This section provides procedures for employment tax on tip income.

Tips are considered wages for purposes of the Federal Insurance Contributions Act (FICA) taxes and federal income tax withholding for cash tips of $20.00 or more. Tips are also subject to various reporting requirements by both the employee and the employer. All tip activity, regardless of operating division, should be coordinated through the SB/SE, Headquarters Compliance Policy Office. This office has responsibility for oversight and policy decisions regarding the tip program.

Under Treas. Reg. section 31.3102–3, the employer is responsible for deducting and depositing the employee's FICA tax on tips included in the written report furnished by the employee to the extent that collection can be made from the employee's funds on or after the time the written statement is furnished. The employee's funds include wages (exclusive of tips) in the employer's possession and amounts turned over to the employer by the employee.

The employer is required to collect employee tax only on tips that are reported by the employee to the employer. If the amount of employee tax on tips exceeds the wages under the control of the employer, the employee may furnish to the employer money equal to the amount of such excess.

If the employee does not provide enough money, the employer will apply the employee's reqular pay and any money the employee gives to the employer to the taxes in the following order:

Any taxes that remain unpaid can be collected by the employer from the employee's next paycheck. If withholding taxes remain uncollected at the end of the year, the employee may be subject to a penalty for under payment of estimated taxes.

Effective January 1,1988, IRC section 3121(q) provides that employers pay their share of FICA taxes on tips reported by their employees in the course of employment. Such remuneration is deemed to have been paid at a time a written statement including such tips is furnished to the employer. If no such statement is furnished (or to the extent the statement is incomplete or inaccurate) such remuneration shall be deemed to be paid on the date on which notice and demand for such taxes is made to the employer. (See IRM 4.23.7.12, Notice and Demand for Purposes of IRC section 3121(q), below).

For income tax purposes, tips are wages that are deemed paid at the time a written statement including such tips is furnished to the employer pursuant to IRC section 6053(a) or, if no statement including such tips is so furnished, at the time received. Employers are required to withhold federal income tax on such tips as listed on such written statement.

The employee taxes withheld from wages or made available by the employee will be applied first to the FICA (or RRTA) tax and any excess will then be applied to the income tax withholding.

The employer is required to furnish a statement to the employee showing the amount of FICA taxes that could not be collected from the employee's wages. Form W–2 is the form prescribed for furnishing this statement.

The Tip Rate Determination and Education Program was initiated by the Internal Revenue Service to improve and ensure compliance by employers and employees in industries where tipping is customary. Businesses currently participating in these agreements are from the restaurant, cosmetology, and gaming (casino) industries.

Under this program, employers can agree to voluntarily enter into one of two arrangements, the Tip Rate Determination Agreement (TRDA) or the Tip Reporting Alternative Commitment (TRAC).

In addition to TRDA and TRAC, the Service is now permitting food and beverage employers to design their own tip compliance program, allowed through the EmTRAC (Employer–designed TRAC) Program.

There are specific agreements for the Food and beverage, Cosmetology and Barber, and Gaming industries. There are also generic tip agreements that permit all other tipping industries to participate in the program.

Section 3414 of the Internal Revenue Service Restructuring and Reform Act of 1998 prohibits the threat of an audit to coerce taxpayers into signing a Tip Reporting Alternative Commitment (TRAC) Agreement. IRS employees will under no circumstances use or imply the threat of an audit when soliciting participants to sign up for either a TRDA or a TRAC agreement.

The mission of the Service is to provide taxpayers with top quality service by helping them understand and meet their tax responsibilities and to apply the tax law with integrity and fairness to all. The purpose of either a TRAC or TRDA is to help business employers in industries where tipping is customary understand their tip income reporting responsibilities, and get their tipped employees to accurately report their tip income.

Examiners should provide educational material and products developed specifically for this program. Offer to provide an educational session to both the employer and employees and explain the tax law related to tip income reporting, whether or not the employer chooses to enter into an agreement.

While emphasizing that the program is totally voluntary, explain to the employer that if compliance does not improve, the Service would have no choice but to apply the tax law and initiate tip examinations. Further emphasis should be made that the Service is available to help the employer and employees voluntarily comply with the law.

If an employer chooses not to participate and tip compliance does not improve, a tip examination should be initiated when a taxpayer demonstrates the most egregious case of noncompliance. IRS policy requires an interval of at least six months from the date of the last contact to solicit a tip agreement to when an examination letter is sent to the taxpayer. This six-month policy applies only to tip examinations and not to general income tax examinations that may warrant an audit under normal examination procedures.

Delegation Orders authorize Territory Managers to sign all tip agreements.

An employer may terminate a TRDA agreement at any time. The Area Director may prospectively revoke or terminate a TRDA agreement when, at the end of two consecutive calendar quarters, fewer than 75 percent of the employees in the occupational categories are participating under the agreement, or if the employer fails to file the necessary tax returns, pay and deposit taxes, maintain records or fails to make the required records available to the Service. In addition, if the Service is involved in an administrative or judicial examination, investigation, or proceeding involving the employer or a related party, the agreement may be prospectively terminated by the Area Director.

If the employer is otherwise complying with the TRDA agreement, the agreement should not be revoked. As a general rule, individual tip examinations will be initiated on the most egregious noncompliant employees.

An employer may revoke a TRAC agreement at any time. The Area Director may prospectively revoke a TRAC agreement if the employer fails to file the necessary returns, pay and deposit taxes, maintain records or fails to make the required records available to the Service. The Area Director may also retroactively revoke a TRAC agreement if the employer fails to substantially comply with the educational program or the tip reporting requirements. In addition to the previously stated reasons, the Area Director may revoke the agreement when the Service or other federal agency pursues an administrative or judicial action relating to the employer or establishment that is a party or related party to the agreement. However, before an Area Director terminates a tip agreement, they must receive approval from the SB/SE, Headquarters Reporting Compliance Office, Employment Tax.

In the case of an employer with establishments in more than one key area, where one or more establishments are not complying with the requirements under an agreement, the Service, through the controlling office, will notify the employer corporate headquarters. The Service will allow the corporate headquarters a reasonable amount of time to get these establishments into compliance (for example, two quarters). If the noncompliant unit or units do not come into compliance, the Area Director may revoke the agreement, but only for the specific unit or units not in compliance with the requirements of the agreement.

If the employer is otherwise complying with the TRAC agreement, the agreement should not be revoked. As a general rule, individual tip examinations should be initiated on the most egregious noncompliant employees.

Responsibility for the Tip Rate Determination and Education program involving chain restaurants rests with the area where the chain is headquartered (Headquarters Area). The Headquarters Area (HQ) is responsible for monitoring the chain as a whole as well as all individual units throughout the chain. Monitoring will include keeping impacted area offices aware of any actions. The HQ Area Tip Coordinator will provide timely status reports to all affected area offices (Member Areas) to include any actions initiated. In addition, the HQ Area Tip Coordinator is responsible for contacting the chain restaurants to make them aware of their tip compliance rates pursuant to a tip agreement. These procedures shall apply starting with the monitoring phase of the agreements and only after the employer has been given a reasonable amount of time to implement the program.

If a Member Area other than the HQ Area detects any unit compliance problems or concerns with a chain establishment located in their Area, they should contact the HQ Area Tip Coordinator, prior to any contact with the establishment.

The HQ Area Tip Coordinator will contact the taxpayer to discuss any tip compliance problems or concerns. The HQ Area Tip Coordinator will formulate any action plan based upon discussions with the taxpayer. The HQ Area should consider the time frame needed for establishing a reporting system and for tipped employees to reach full compliance when determining how to proceed.

The HQ Area Tip Coordinator will respond to the Member Area's compliance concerns as soon as possible, but no later than 30 days after receiving the inquiry. In the event that more than 30 days is needed, the HQ Area Tip Coordinator must contact the Member Area Tip Coordinator and advise him/her of the current status of the inquiry. No further action by the Member Area will be taken without first coordinating with the HQ Area Tip Coordinator.

If the HQ Area Tip Coordinator and Member Area Tip Coordinator cannot reach an agreement regarding proposed actions/time frames, etc., all concerns should be addressed upward through the regular chains of command, as appropriate. Once the final decision is made on how to proceed, it must be communicated in writing to all affected Area Tip Coordinators.

LMSB Cases. If the chain is part of an LMSB entity, follow the same procedures, except that the Team Manager will be contacted and briefed by the HQ Area Tip Coordinator. If the LMSB case is in process, coordinate any contact with the chain through the Team Manager or Team Coordinator. If the LMSB case is not in process, the HQ Area Tip Coordinator should get the Team Manager's approval to make whatever contacts are necessary.

Examination Procedures. Coordinate the examination process through the HQ Area Tip Coordinator who will be the contact for communication between the Member Areas and the chain headquarters. The HQ Area Tip Coordinator will provide a "pro-forma" Information Document Request (IDR) for use in non-LMSB cases. For LMSB cases, issue all IDR's through the Team Manager.

Forms 941 Filed in Headquarter Areas. Forward all Status 90 tipped employee examination results to the HQ Area Tip Coordinator (see Exhibit 4.23.7–1). The HQ Area will send a Notice and Demand Letter to the chain headquarters. The Notice and Demand Letter will include the closed employee tip examination results for all restaurants in the chain where employee examinations have taken place. The HQ Area Tip Coordinator will follow-up to ensure that the amount reflected on the Notice and Demand Letter(s) is paid with the next filed Form 941.

Forms 941 Filed in Member's Area. Follow regular non-chain examination procedures, unless the HQ Area requests otherwise. These procedures include issuing a Notice and Demand Letter for the employer's share of FICA tax on unreported tips determined from Status 90 tipped employee examinations. A courtesy copy of all Notice and Demand Letters and affected Forms 941 should be sent to the HQ Area Tip Coordinator for reference only.

Securing the agreement is only the first step in increasing compliance for employers with employees who receive tip income. To ensure employers and their employees continue to report their tip income accurately, it is imperative that the Service monitor the compliance level of the program participants.

Each Area must implement a system to follow-up and measure whether compliance is improving for those employers and employees participating in any of the agreements.

Follow-up procedures for establishments participating in a TRAC, TRDA, or EmTRAC agreement, should include a review of the employer's Forms 941, Employer's Quarterly Federal Tax Return. If the program is working, an increase in the tip wages that are reported on Forms 941 should be evident.

Under TRDA, the Service and the employer establish a tip rate for the various worker categories. At least seventy-five percent of the employees must sign an agreement and agree to report at or above the established tip rate for their job category. As long as participating employees are reporting at or above this established tip rate, the Service agrees not to examine prior tax periods.

TRAC does not require any tip rates to be established. However, employers do agree to educate new employees and re-educate continuing employees on a quarterly basis. TRAC also requires the employer to establish a reporting system and to file and pay taxes properly.

When the employer enters into a TRDA agreement, the employer agrees to review its tip rates annually and determine whether or not increases to tip rates must be made. If the employer does not contact the Service by the specified date, the Service Representative should be following up to verify whether any rate increases are required.

Monitoring the Tip Compliance Agreements should be done at least annually. For TRAC, if the reporting of tip wages by tipped employees has not improved six months after securing the agreement, the employer should be notified. The Service should offer to meet with the employees to remind them of their tip reporting obligations and the consequences for failing to comply with the law.

Implementation of these follow-up procedures enables each employer to gauge how well their education requirement is being fulfilled and whether the employees are complying with their tip reporting requirements. If noncompliance is identified, then examination referrals should be considered.

IRC section 6053(a) requires that if any employee receives $20.00 or more in cash tips in a calendar month, the employee must report such tip income to the employer by the 10th day of the following month. No particular form must be used in reporting tip income. However, Treas. Reg. section 31.6053–1 requires that the form used should be signed by the employee and disclose:

Unless some other written statement is provided by the employer for use by the employee in reporting tip income, Form 4070 (Employee's Report of Tips to Employer) along with Form 4070A (Employee's Daily Record of Tips) may be used by the employee.

In lieu of a special form for tip reporting, Treas. Reg. section 31.6053–1(b)(2)(iii) provides that an employer may provide regularly used forms (such as time cards) for use by employees in reporting tips. Any such regularly used form must meet the requirements of Treas. Reg. section 6053–1(b)(1)(iii) and (iv) and must contain identifying information which will assure accurate identification of the employee by the employer.

If an employee does not report to the employer tips of $20 or more per month, the employee may be subject to the penalty imposed by IRC section 6723, Failure to Comply with Other Information Reporting Requirements.

The cash tips to which this provision applies include checks and any other monetary medium of exchange. Tips received by an employee in any medium other than cash, such as passes, tickets, or other goods or commodities do not constitute wages for FICA purposes (Treas. Reg. section 31.3121(a)(12)–1).

If an employee fails to maintain such records, or if the records kept do not accurately reflect the amount of tip income received, the Service is authorized, under IRC section 446(b), to reconstruct income in accordance with any method that in its opinion clearly reflects the amount of tip income received.

The employee is responsible for reporting all tip income on his or her Form 1040. Tip income includes cash tips and the value of tips not paid in cash, such as passes, tickets, goods, or services. These are generally included in the Form W–2 and must be reported for Federal income tax purposes. In addition, the employee must also report any employee FICA tax on tips reported in (1) above, plus any employee FICA tax attributable to tip income not reported to the employer.

Form 4137, Social Security and Medicare Tax on Unreported Tip Income, is used by an employee to compute the social security and Medicare tax owed on tips not reported to the employer, including any allocated tips shown on the employee's Form(s) W–2 (unless the employee can prove a smaller amount with adequate records). The employee may be subject to a penalty equal to 50 percent of the FICA tax due for failure to report the cash tips to the employer unless reasonable cause exists (IRC section 6652(b)). The Form 4137 is filed with the Form 1040.

The statute of limitations on unreported tips does not start to run until the Form 4137 is filed. Therefore, FICA tax on unreported tips can be assessed even if the statute of limitations has expired for the Form 1040, provided that Form 4137 was not filed with the original Form 1040. (See Rev. Rul. 79–39, 1979–1 C.B. 435.)

Treas. Reg. section 31.6053–3 provides for certain large food or beverage establishments to make an information return with respect to tips. The employer is required to file a separate information return for each calendar year in which the employer has employees. The information return will contain the following:

Treas. Reg. section 31.6053–3(j)(7) defines a " large food or beverage operation" as one which normally employs more than ten employees on a typical business day during the preceding calendar year, and the tipping of food or beverage employees of the food or beverage operation is customary.

Treas. Reg. section 31.6053–3(j)(9) defines what represents more than ten employees on a typical business day. This test is met if one-half of the sum of the average number of employee hours worked per business day during the calendar month in which the aggregate gross receipts from food or beverage operations were the greatest plus the average number of employee hours worked per business day during the calendar month in which the aggregate gross receipts from food or beverage operations were the least, is greater than 80 hours. This test includes all employees of a food or beverage operation not only food or beverage employees.

Treas. Reg. section 31.6053–3(j)(10) defines a food or beverage employee as an employee who provides services in connection with the provision of food or beverages. Such employees include, but are not limited to, waiters, waitresses, busboys, bartenders, hostesses, maitre d's, dining room captains, wine stewards, cooks, and kitchen help.

Form 8027 (Employer's Annual Information Return of Tip Income and Allocated Tips) is used by large food or beverage establishments when the employer is required to make annual reports to the Service on receipts from food or beverage operations and tips reported by employees. A separate Form 8027 must be filed for each location under common ownership or control. If the total hours of all locations exceed the 80 hours computation, then all the locations must file a separate Form 8027. This is true even if the individual locations, when considered separately, would not exceed the 80 hours test.

Where the employee failed to report tips, in determining the employer's FICA tax liability, those tips are deemed, for purposes of subtitle F (Procedure and Administration), to be paid to the employee when a notice and demand for the taxes is made to the employer by the Secretary. IRC section 3121(q) applies with respect to tips received (and wages paid) on and after January 1, 1988.

IRC section 3121(q) allows the Service to assess the employer's share of FICA taxes with respect to tips where no statement reporting such tips was furnished to the employer by an employee (or to the extent the statement is inaccurate or incomplete). This additional tax liability is determined based upon remuneration deemed paid on the date notice and demand is made to the employer.

The Service must issue a notice and demand to the employer once a determination of the amount of unreported tip income is made. No specific form is required for the notice and demand. It must include:

The employer must report these amounts on the quarterly Form 941 for the quarter in which notice and demand is made. If the employer fails to report the amounts for which notice and demand was given, the examiner will assess the employer for the FICA liability. The standard employment tax reports are used for this purpose.

The examiner may disclose certain taxpayer return information to the employer in the notice and demand to substantiate the employer's share of the FICA tax assessments. This information can be disclosed as it plays an integral part in calculating the amount of the employer's share of FICA tax on the unreported tip income. The information "directly affects " or "directly relates to" the resolution of an issue and there is a transactional relationship between the employer and the employee. See IRC sections 6103(h)(4)(B) and (C).

The examiner should attach a spreadsheet to the notice and demand explaining the assessment. The spreadsheet should include such information as the following:

IRC section 45B allows a tax credit to food and beverage businesses for the portion of employers' FICA taxes paid with respect to employees' cash tips. Effective for FICA taxes paid after December 31, 1993, the employer can claim the tax credit whether or not the employee reports the cash tips. Effective for services performed after December 31, 1996, the credit is allowed whether or not the food or beverages are for consumption on or off the premises. Thus, the credit may apply to employees who deliver food or beverages. Form 8846, Credit for Employer Social Security and Medicare Taxes Paid on Certain Employee Tips, is used to compute the credit.

The taxpayer entitled to the IRC section 45B credit is the employee's employer. This is generally the employer under the common law, unless there is another entity that has control of the payment of the wages (i.e., an IRC section 3401(d)(1) employer). The application of the common-law rule is a factual determination. Furthermore, the determination of whether an entity is an IRC section 3401(d)(1) employer is also a question of fact. Therefore, the taxpayer entitled to claim the IRC section 45B credit is the employer on whom IRC section 3111 imposes the employer portion of the Federal Insurance Contributions Act (FICA) tax.

Leasing agencies have been found to be common-law employers of these workers. However, a number of cases have found that a leasing company is not the IRC section 3401(d)(1) employer. Thus, the examiner must, through an examination, first determine who is the employee's common law employer or the section 3401(d)(1) employer before the examiner can determine who is entitled to the credit.

When tip income is an issue, the examiner should determine whether employees are reporting tips to their employer and if the employer is withholding employment taxes as required.

The examiner should determine if the amount of tip income reported is reasonably correct. At a minimum, the examiner should consider the following:

When the examiner determines it is necessary to pursue the tip issue, the "McQuatter'’s Formula" provides a method of reconstructing tip income that has been accepted by the courts. It specifically addresses factors to be considered in determining a tip rate and the types of items used for making a reduction. (McQuatters v. Commissioner , T.C. Memo. 1973–240.)

The examiner should determine if the employer is paying minimum wages under the Fair Labor Standards Act of 1938 to employees who receive tips.

The examiner should use the examination report writing procedures in IRM 4.23.10, Reporting Writing Guide for Employment Tax Examination, of this Handbook to report examination adjustments to employers for employment taxes. This is the procedure only when the employer does not pay the tax shown on the Notice and Demand Letter.

If unreported tip income is identified as a result of a tip examination, then the employee and employer are liable for FICA tax. The employee's tax adjustments should be made on forms prescribed for individual income tax examinations. The examiner should use the examination report writing procedures in IRM 4.23.10, Report Writing Guide for Employment Tax Examinations, of this Handbook to report examination adjustments to employees for employment taxes.

When both the employment tax examination file and the related income tax case are being worked, these files will remain together when processed, where possible.

Advance payments received for employment tax cases should be reported in accordance with the taxpayer's instructions. Absent instructions, the payments will be reported first as if they were for income tax and the balance will be reported as employment tax.

When a statutory notice of deficiency is issued on the income tax case, the related adjustments to employment tax on the tip income and the related amount of penalty will not be included in the income tax report. However, the notice to the taxpayer will include a statement concerning the related employment tax and penalty liability.

Examiners must remember to properly code the tip audit adjustments on the Form 5344, Examination Closing Record or Form 5599,EO Examined Closing Record. The codes can be found in the AIMS Processing Handbook, IRM 4.4. If these codes are not entered properly, the tipped employee's social security and Medicare wages will not show increase in wages due to the adjusted tip income and the employee will not receive social security credit. IRS submits this information electronically to the Social Security Administration Office.

Include in the explanation of adjustments portion of the report the following statement, "Changes to amount of wages subject to railroad retirement tax will be reported to the Railroad Retirement Board. "

After completing the examination, prepare a memorandum addressed to the Chief Financial Officer, Railroad Retirement Board, 844 Rush St., Chicago, Illinois, 60611. This memorandum will include employee's name, social security number, name of railroad employer, and the yearly increases or decreases to amounts subject to railroad retirement tax.

Attach the memorandum to the completed Form 3198 (Special Handling Notice) and place on outside of case file where it will remain as the file is processed. Enter notation "RRTA Tax on Tips" on line " Other" of Form 3198.

This section provides guidelines to IRS area office personnel in determining whether the information submitted with rate reduction requests supports the granting of such a reduction. Areas will designate one or more employees to review tip rate reduction requests and recommend determinations to the area director. Ordinarily, these determinations are made by a Tip Coordinator.

Upon receiving the request and the user fee, complete Form 3244–A and forward the user fee to the remittance processing area. The user fee and original Form 3244–A need to be transmitted no later than the next working day after receipt. Payments will be forwarded using Form 3210. Keep a copy of all the paperwork as evidence that a user fee was collected.

User fees are credited to the general fund revenue account and not to a taxpayer module. Do not enter a form number, MFT, or a tax period on the Form 3244–A. The following must be included on the form:

Under IRC section 6053(c)(3)(A), if the employees of a large food or beverage establishment report as tips to the employer an amount less than 8 percent of the establishment's gross receipts, then the difference between the amount reported and the 8 percent must be allocated as tips among the employees who customarily receive tip income. Certain receipts not ordinarily subject to tipping (known as non-allocable receipts) are not considered for this allocation.

Revenue Procedure 86–21, 1986–1 C.B. 560, provides guidelines for employers and employees who wish to apply to their area director of Internal Revenue to have the percentage of gross receipts required to be allocated as tips reduced from 8 percent to a lower percentage (not below 2 percent).