Points to Consider on Tip-Reporting Agreements

By John Mills and Richard Mason

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A substantial number of employees in the service sector earn a large proportion of their earnings from tips, including restaurant employees, valet parking attendants, hair salon workers, casino employees, and bartenders. The IRS has long held the belief that certain employees have underreported tip income, and in the past the IRS has selectively targeted individuals employed in these areas. The IRS found that a large number of these individuals were not properly reporting tips and therefore owed significant taxes and penalties. The result has been sizable tax burdens for employees frequently not in a position to easily meet the burden. This selective audit process has also resulted in additional assessments for employers. On the other hand, the IRS believes that auditing each employee is not an effective or efficient way to collect the proper amount of tax revenue. Assessing tip revenues by property provides a more effective approach to efficiently maximize the collection of tax revenues.

In general, an employee who receives tips that constitute wages is required to report to the employer on Form 4070, Employee’s Report of Tips to Employer, disclosing the total amount of the tips received by the employee in the course of employment. Tips received by an employee in a calendar month are required to be reported to the employer on or before the 10th day of the following month. The employer uses this reported information to withhold and contribute proper FICA taxes. But if the employee underreports the tip income, the employer can also be held liable for back FICA taxes, as well as penalties and interest associated with late payment. For example, IRC section 6652 allows for a 50% penalty for underreported FICA tax due to tips. Penalties could potentially be assessed for back taxes representing three or more years. The penalty for willful failure to collect, account, or remit is 100% of the tax [IRC section 6672(a)]. This penalty may be assessed on corporate officers, directors, or others who had responsibility for the corporate actions. In addition to these civil penalties, in aggravated cases of nonpayment criminal sanctions might also apply.

The recent Supreme Court’s favorable decision for the IRS in Fior D’Italia [122 S.Ct. 2117 (2002)] means that additional audits are likely of businesses that employ employees earning tips. The Court held that the IRS may properly use an aggregate estimate of all tips to calculate employment tax liability. While the food service industry represents the largest single industry group, additional groups, such as taxicab and limousine companies, car wash operations, cosmetologists, hair salons, and the gaming industry, are also likely to be targeted. The IRS is continuing to develop and implement various tip compliance programs as a way to get employees to report all tip income. For example, Revenue Procedure 2003-35 (May 1, 2003), which deals with the Gaming Industry Tip Compliance Agreement Program, advises employees earning large tip income to enter into such agreements to protect themselves from underreporting employees.

Tip Determination and Education Program

The Tip Determination and Education Program (TRDA and TRAC) is intended to increase employees’ reporting of tips to their employers by means of customer outreach and education. The program involves working with employers to educate employees, employer execution of an agreement between the business owner and the IRS, and employer participation in one of two programs. The two tip reporting options are the Tip Rate Determination Agreement (TRDA) and the Tip Reporting Alternative Commitment (TRAC). Over the last 10 years, the IRS has successfully signed more than 11,000 TRACs, covering close to 31,000 restaurants and bars. In addition, the IRS has expanded its tip-reporting program to cover hair stylists, barbers, and casinos, and has added the Tip Rate Determination Agreement program. According to estimates by industry representatives, between 175,000 and 200,000 employers are eligible to participate in the tip-reporting programs.

Both the employer and the IRS agree to certain terms under these agreements. A TRDA is available for the food and beverage industry, and there is one specifically for the gaming industry (Revenue Procedure 2003-35, May 1, 2003). A TRAC is available to employers in the food and beverage industry, and there is one specifically for the cosmetology and barbering industry. Other industries where tipping is customary now may participate in this highly successful program. Copies of TRDAs and TRACs can be accessed at the IRS website (www.irs.gov).

Participation in either a TRDA or TRAC is voluntary. Section 3414 of the IRS Restructuring and Reform Act of 1998 prohibits the IRS from threatening to audit any taxpayer to coerce the taxpayer into entering into a TRAC agreement.

Tip Rate Determination Agreement (TRDA). A TRDA represents an agreement between the IRS and the employer that specifies an agreed-upon rate of tips for each occupational category of tipped employees. The program requires the employer to work with the IRS to calculate a tip rate for each occupational category. To be enforceable, the agreement requires the participation of at least 75% of the employees. Participating employees must sign an agreement to report tips at the rate specified in the TRDA.

Tip Reporting Alternative Commitment (TRAC). A TRAC agreement emphasizes employee education rather than agreed-upon tip rates. The employer agrees to establish an educational program that educates all employees on a quarterly basis about their statutory requirement to report all tips to their employer. The manner in which the employees are educated about their obligations is left largely to the employer. The employer also must ensure that a statement of employee tips will be produced at least once a month and distributed to the employees. As with TRDAs, the IRS can terminate these agreements for failure to comply with any of these requirements.

While both programs were initially available for all employers, there appears to be a push toward the TRDA agreements. For example, under the new agreement for casinos, they are allowed to enter into only a TRDA agreement.

Determining the Tip Rate in a TRDA Agreement

The foundation and starting point for any tip agreement is the McQuatters formula. This formula is a statistically valid computation of tips based on a 28-day sample of the restaurant’s credit card tip receipts. Once a rate is established based on credit sales, discussions with management and tipped employees are performed to adjust this figure for any unusual factors that might impact the tip rate. For example, some customers do not tip, customers that pay in cash tend to leave smaller tips, and some tips are direct and others indirect. A full discussion of other factors considered is presented in chapter 5 of the IRS “Tip Audit Guide for Restaurants and Bars.”

This approach is usable in industries that generate credit card sales, but many industries work on a pure cash transaction basis. For example, valet parking attendants usually receive only cash tips and would require rates to be determined by observation. The determination of tip income for casino dealers can also become very challenging because these are a function of the type of player and the player’s success at the game. Inevitably, the final tip rate is a guesstimate based upon an average rate. The gaming industry tip rate can also differ substantially depending on which shift (day, swing, or graveyard) the employee works. While many casino properties pool tips, others allow employees to keep their own tips. In those cases where they keep their own tips, those employees working at the high-roller tables or high-stakes slots could make substantially more in tips than other employees.

Because employers want to minimize the additional paperwork associated with any tip agreement, they might tend to use averages for dealers and waitresses, without considering individual circumstances. Such an approach could result in unjustly penalizing some employees. When negotiating a specific rate, the more detailed the rate is in terms of shift, location, and category, the more fair it will be for employees. Of course, the problem that many employers will face is that employees may work different shifts, work overtime, or work in the fine-dining section one day and the buffet the next. Despite these concerns, it is clear that the perceived efficiency of tip agreements, coupled with the discretion allowed to the IRS by the courts, appears to favor increased use of these agreements over time. Employers in industries where tip income is a major component of employee compensation that are not yet participating in an agreement with the IRS would be well advised to consider this option. If the rates are set correctly, the certainty that these agreements provide may well outweigh the additional costs and paperwork.

Advice for Employers

Whether an employer should enter into a tip agreement depends on two factors:

  • Getting at least 75% of the employees to sign such an agreement.
  • Arriving at a tip rate that employees feel is fair and equitable to be used for deducting FICA taxes. This rate, sometimes quite difficult to calculate, often dictates whether the requisite number of employees will choose to participate.

Employers that sign the TRDA agreement will be deemed in compliance, meaning the IRS will not audit the employer’s payroll tax returns for periods prior to the agreement, or for those years covered by the agreement, as long as the employer remains in compliance with the agreement. Both programs prohibit “employer-only assessments” (assessments without auditing the employee) during the period the program is in effect. Thus, participating in these agreements reduces uncertainty for employers.

As with any program, however, there will be administrative costs. Both programs require the employer to keep four years of records related to gross receipts subject to tipping and of charge receipts showing charge tips. The employer must make certain quarterly numbers available to the IRS upon request, and comply with filing and depository requirements.

In addition, the TRDA program requires the employer to provide the IRS with quarterly reports detailing the number of total employees and participating employees. An annual report is required from the employer, providing identification, shift, and hours of nonparticipating employees. If an employer is audited, these are the same records that would be used to verify that the employer is in compliance. Many accounting information systems can be fairly easily adapted to add any additional information needed to comply with these requirements.

An additional negative impact to consider would be the employee compensation expenditure based on the employee’s higher reportable income. For example, the company may have a retirement plan with contributions tied to total earnings. If the tip agreement increases overall earnings, it will result in additional compensation expenses. Some employers might consider these higher compensation costs to be greater than the potential costs associated with a possible audit with negative findings.

Having a TRDA agreement might also affect hiring practices. Employees could reject an employer that appears to have a higher tip rate than another property. Another concern is that once an agreement is signed, the IRS may use an established rate as a baseline for increasing the rates on renewed agreements.

Advice for Employees

Interestingly, many of the negative factors for an employer can become positive factors for an employee. Employees would, assuming that the employer recognizes higher income, be eligible for greater Social Security and increased unemployment benefits and worker’s compensation. The increased income would also improve opportunities for financing approval when applying for mortgage, car, and other loans. If the employer has a retirement contribution plan, there may be additional funding for employees.

A major factor is certainty. Once an employee signs the TRDA plan agreement, the employee does not have to fear any audits on future tips above the agreed tip rate during the agreement period. If the employee does not sign an agreement with the employer that has the TRDA plan, the employee will be subject to a possible audit.

The biggest objection that employees have is that the taxes are taken out of their paychecks based on anticipated rather than actual earnings. In an environment subject to seasonal ups and downs, this procedure can result in an overpayment of taxes by employees during the off-season. An employee who works only during the off-season may be overtaxed. The calculation of the tip rate is based on the average tip of all employees. If employees do not pool tips, some employees might pay taxes on tips not actually earned, while other employees might underpay.

Probably the best approach for a business is to track all tip income, and if that income is substantially less than the estimated tip income, seek refunds for overpayment. Of course, that entails maintaining proper records. If employees as a whole find similar results, the employer should renegotiate the agreement.


John Mills, PhD, CPA, is a professor of accounting, and Richard Mason, PhD, JD, is an assistant professor, both at the University of Nevada, Reno.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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