WHERE DID THE TRAC COME FROM? Effective June 1995, the Internal Revenue Service (IRS) instituted a new program, Tip Reporting Alternative Commitment (TRAC), to further encourage the accurate reporting of all tips. Restaurant employees failing to report all of their tips is a common issue. While credit card tips that restaurant employees receive from patrons are often easy to trace because the amounts are clearly listed on the charge receipts, cash tips are not as easy to trace. As a result, in 1994 a coalition of employers from several restaurants and hotels, along with IRS representatives, developed TRAC to increase legitimate tip reporting by employees. TRAC is a more palatable alternative to the IRS’s Tip Reporting Determination Agreement (TRDA), which the IRS rolled out nationwide in 1993.
TRAC encourages tip reporting by focusing on charge receipts and enlisting the assistance of the employer in monitoring the reporting of tips. However, TRAC does not force employees to report tips at a set rate, nor does it require employee sign-up, as TRDA did. Employers who have signed a TRDA can readily switch to a TRAC.
WHAT ARE THE BENEFITS OF SIGNING A TRAC? Employers who are using TRAC are protected from “employer-first” and “employer-only” audits. The IRS agrees that it will not bill an employer using TRAC for employees’ unreported tips without first establishing that FICA taxes are owed by each individual employee.
Also, with the exception of any years for which the employer is currently undergoing a tip audit, an employer on TRAC is protected from assessments for FICA tax on unreported tips in pre-TRAC years back to 1988 (when tips first became subject to FICA tax). Previously, the IRS enraged the restaurant industry by demanding that operators pay the employer portion of FICA tax on tips that the IRS claims employees failed to report without first attempting to collect funds from the employees who supposedly failed to report the tips in the first place.
ARE THERE ANY DOWNSIDES TO SIGNING A TRAC? Under TRAC, employees are under more pressure to report all the tips they receive. Consequently, both the employee and employer will be liable for more tip taxes. For the employer, some of the FICA tax paid for an employee’s tips may be offset by the 45(B) tax credit.
The other downside to TRAC is that persuading employees to report all of their tips—even though this is required by law and is nothing new—may be difficult, especially since many restaurant employees have little understanding of their tip-reporting requirements.
WHAT IS REQUIRED OF AN EMPLOYER UNDER A TRAC AGREEMENT? To participate in a TRAC, the employer must follow four requirements:
Each quarter, the employer must educate all new directly tipped and indirectly tipped employees about tip reporting responsibilities, as well as periodically update existing employees on reporting requirements, emphasizing that cash tips must be reported. This training can take place on or off site and can include video programs and written materials. The employer must emphasize that all tips received by employees, both charged and cash tips, must be reported to the employer. The employer may illustrate this point by explaining the relationship between charged and cash tips. Auditors will conclude as a general rule that the tipping percentage on cash sales is only slightly less (roughly 2 percent) than the tipping percentage on charge sales. Employees would be foolish to assert that they receive tips of 15 percent on charge sales, but nothing on cash sales.
The employer must also stress that accurate tip reporting is important for Social Security benefit calculations at the employee’s retirement and that all employees are obligated to maintain records of the tips they report.
The employer must establish a system wherein each directly tipped employee receives a written statement at least once a month that reflects the amount of charged tips and cash tips apportioned to that employee. The employer must also allow the employee an opportunity to verify and change any amount of charged or cash tips to reflect the amount of money the employee may have contributed to tip outs, tip sharing, tip pooling, etc.
The employer must also establish a system for indirectly tipped employees who receive a portion of charged tips. Examples provided by the IRS of possible systems are: any employee may report to the employer the amount of money he shared with another employee from a charged tip; or, the employer could issue a written statement to the indirectly tipped employee that states the amount of tips apportioned to that employee and then provide the employee with an opportunity to verify and correct the statement.
NOTE: The IRS does not require employers to report tipped employees who refuse to verify their charged tips. However, the employer must still complete the Form 8027 (which allocates tips to certain employees) if overall tip reporting falls below 8 percent. Also, the employer does not have to reconcile tip sharing between directly and indirectly tipped employees. Whatever system an employer decides to implement, the employer must make sure that the system enables the employees to satisfy their reporting requirements under section 6053(a) of the IRS Code.
Employers must comply with all existing tax filing, deposit and reporting requirements. Employers must properly complete Form 941, Form 8027 and Form W-2, and pay the amount of any undisputed federal tax that is due. An employer must also deposit federal taxes.
4. Maintain Records: Finally, the employer must maintain certain records (gross receipts subject to food or beverage tipping and charge receipts showing charged tips) and make these records available to the IRS.
HOW DOES AN EMPLOYER APPLY FOR A TRAC? Employers may apply for TRAC by sending a letter of intent to the Tip Coordinator in the employer’s IRS district. After receiving the TRAC application, the IRS will review the letter and the employer’s tax compliance. If the IRS approves the employer’s application, TRAC is effective the first day of the first calendar quarter following the signature of the TRAC by the IRS District Director.
HOW IS A TRAC REVOKED? The IRS can revoke a TRAC for any of the following reasons:
if the employer has not complied with the employer’s responsibilities listed above;
if employees at the employer’s business have collectively and substantially underreported their tips if the IRS or other federal agency pursues an administrative or judicial action against the employer or the employer’s business
Conversely, an employer can revoke TRAC at any time by providing written notification to the IRS that identifies the employer, the employer’s business and the employer’s intent to revoke TRAC.
OTHER IRS TIP AGREEMENTS EmTRAC. In 2000, the IRS introduced a modified variation of the TRAC, the Employer-Designed TRAC Agreement (EmTRAC), available only to employers in the food and beverage industry that have employees that receive both cash and charged tips. EmTRAC retains many of the provisions of the TRAC agreement, including protection against employer-only audits. The employer also agrees to comply with TRAC’s tax reporting, filing, payment and record maintenance requirements. The employer must also establish an educational program on tip-reporting requirements. Education must be provided to new employees and provided quarterly for existing employees. The EmTRAC program, however, provides an employer with a little more flexibility in designing its educational program and tip reporting procedures. Also, while an EmTRAC must be approved by the IRS, it does not require an employer to enter into a formal written contract with the IRS.
ATIP. On July 31, 2006, the IRS announced that it would be offering another tip agreement called the Attributed Tip Income Program (ATIP). ATIP provides benefits similar to the existing TRAC, EmTRAC and TRDA programs but has simpler paperwork requirements. The ATIP program is available for an initial three-year period from January 1, 2007 through December 31, 2009. Eligible employers elect to participate in ATIP by individual establishment and must file a new election for each establishment each year. Notice of participation is made by checking a box on Form 8027 and sending the ATIP coordinator a copy of last year’s Form 8027. An employer that would not otherwise file Form 8027, such as an employer with less than 10 employees, must check the box and complete only the first five lines of Form 8027 to show participation. Similar to EmTRAC, ATIP does not require an employer to enter into a formal written contract with the IRS.
An establishment must meet two requirements to participate in ATIP: Under ATIP, tips are attributed to employees based on a percentage of food and beverage sales. The percentage used is the charge tip rate from the prior year’s Form 8027, less two percent. The employer must devise a method to allocate tips among employees. Tips are attributed to both participating and nonparticipating employees, but attributed tips are not considered taxable income to nonparticipating employees. Nonparticipating employees must still maintain tip logs and report tips to their employers.
FACTS REGARDING TIP REPORTING REQUIREMENTS Whether an employer signs a TRAC or not, an employer must ensure its employees understand their tip-reporting requirements. As long as employees underreport tips, an employer may be liable for the employee’s taxes on the underreported tips.
Many employees are so ill-informed about tip reporting that they may balk at an employer’s TRAC efforts. The CRA urges employers to open lines of communication with employees to make sure they understand their responsibilities for reporting tips and the consequences they may face if they do not comply. The CRA suggests that employers meet with their employees to clarify the following points:
At least 20 percent of the preceding year’s food and beverage sales must have been charge card sales showing a charged tip; and
At least 75 percent of tipped employees must agree to participate in ATIP for the current year.
All tips are taxable. They have been taxable since 1966.
By law, employees must report tips to the employer at least once a month, and more often if the employer requires it.
It is the employee’s responsibility to report tips to the employer if the employee receives $20 a month or more in tips. This report must be made by the tenth of the month following the month in which the tips were received.
Employees must keep a daily record of tips showing the following information:
total cash tips received
total charged tips received
amount of tips paid out to other employees
the names of the employees who received these tip-outs
Charge receipts reveal a substantial portion of an individual employee’s tips, as well as the approximate tipping rate in the restaurant.
A tax audit can be very costly. Employees audited for underreporting tip income could find themselves paying penalties of as much as 50 percent of the unpaid taxes, plus interest.
Reporting a higher income level will yield employees greater Unemployment Insurance, Disability Insurance and—eventually—Social Security benefits, as well as a better credit rating for a car or home.
NOTE: Convincing employees that it is in their own best interest to pay higher FICA taxes to boost their retirement benefit is a tough sell. A recent study indicated that more young people believe in UFOs than believe the Social Security system will have funds for them when they retire. However, pointing out that California counts tips as part of the income level it uses to award Unemployment and Disability Insurance benefits may prove more persuasive to these same employees.
(Employees can use IRS Form 4070-A for this information. To get free copies, call the IRS at 800.TAX.FORM.) The magic number for tip reporting is 100 percent. The “8 percent of sales” figure comes from the tip allocation procedure established in 1983 as a first step to encourage employees to report more of their tip income. Americans commonly tip somewhere in the range of 15 percent, and employees who report a straight 8 percent of their sales as tips may be liable for taxes for the difference between the 8 percent of tips the employee reports and the higher amount that the employee presumably receives.
Although an employer may have no desire to play tip cop, the IRS has increasingly used threats of extensive audits to compel restaurant owners to intervene in the tip-reporting procedure. The goal of the IRS is to collect the full amount of taxes on tips received by employees, and the agency is using stern new tactics to do so.
This report was reviewed for legal accuracy and updated in 2016 by Weintraub | Tobin.
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