Employers with tipped employees have payroll tax withholding, payment, and reporting responsibilities for tips that are considered taxable compensation. Some employers will qualify as large food and beverage establishments and may be subject to special tip allocation and reporting rules.
If you're an employer, you have different payroll tax obligations depending on various factors. One of the factors is having tipped employees. If you have employees who receive cash tips from your customers, the tips may constitute taxable wages for payroll tax purposes. This designation subjects you as an employer to additional payroll tax withholding, reporting and payment requirements.
The first step is to define what constitutes a "tip". Tips are defined as payments that customers make without compulsion. Customers should have the unrestricted right to determine the amount of their tips. That is, the amount shouldn't be subject to negotiation or dictated by your own policy.
If this isn't the case, the so-called tips may in fact be service charges.
You own and operate J & M's restaurant, and you do not permit direct tipping. However, on each J & M check you include a "mandatory gratuity," which you distribute among your employees. Is this gratuity considered a tip? No, such a mandatory charge is not a "tip." The gratuity constitutes taxable wages upon its distribution to the employees.
An employee's cash tips are not taxable wages unless they amount to $20 or more in a calendar month, and the employee reports them to you by the 10th of the month following the month in which they were received. Once the $20 threshold has been reached, however, all cash tips are wages, including the initial $20.
Employer tax withholding and payment obligations
You are responsible for withholding income taxes and FICA (social security and Medicare) taxes on reported tips, and for paying the employer's portion of FICA and FUTA taxes on them, even though you have no control over the amount of tips the employees receive. This includes withholding for the 0.9 percent FICA Medicare surtax. Tips are subject to FICA Medicare surtax withholding if, in combination with other wages paid by you, they exceed the $200,000 withholding threshold.
However, your obligation to withhold the employee's portion of FICA and income taxes is limited to the amount of employee funds under your control (e.g., the non-tip wages you would otherwise pay the employee). If insufficient funds are available, they should be applied to the taxes in the following order:
- first, to the employee's portion of the FICA tax due on the nontip wage payment
- next, to the income taxes that you're obligated to withhold on the nontip wage payment
- next, to the employee's portion of the FICA tax due on the tip income
- finally, to the income taxes that you're obligated to withhold on the tip income
For purposes of these ordering rules, the rules for withholding an employee’s share of the “regular” 1.45 percent Medicare tax on tips also apply to withholding the 0.9 percent FICA Medicare surtax on tips.
If this process leaves you with insufficient funds to collect the employee's FICA tax, your obligation to withhold the uncollected portion ends. In contrast, any outstanding income tax collections should be withheld from your next payment of wages to the employee.
Also, note that you may be eligible for an income tax credit against the amount of FICA tax you have to pay on your employees' tips.
Employees' reports. Your employees may use Form 4070, Employee's Report of Tips to Employer, and Form 4070A, Employee's Daily Record of Tips, to report their tips to you. You may want to give your tipped employees those two forms and a copy of IRS Publication 1244, which discusses their reporting requirements. Or, you can use some other similar form of your own design.
You are not responsible for verifying the accuracy of the amount of tip income your employees report to you. Rather, the employees are responsible for the accuracy of their own tip reports.
What if an employee doesn't report tips to an employer? If your employees fail to report tips of $20 or more per calendar quarter to you, you can be held liable only for the employer's portion of FICA, and this liability does not arise until the IRS makes a written notice and demand.
If you receive any type of letter from the IRS concerning your payroll tax responsibilities, be sure to contact your accountant or tax advisor right away, to find out your options for responding. As with any notice from the IRS, take it seriously. In most cases you must respond within a specified time period or lose your rights to contest the IRS's assessment.
Tip rate alternative agreement commitments. If you are a food service employer, you can agree to take certain steps to increase tip reporting compliance by your employees in exchange for a promise by the IRS not to demand more FICA than you determine to be due.
To participate in this program, you have to enter into a Tip Rate Alternative Agreement Commitment (TRAC) with the IRS. What does this mean? Basically, under this program, you must agree to:
- Maintain a quarterly educational program that trains newly hired employees and periodically updates existing employees about their tip reporting obligations.
- Comply with all federal tax requirements regarding the filing of returns, paying and depositing of taxes, and maintaining records; and establish employee tip-reporting procedures to ensure accurate tip reporting by your employees.
However, IRS agents can't threaten to audit you in order to convince you to sign a TRAC.
Special rules apply to large food and beverage establishments
Special tip reporting and allocation rules apply to what the IRS considers large food and beverage establishments. Basically, these rules require you to file some special information returns with the IRS that, in effect, allocate 8 percent of your gross receipts as tips to your employees, if the employees don't report at least that much in tips.
The allocated tips must also be reported on each employee's W-2 form; however, you do not actually pay or withhold taxes on the allocated amounts. They are reported to the IRS for informational purposes only.
Should you be concerned about these special rules? First, consider what criteria determines whether you are a large food or beverage establishment. You may be surprised to find that the IRS's definition does not mesh with yours!
Large food and beverage establishments defined for payroll tax purposes
For tip reporting and allocation purposes, the IRS says a large food or beverage establishment is any trade or business that:is a food or beverage operation where tipping is customary; andnormally employed more than 10 employees on a typical business day during the preceding calendar year
Operations with customary tipping
A food or beverage operation is any business activity that provides food or beverages for on-site consumption, but does not include fast-food operations, where the customers order, pick up, and pay for food and beverages at a counter or window and carry the food to another location, either on or off the premises.
Tipping is not considered customary at cafeteria-style operations or self-service operations if the customer pays or receives a check before being seated. Tipping is also not considered customary if at least 95 percent of an establishment's total sales are either carryout sales or services for which a service charge of 10 percent or more is added. These sales and services are called "nonallocable receipts" and can be estimated in good faith based on generally accepted accounting principles if they are not recorded separately from other receipts.
Establishments with ten or more employees
An employer is considered to employ more than 10 employees on a typical business day during a calendar year if, on an average day, more than 80 employee hours were worked in the establishment. You must count all employees of your operation, not just food and beverage employees.
To determine whether you have more than 10 employees on a typical business day for a calendar year, use the following procedure:
- Step 1: For the month with the highest gross receipts for the year, divide the total hours worked by all employees by the number of business days in that month.
- Step 2: Make the same calculation for the month with the lowest gross receipts.
- Step 3: Add the results of the first two calculations and then divide the sum by two.
If the result of this calculation is more than 80 hours, you are considered to have employed more than 10 employees on a typical business day.
Pepe's Bistro, located in a seaside resort town, is busiest during the summer months. In June, when its receipts were highest, the total number of employee hours worked was 1,200 and the bistro was open 21 days. In January, when its receipts were lowest, the total number of employee hours worked was 800 and the bistro was open 15 days.
The average number of employee hours worked per business day in June was 57 and in January, 53. The sum of those figures is 110. After dividing by 2, the result is 55.
Pepe's Bistro is not deemed to have employed more than 10 employees during a typical business day; thus, it is not subject to the reporting requirements of large food or beverage establishments.
If you operate a seasonal food or beverage operation, you may be considered to be a large food or beverage operation on the basis of one successful month!
If, in any one month, more than 160 employee-hours are worked on the average day, you are deemed to employ more than 10 employees per typical business day because, even if no employees worked in some other month, the average employee hours still exceed 80.
In the calendar year in which a food or beverage operation is a new business, it is considered a large food or beverage establishment if all of its employees together work more than an average of 80 hours per business day during each of any two consecutive calendar months.
Payroll tax reporting for large food and beverage establishments
If you operate a large food or beverage establishment, you have to file Form 8027, Employer's Annual Information Return of Tip Income and Allocated Tips, with the IRS every calendar year for each large food or beverage establishment in which you have employees. These forms are transmitted with Form 8027-T, Transmittal of Employer's Annual Information Return of Tip Income and Allocated Tips, if you have more than one establishment.
A copy of any good faith written agreement for allocating tips must also be attached to the annual information return.
Regardless of the tip income reported on Form 8027, you are required to withhold income tax and Social Security tax only on the tips actually reported by employees.
Form 8027 must be filed by the last day of February (the filing date is March 31 if you file electronically) of the year following the calendar year for which the return is made.
Statements provided to employees
You must provide written statements to your employees that show your name and address, the name of the employee, and the total tips allocated to the employee for the calendar year. You must also report to your employee the amount by which the Social Security tax or railroad retirement tax imposed on him or her exceeds the amount of these taxes that you can collect from the employee. This information is provided on the employee's Form W-2, Wage and Tax Statement.
A tip allocation is not required, however, if an employee requests an early Form W-2 for a year in which his employment is terminated, though you may provide a good faith estimate of the tip allocation. An amended Form W-2 must then be provided if no tip allocation is actually made or if the estimate varies by more than 5 percent from the actual tip allocation for the year. An amended Form W-2 must also be issued to an employee if the tip allocation varies by more than 5 percent from the actual amount of his tips.
Tip allocation in large food and beverage establishments
If, according to the IRS, you are a large food or beverage establishment, this means that as an employer you have the same general reporting obligations with regard to tips that other employers have and then some. Your employees must report tips received to you. You, in turn, report this information to the IRS.
What's unique to large establishments is that if your employees don't report total tips equal to at least 8 percent of your gross receipts for a payroll period, you must also allocate some extra tips to employees, so that this 8 percent floor is achieved. You do not pay any payroll taxes on these allocated tips — they are reported to the IRS for information purposes only.
Gross receipts are all receipts (except nonallocable receipts from carryouts or services with gratuities added) from the provision of food or beverages, including cash sales, charged sales, and the retail value of any complimentary food or beverages served, but excluding tips and state or local taxes.
Michael's Pizza & Pasta has gross receipts of $20,000 for a payroll period. Employees report tips for that period totaling $1,000. The amount allocated to employees is therefore $600 ($20,000 X .08 = $1,600; $1,600 - $1,000 = $600).
What can you do if you feel that the percentage of gross receipts you must use to determine the tip allocations doesn't accurately reflect the tips your employees are actually getting?
You do have a course of action available. Either an employer or a majority of directly tipped employees can petition the IRS to lower the percentage of gross receipts used to determine tip allocations to a percentage that will better reflect the tips actually paid in the establishment.
If convinced, the IRS can lower the percentage to as low as 2 percent. You can't use a reduced percentage before receiving notice in writing from the IRS that the petition is approved.
Allocations based on good faith agreements
One option you have for allocating tips to individual employees is on the basis of a "good faith agreement" between you and your employees. That means a written agreement consented to by you as the employer, and at least two-thirds of the members of each occupational category of tipped employees (for example, waiters and busboys) employed in the establishment when the agreement is adopted. Keep in mind, employees who receive less than $20 per month in tip income are not considered "tipped employees."
A good faith agreement must contain the following four elements:
- It must provide for an allocation that, together with reported tips, reflects a good faith approximation of the actual distribution of tip income.
- It must become effective prospectively on the first day of a payroll period but no later than the first day of the succeeding calendar year.
- It must be adopted when tipped employees are employed in each occupational category of tipped employees affected by the agreement.
- It must allow for prospective revocation of the agreement by a written instrument adopted by at least two-thirds of the tipped employees affected by the agreement at the time of revocation. (A revocation can be effective only at the beginning of a payroll period.)
Allocations made without an agreement
What do you do if you don't have a good faith agreement in place? In that case, you must allocate tips to each "directly tipped" employee who has a reporting shortfall for the payroll period.
Directly tipped employees are any tipped employees who receive tips directly from customers, including employees who turn all tips over to a tip pool. Indirectly tipped employees are tipped employees who do not ordinarily receive tips directly from customers, such as busboys, service bartenders, and cooks. No allocations are made to indirectly tipped employees.
Employees who receive both direct and indirect tips, such as a maitre d', are treated as directly tipped employees.
Here's how you would perform the allocation, step-by-step:
- Multiply your establishment's gross receipts for the payroll period by 8 percent (.08).
- Subtract from this amount the total tips reported for the payroll period by indirectly tipped employees.
- Allocate the remainder to directly tipped employees by multiplying the remainder by the percentage of gross receipts attributable to each employee. To calculate that percentage, divide the gross receipts attributable to each employee by the gross receipts attributable to all tipped employees. (Alternatively, the basis for allocation can be the number of hours worked by each employee for a payroll period, but only if you employ less than the equivalent of 25 full-time employees at your establishment during the payroll period. To qualify, the average number of employee hours worked per day at your establishment during the period must be less than 200.)
- Subtract the tips reported by each directly tipped employee from the amount allocated to each employee in Step 3. Any remainder is the employee's shortfall for the payroll period.
- Subtract the total tips reported by all directly and indirectly tipped employees for the payroll period from 8 percent of gross receipts for the period (which is calculated in Step 1).
- Allocate the remainder from Step 5 to directly tipped employees who had a shortfall for the payroll period by multiplying the remainder by the pro rata share of the total shortfall attributable to each such employee.
For additional guidance, our case study illustrates the allocation process for tips in a large establishment.