. "The IRS simply came up with a calculation -- what each server should make on an average per-hour basis," he says. "And if you were claiming that much, you were safe. If you weren't claiming that much, you had to prove why."
Wedge had virtually no records to show. He was able to avoid more serious consequences by arranging a payment plan with the IRS. "As I recall," he says, "I was paying $300 to $400 a month for several years." Today, his experience is the best lesson he can pass on to his servers. "From that day forward," he says, "I have tried to be a good big brother and warn servers of the hazards." Do they heed Wedge's brotherly advice? He's not sure. "I hope so, but I'm realistic," he says. "I remember myself at that age, and I thought I was bulletproof." Knowing his own experience may not be convincing enough, Wedge uses other techniques. He tells his servers that if they are not recording cash tips, it must mean they're not getting them. Wedge tells them he can only assume there's something wrong with a server who is not getting tips. Therefore he suggests a program of more training -- from him. He also relies on his POS system to prod his servers into reporting cash tips. Of course, the POS system has already recorded the credit card tips. "At the end of the shift, before you can clock out, the POS systems prompts, "Report cash tips" -- that's how we collect the information." he says.
Don Stull relies on his POS system as well for his Virginia Beach, Virginia, Baker Street restaurant. "Our POS system tracks server tips," Stull says. "The checkout sheet requires the server to enter their cash tips -- credit card tips are already listed. The software is configurable, and I have set the threshold for tips at 12 percent of sales."
Stull, too, has other weapons in his arsenal. "At each staff meeting, an emphasis is placed on accurate reporting of tips," he says. "I have used articles about IRS audits as examples of the importance of tip reporting. The scare tactic seems to have worked since most -- and the best -- servers report more than the 12 percent."
At The Links Southwest Grill and Rita's on the River, both in San Antonio, David Mendelson, who is general manager and executive chef, relies on his POS system, too. "We currently use the Aloha POS system, which tells the servers their credit card tip amounts when they do their checkout," he says. "It also notifies them when they do not claim 8 percent." He adds, "When I process payroll, I make sure that no one forgot to claim at least their credit card tips for the day. If they did, I correct the amount."
Hospitality industry consultant Jim Moore is a believer in POS systems. "The POS system does assist in the overseeing of many things in a restaurant," he says. Then he strongly emphasizes this point: If the management looks at it. Having a POS system where the data is not used or analyzed turns the system into nothing more than a fancy -- and expensive -- cash register.
The IRS looming as a dark force in the background is not the only reason to make sure your servers are reporting their tips. Moore believes it's just good business practice to do so. "I have found that the restaurant management who pays attention to the percentage and continuously reminds the servers they are falling below the threshold has the best success," he says.
When scare tactics, life experience, financial education, and computer reporting aren't enough, Moore offers one more technique that restaurant owners may use: peer pressure. "A few servers who do not report enough tips can get the entire restaurant audited," he says. That's a good message to spread among your servers. The server who is not reporting all his tips is not just putting himself at risk; he is putting all of his fellow servers at risk, too. That's why Rodney Wedge removes the smile from his face when he says to his servers, "You've got to report every dime you make."
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