IRS Answers 15 Payroll Questions on Tip Reporting


Tip reporting is often a tricky proposition for employers at restaurants and other industries where tipping is common. Employees often try to sweep tips "under the table" by failing to properly report tips that they receive so they don't have to pay tax on them. But an employer can end up taking the fall for failing to comply with the rules. To provide some much-needed guidance in this area, the IRS issued new Publication 5080, Form 4137, Compliance Program Frequently Asked Questions, with 15 Q&As on the tip reporting compliance program.

A Few Tips for Reporting Tips

Employees who receive cash tips of $20 or more in a calendar month are required to report the total to their employers. These employees must provide written reports by the tenth of the following month. Employees who receive tips of less than $20 in a calendar month aren't required to report their tips to employers, but are still required to report the amounts as income on their tax returns.

Cash tips include tips received directly from customers, tips from other employees under a tip-sharing arrangement, and charged tips (from credit and debit cards) distributed to the employee. But service charges, which are added to a bill or fixed by an employer, do not constitute tips, but rather non-tip wages. These non-tip wages are subject to Social Security tax, Medicare tax, and federal income tax withholding.

Some common examples of service charges (sometimes called "auto-gratuities") in service industries are:

  • Large party charge (restaurants);
  • Bottle service charge (restaurant and night-clubs);
  • Room service charge (hotels and resorts);
  • Contracted luggage assistance charge (hotels and resorts); and
  • Mandated delivery charge (pizza, food or retail deliveries).

Employees can use Form 4070A, Employee's Daily Record of Tips and Form 4070, Employee's Report of Tips to Employer, to report their tips to employers. Both forms can be found in IRS Publication 1244, Employee's Daily Record of Tips and Report to Employer

Background: Employers in industries where tipping is customary know they must pay the employer's share of Social Security and Medicare (FICA) taxes on tips employees report to them. However, many employers don't realize that they may be liable for these same taxes on tips employees do not report to them.

For tips that employees do not report to the employer, the employer's liability for the its share of FICA taxes doesn't arise until the IRS issues a "Section 3121(q) Notice and Demand."

The Section 3121(q) Notice and Demand instructs the employer to include the Social Security and Medicare tax amount shown on the employer's next Form 941. The Notice and Demand is based on information the IRS collects from the employees' Forms 4137, Social Security and Medicare Tax on Unreported Tip Income.

Employees use Form 4137 to report and pay their share of Social Security and Medicare taxes due on the tips they did not report to their employers, including any tips allocated to employees of large food and beverage establishments. The employer is not subject to any interest charges or deposit penalties if it properly reports and pays the taxes as instructed in the notice and demand.

The IRS generally notifies an employer at least 30 calendar days in advance of the issuance of the Section 3121(q) Notice and Demand by issuing a "pre-notice letter" ("Letter 4520-P"). The IRS has designated a staff that may help resolve any discrepancies an employer notes on this official advance notice.

Several of the Q&As in the new IRS publication focus on "allocated" tips. For instance, one states that an employer who operates a large food or beverage establishment must allocate tips among its tipped employees if the total tips reported to the employer during any payroll period are less than 8 percent (or the approved lower rate) of the establishment's gross receipts for that period.

Also, the IRS advises employers in another Q&A that they can't report allocated tips in Box 1 (Wages, tips, other compensation), Box 5 (Medicare wages and tips), and Box 7 (Social Security tips) of Forms W-2, and pay the taxes on Form 941 for the year in which the tips are allocated, in order to avoid an unplanned liability on a Section 3121(q) Notice and Demand.

Best approach: The IRS says the best way to minimize any unexpected Section 3121(q) assessments is for employers to educate their employees on tip reporting responsibilities and to administer a system that allows employees to report their tips accurately when received.

Here's the complete list of the 15 questions in new Publication 5080:

Question 1. What tips does an employee have to report to his or her employer? 

Question 2. How are tips reported by the employee to the employer?

Question 3. If an employee fails to report tips to his or her employer, how are Social Security and Medicare taxes paid on those tips by an employee?

Question 4. What are allocated tips?

Question 5. If an employee fails to report tips to his or her employer, when is an employer liable for Social Security and Medicare taxes on those tips?

Question 6. What is Letter 4520-P?

Question 7. Can an employer get an extension of time to respond to the pre-notice (Letter 4520-P)?

Question 8. What should an employer do if it does not agree with the amounts shown in the pre-notice (Letter 4520-P) for some of the employees listed?

Question 9. If an individual listed in the attachment to the pre-notice (Letter 4520-P) did not work in a tipped capacity, what should the employer do to resolve this inquiry?

Question 10. How does an employer that files Form 941 report the Code Sec. 3121(q) FICA tax liability after notice and demand is made?

Question 11. How does the employer pay the tax?

Question 12. An employer understands that the additional tips reported by many of its employees represent allocated tips shown on their Forms W-2. Is there any way the employer can report allocated tips in Box 1 (Wages, tips, other compensation), Box 5 (Medicare wages and tips), and Box 7 (Social Security tips) of Forms W-2, and pay the taxes on Form 941 for the year in which the tips are allocated so that it won't have this unplanned liability in the future?

Question 13. If an employer receives the pre-notice (Letter 4520-P) and agrees that it owes the stated taxes, can the employer include the amount immediately on the current quarter's Form 941 instead of waiting until the Section 3121(q) Notice and Demand is issued?

Question 14. If an employer receives a Section 3121(q) Notice and Demand (Letter 4520) after it closed its business, is the employer still liable? How does the employer report and pay the amount it owes?

Question 15. Is the Code Sec. 45B credit, with respect to the tips reported on the Section 3121(q) Notice and Demand, available to the employer in the year the Section 3121(q) Notice and Demand is made? Or does an employer need to file an amended return for the year in which the unreported tips were received by the employee?

Click here to read the answers to these questions in Publication 5080. If you have questions about tip reporting in your business, contact us. We are happy to assist. 

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