Due to the fact that some businesses may have to change automated or manual reporting systems in order to comply with the proper treatment of service charges on June 20, 2012, the IRS released updated guidance to assist employment tax examiners in the assessment of tips pertaining to the hospitality and restaurant industry.
Revenue Rule 2012-18 provides essential advice on the imposition of taxes on tips under the Federal Insurance Contributions Act (FICA), including information on the difference between tips and service charges, the reporting of the employer share of FICA under section 3121(q) of the Internal Revenue Code (Code), and the section 45B credit for the excess employer Social Security tax an employer pays on tips. It mandates immediate compliance, is applicable retroactively and affects employers whose bread and butter is earned within tip-driven industries. However, the accompanying Internal Revenue Bulletin 2012-26 and Announcement 2012-25 reveal flexibility in that the compliance period may be extended to allow businesses additional time to amend practices and implement system changes.
The determination of whether a payment is a “tip” or “service charge” is on the front burner in Revenue Rule 2012-18. Keeping a close eye on the customer is fundamental to the hospitality and restaurant industry and is also at the heart of Ruling 2012-18, as it extracts the most important factors established in prior Revenue Ruling 59-252. The employer’s characterization of a payment as a “tip” is not determinative, and the essence of the IRS’ recipe for compliance points to a review of the payment’s source and requires consideration of the circumstantial events.
Employers are advised an examiner will consider the payment a “service charge,” thus a wage subject to normal reporting and withholding requirements, in the absence of any of the following factors: 1) the payment must be made free from compulsion; (2) the customer must have the unrestricted right to determine the amount; (3) the payment should not be the subject of negotiation or dictated by employer policy; and (4) the customer has the right to determine who receives the payment. In addition, the employer cannot use these “wages” when computing the credit available under Code section 45B because these amounts are not “tips.” This provision will apply to amounts being paid after January 1, 2013 unless the employer demonstrates the particular situation is not addressed in prior guidance or additional compliance time is necessary.
By illustration, if an employer adds an automatic, predetermined charge, indicating such on the tip line of the receipt, the charge is not a “tip” within the meaning of Code section 3121. The scenario customarily arises in restaurants and is often called an “auto-gratuity.” The Rule explains the payment would not be made free from compulsion, the customer would not have the unrestricted right to determine the amount, and the payment would not be the subject of negotiation or was dictated by employer policy.
Revenue Rule 2012-18 reiterates that all cash tips received by an employee are wages for FICA tax purposes. Cash tips include tips received from customers, charged tips distributed by the employer, and tips received from other employees under tip-sharing arrangements. Employees who receive tips, directly or indirectly, must report them to their employer.
FICA taxes consist of two separate taxes, Social Security and Medicare and sections 3101 and 3111 of the Code impose FICA taxes on employees and employers. Section 3121(a) of the Code defines “wages” for FICA tax purposes as all remuneration for employment, with certain exceptions; tips paid in any medium other than cash or the tips received by an employee in any calendar month is less than $20.
Revenue Ruling 2012-18 guides compliance with unique tip reporting and payment of FICA taxes by employees and employers. The Rule points to Code section 6053(a) requiring every employee who, in the course employment, receives in any calendar month tips that are wages to report all tips in a written statement furnished to the employer within a specified time frame. Employers are required to withhold the employee share of FICA taxes on the reported tips from the employee’s wages or from other funds made available by the employee for this purpose, pay the employer and employee shares of FICA taxes in the same manner as the taxes on the employee’s non-tip wage and include the reported tips on the employee’s Form W-2. The employer must make a current period adjustment on Form 941 to reflect any uncollected employee FICA taxes on reported tips and report the amounts on the employee’s Form W-2.
If an employee fails to report tips, the employer is not liable for the employer share of FICA taxes on the unreported tips until notice and demand is made by the Service, is not liable to withhold and pay the employee share of FICA taxes on the unreported tips nor is liable for interest on the employer’s FICA tax liability for unreported tips if the tax is paid on or before the due date of the Form 941 for the quarter during which the notice and demand is made. Revenue Ruling 2012-18 contains guidance for compliance with a Code section 3121(q) notice a demand.
Keeping the principles in mind, best practices for compliance with Revenue Rule 2012-18 includes:
- Understanding and becoming acquainted with Revenue Rule 2012-18, which lends itself to a practical application by employers in the hospitality and restaurant industry.
- Developing policies that require examination of employees’ written statements pertaining to cash tips. Form 4070, Employee’s Report of Tips to Employer, is available for this purpose and may be found in Publication 1244, Employee’s Daily Record of Tips and Report to Employer.
- Reviewing voluntary tip compliance agreements and related systems to determine if they accurately reflect auto-gratuities as service charges.
- Staying abreast of the IRS’ proposed changes to voluntary compliance agreements for industries where tipping is customary because Announcement 2012-25 states the IRS is considering significant changes to the Tip Reporting Alternative Commitment (TRAC) program.
- Maintain routine education about tip reporting to front of house or other tipped employees.
About the Authors
Paul Caleo, is the Retail and Hospitality Chair for DRI – The Voice of the Defense Bar, an association of more than 22,000 defense attorneys and corporate counsel members and defending the integrity of the civil judiciary. A thought leader, DRI provides world-class legal education, deep expertise for policy-makers, legal resources, and networking opportunities to facilitate career and law firm growth.
Additionally, Mr. Caleo is the Chair of Burnham Brown’s Retail and Hospitality Law Practice group and one of its premier trial lawyers. Mr. Caleo can be reached at 510.835.6809 or firstname.lastname@example.org.
Anjuli Cargain provides counsel to clients in a broad array of employment and business litigation matters, as well as works with employers to develop and enforce effective policies, practices, and procedures. Ms. Cargain can be reached at 510.835.6289 or email@example.com.