Calling a Payment a Tip Doesn't Make It a Tip [Update]
If you have tipped employees, you may want to review your policy on automatically adding "tips" to bills of large parties. Last year, the IRS clarified its rules on these charges, and gave some employers an extension — until the end of 2013 — to update their systems.
An employer's characterization of a payment as a tip or a service charge will not control how the IRS views the payment. Regardless of whether the employer calls a payment a tip or a service charge, the IRS will make its own decision by applying the four criteria for tip income. (This is simply another application of the "substance over form" rule that applies throughout tax law.)
More than 50 years ago, the IRS provided factors to determine whether amounts received by an employee were tips. These four criteria still represent the IRS's position in this area and are what the IRS considers when auditing an employer who has tipped employees.
- The payment must be voluntary on the part of the customer.
- The amount must be completely within the customer's control.
- The amount must not be subject to negotiation or dictated by employer policy.
- The customer must have the right to determine who receives the payment.
The absence of any of these factors creates a serious doubt as to whether the payment is really a tip. Unless all four are present, in all probability the payment will be considered a service charge.
In 2012, the IRS clarified how these four factors apply to "tips" a restaurant automatically adds to bills for large parties, but also provided relief for some employers until the end of this year. In situations like the one in the example below, the payment is a service charge — not a tip.
The menu at Bangs Lake Bistro states "A gratuity of 18 percent will be added to all bills for parties of six or more." The restaurant distributes this amount to all serving staff, regardless of whether they had actually served that customer.
Isabella's bill for her party of eight included an amount on the "tip line" equal to 18 percent of the price for food and beverages. Because the amount was dictated by the restaurant's policy and not Isabella's opinion of the service received, the payment was not free from compulsion. The fact the amount was labeled a tip did not make it one: It was a service charge. (However, if Isabella had added an extra three percent to the amount because the service was extraordinary, then that three percent would be considered a tip.)
Why Does the Characterization Matter?
Virtually all employees and employers have payroll tax obligations. Although both parties are liable for taxes, in most cases the compliance burden falls on the employer. The employer must pay the employer-share of FICA taxes and withhold the employee-share of FICA tax and income tax from the employee's wages at the time the wages are paid.
Both income from cash tips and income from service charges are considered remuneration paid by the employer. In both cases, there will be FICA and income withholding tax obligations.
So why does it matter how the income is characterized? It matters because special withholding and payroll tax rules apply to tip income. These special rules affect the timing of the employer's obligation to collect and pay over taxes. They also affect the penalties and interest that can be imposed for failure to meet payroll obligations.
The need for special tip income rules arises from the nature of the payments. Customers often pay the tips directly to the server, who may not have an obligation to turn over tips to the employer. How can an employer meet payroll tax obligations on income that may not be reported to him or her? The answer is that the employer's duty to pay is triggered by the employee's written statement filed with the employer. An employer does not have an immediate tax obligation with respect to any amounts that the employee fails to report.
By law, employees who receive cash tips of $20 or more in a calendar month must report the total amount of tips received to their employers on or before the tenth day of the following month. This rule applies to indirectly tipped employees (such as someone who busses tables and receives a percentage of tips) as well as those who are directly tipped by the customer.
Form 4070, Employee's Report of Tips to Employer, may be used to report tip income, but it does not have to be. Form 4070 can be found in IRS Publication 1244, Employee's Daily Record of Tips and Report to Employer.
Characterizing what is really a service charge as tip income makes the employer's payroll obligations dependent upon the employee's diligence in monthly reporting. If the employee does not report the tips, the employer is not liable for any payroll tax on the unreported amounts until the IRS makes notice and demand to the employer. This means it may be years before the employer has to pay these taxes.
Relief from Rules Ends This Year
The IRS has indicated that it will apply the criteria to recharacterize income retroactively to tax years under examination. However, if an employer can show that he or she needs additional time to change its business practices and make system adjustments to properly report amounts as service charges, rather than tips, then the recharacterization may be delayed and applied only prospectively, to amounts paid on or after January 1, 2014.
The IRS initially provided this relief through the end of 2012, and then extended the time for compliance until December 31, 2013.