Tips on tips legal and tax issues regarding tips

Tips on Tips
Legal and Tax Issues Regarding Tips
June 25, 2014
Marney Zellers, CHAE
Hospitality Specialist

Tips on Tips Overview
• Tips vs. Service Charges
• Tip Pools and Tip Sharing
• Tip Reporting and Tip Income Audits
• Best Practices

Tips on Tips Internal Revenue Code History
1965: IRC
requires
employers to
withhold FICA
tax on tips from
employees’ pay,
but employers
did not have to
pay a matching
amount
1977: IRC
requires
employers to
pay its share of
FICA tax on
tips, but only up
to the minimum
wage
1982: IRC
requires
employers
whose
employees fail
to report at
least 8% of
gross sales as
tips to allocate
tips to this level
1987:
Congress
amends IRC to
require
employer
portion of FICA
tax on all tips
1993: FICA
tip credit
enacted -
employers
allowed a tax
credit for the
FICA taxes
paid on their
employee tips
1993: IRS introduces
the Tip Rate
Determination/Education
Program (TRDEP) to
encourage employees to
report the correct
amount of tip income to
their employer.
2002: Supreme Court
rules the IRS can
determine the amount of
tips it thinks employees
should have reported
based on restaurant
data and can assess the
employer share of FICA
tax on suspected
unreported tips
2013: IRS
enforces Revenue
Ruling 2012-18,
clarifying their
distinction between
tips and service
charges and their
treatment of each

QUESTION
Tips on Tips Tips vs. Service Charges
Service charges differ from tips in the following
way:
a) Tips are subject to the employer matching FICA tax but service
charges are not.
b) Tips can be considered toward minimum wage in states with a
tip credit while service charges may not.
c) Service charges belong to the employer while tips belong to the
employee.
d) All of the above.

Tips vs. Service Charges - Defined
Tips Service Charges
Payment is free from compulsion Payment is required
Customer has unrestricted right to determine
amount
Amount is determined by someone other than
customer
Generally, the customer has the right to determine
who receives the payment
Someone other than the customer determines who
receives the payment

Tips vs. Service Charges - Treatment
Tips Service Charges
Reported to IRS as tip income and eligible for the
FICA tip credit
Reported to IRS as wages and not eligible for the
FICA tip credit
Legally belong to the person for whom the
customer intended payment. Employer distribution
of tips to those other than said person are limited.
Legally belong to employer. Treated as income and
subject to sales tax in applicable states. Employer
retention and distribution of payments more liberal.
Count toward meeting minimum wage requirement
in states with tip offset (tip credit)
Count toward meeting minimum wage requirement
in states with tip offset (tip credit)
Included in hourly rate used to determine overtime
rate

AUTOMATIC GRATUITY
• Commonly referred to as “Auto Grat”
• Commonly added to restaurant checks of larger parties
• Automatic gratuity policies are commonly written on menus and verbalized by
front desk staff
• IRS Rev. Ruling 2012-18 declares auto grat to be a service charge, not a tip

QUESTION
Tips on Tips Tip Pools and Tip Sharing
A reasonable tip pool, according to the US Dept.
of Labor, includes the following:
a) Employers may require directly tipped employees to share
service charges such as auto gratuity, but not discretionary tips.
b) Employer may require directly tipped employees to share up to
15% of all their tips with other employees involved in the service
of the customers
c) Salaried managers may be included in a tip pool as long as they
are directly serving the customers
d) None of the above

Tip Pools and Tip Sharing – Definitions
Tip Pool Tip Share
All tips collected and distributed by “house”
Tipped employee required to share a percentage of
tips with other employees

Mandatory Tip Pools and Tip Sharing – Who
Can and Cannot Partake
Can Cannot
Food and beverage servers (waiters, waitresses,
cocktail servers)
Owners or managers
Bartenders Cooks or chefs
Bussers and bar backs Dishwashers
Hosts and greeters Laundry room attendants
Counter personnel Janitors
Bellhops “The house”
Some hourly supervisors
Some sushi and teppanyaki chefs

Tip Pools and Tip Sharing – Department of
Labor Rules and Regulations
Permissible as long as the employees sharing in the tips have somehow participated in serving of
the customers who left the tips
Legally belong to the person for whom the customer intended payment. Employer distribution of tips
to those other than said person are limited.
Count toward meeting minimum wage requirement in states with tip offset (tip credit). Employer may
only take a tip credit for the amount of tips each employee ultimately receives.
Employer must notify its employees in advance of any required tip pool contribution amount.
Employer may not retain any of the employees' tips for any other purpose.
Department of Labor tip pool/tip share rulings do not apply to employer mandated service charges.

Tip Pools and Tip Sharing – The Mario Batali
Case
STEPHANIE CAPSOLAS, et al v. PASTA RESOURCES, INC., et al
Class action lawsuit claiming employees were required to tip out 4-5% of wine sales to support the
wine program.
Employees claimed the proceeds went to “the house”. The judge agreed.
Batali’s group agreed to pay $5.25 million in restitution.

Tip Pools and Tip Sharing – Cumbie v. Woody Woo
and Oregon Restaurant Association et al v. Solis
Ninth Circuit Court of Appeals – Jurisdiction includes California, Nevada, Washington, Oregon, Alaska, Idaho,
Montana, Hawaii, and Arizona
An employer can require servers to pool their tips with non-tipped kitchen and other “back of the house staff,”
so long as a tip credit was not taken and the servers were paid minimum wage.
In 2011, the DOL issued regulations that directly conflicted with the holding in Woody Woo. As a result,
employers could no longer require mandatory tip pooling with back-of-the-house employees.
Shortly after the 2011 regulation, the National Restaurant Association, Washington Restaurant Association,
Oregon Restaurant and Lodging Association, and Alaska Cabaret, Hotel, Restaurant, and Retailer Association
filed a law suit in the US District Court.
On June 10, 2013, the District Court granted the plaintiffs’ summary judgment motion, holding that the DOL
exceeded its authority by issuing regulations on tip pooling in restaurants. The District Court stated that the
language of the FLSA is clear and unambiguous; it only imposes conditions on employers that take a tip
credit.
Final implications are still not clear. Employers of non-tip credit states are still advised to act cautiously
around tip pools involving back of the house staff.

QUESTION
Tips on Tips Tip Reporting and Audits
When declaring tip income, the IRS requires an
employee report:
a) At least 8% of the employee’s total sales
b) 10% of the employee’s total sales or 100% of credit card tips,
whichever is higher
c) 100% of credit card tips plus 10% of the employee’s cash sales
d) None of the above

Tip Reporting - Requirements
Employee
Keep a daily record of tips and sales
Employee who receive $20 or more in tips, either directly or indirectly, in a month must report all tips
to the employer by no later than the 10th day of the following month. (Employers may require
employees to report tips more often.)

Tip Reporting - Requirements
Employer
Collect employee tip reports
Withhold and pay Social security, Medicare and federal income taxes on all employee tips
Employers must match employee’s Social Security and Medicare taxes on all employee tips (NOTE: this
is true whether or not the employee reports the tips)
When preparing an employee's Form W-2, include wages, tips and other compensation in the box
labeled "Wages, tips, other compensation." Include Medicare wages and tips, and social security tips in
their respective boxes. When figuring the employer's liability for federal unemployment tax, add the
reported tips to the employee's wages.
Allocate tips to any directly tipped employees who reported tips of less than 8% of his or her sales.
File Form 8027 if tipping is customary, food and drink are provided for consumption on premises and
the business employs more than 10 employees or the equivalent (more than 80 employee hours per day)
on a typical day.

Tip Reporting - Forms
Form Purpose/Requirements
941
Employer’s Quarterly Federal Tax Return (for
payroll taxes)
8027
Employer's Annual Information Return of Tip
Income and Allocated Tips (employers with 10 or
more employees who work 80 hour or more in a
typical day)
4137
Social Security and Medicare Tax on Unreported
Tip Income (for employees to report and pay
uncollected taxes if regular pay was not enough for
employer to withhold all the taxes owed, or on
allocated tips)
4070 Employee’s Report of Tips to Employer

QUESTION
TRUE
or
FALSE
In a tip income audit, the IRS focuses solely on
recovering income tax from employees who underreport
their tip income.

Tip Audit Facts
The IRS has the right to audit at least as far back as three years - further, if the agency believes it's a
case of fraud. Some restaurant servers have even been jailed for tax evasion.
Courts continue to hold that the IRS may use indirect and aggregate methods for determining
underreported tip income in audits where employee tip reporting records are incomplete or in
employer-only audits.
In an employer-only audit, the determination is made through an observation that the overall rate of
tips for a restaurant is not high enough. Audits are made without auditing the employees of the
restaurant.
Along with requiring employers to pay their share of FICA taxes on underreported tip income, the IRS
may also assess penalties to employers equal to the EMPLOYEE portion of FICA taxes.

Triggering a Tip Audit
Red Flags
Percentage of total reported tips relative to total sales is below industry average
Credit card tips reported on form 8027 exceed total tips declared to employer by employees
Percentage of reported cash tips relative to cash sales is significantly lower than that of credit card
tips to credit card sales

Tip Rate Determination/Education Program (TRDEP)
Program Summary
TRDA (Tip Rate Determination Agreement)
• Restaurant specific
• IRS works with employer to determine tip rate
for each job classification
• Requires at least 75% of employees to sign a
Tipped Employee Participation Agreement
(TEPA) and report at or above the determined
rate
• Employer provides IRS with name, SS#, sales
and tips reported, etc. of employees who do not
comply
• Protects employer from prior period audits

Program Summary
TRAC (Tip Reporting Alternative Commitment)
• Employer must establish a quarterly education
program for existing employees and educate
newly hired employees about their tip-reporting
responsibilities.
• Employer must file all appropriate returns and
make timely tax deposits to be in compliance.
• Employers with more than 10 employees (80
work hours per week) must file Form 8027.
• Adequate records must be maintained and
made available to the IRS.
• Complying employers will not be subject to
employer-only audits.

Program Summary
emTRAC (Employer-Designated TRAC)
• Same requirements and advantages as TRAC
• More flexible than a TRAC.
• Employer develops and submits for IRS
approval a tip education and reporting program
for their employees.

Tips on Tips Best Practices
Problems and Solutions
Issue Best Practices
Auto gratuity is common in your business.
Reduced FICA tip credit would have a major
impact on business.
• Consider reducing use of auto gratuity and
printing suggested tip amounts on guest checks
• Retain a portion of the auto gratuity for the
house
Employees underreport tips
• Strong policy including tip allocation policy
• Tip reporting training and education
• Tip Agreements (TRDA, TRAC, emTRAC)
Want to include kitchen staff in tip pool
• Voluntary tip pool
• Service charge instead of tip

Tips on Tips Final Tips
• Know the difference between tips and service
charges and maximize the advantages of each
• Structure fair and compliant tip pools and tip
sharing agreements
• Understand your tip reporting and withholding
responsibilities
• Avoid tip income audits through education and
solid employee requirements

LET’S HEAR FROM
YOU
Questions?
What are your experiences and best practices?
Tips on Tips

The material appearing in this presentation is for informational purposes only and is not
legal or accounting advice. Communication of this information is not intended to create,
and receipt does not constitute, a legal relationship, including, but not limited to, an
accountant-client relationship. Although these materials may have been prepared by
professionals, they should not be used as a substitute for professional services. If legal,
accounting, or other professional advice is required, the services of a professional should
be sought.

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