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.
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?
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