Tip reporting requirements

Tips

In August 1982, Congress enacted the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), one of the most far-reaching tax laws in U.S. history. TEFRA aimed to generate additional revenue through a combination of spending cuts, tax increases, and reform measures. One area targeted for reform was tip reporting. According to the IRS, at the time TEFRA was enacted, only 16 percent of restaurant and bar employees accurately reported their tip income. This act requires employees to accurately report their tips and encourages employers to make sure employees are complying with tip reporting responsibilities.

What the law requires

TEFRA requires tipped employees working at “large food or beverage establishments” to report, at a minimum, 8 percent of the establishment’s gross receipts – less carryout sales and sales on that a service charge of 10 percent or more is imposed – to the IRS as income for Federal Insurance Contributions Act (FICA) and income tax purposes. The employer is required to file IRS Form 8027, the Employer’s Annual Information Return of Tip Income and Allocated Tips, which highlights any deficiency with the tip reporting requirements. Employers are required to disclose in Form 8027 the establishment’s gross receipts, charge receipts and the amount of tip income reported by all tipped employees.

When the aggregate of employees’ reported or declared tips does not reach 8 percent of gross sales, the difference between reported tips and 8 percent – or the “shortfall” – must be allocated among tipped employees by the employer and reported to the IRS. While the employer is not to withhold taxes on the allocated amounts, the IRS will expect employees to pay FICA and income taxes on such amounts when they file their individual tax returns.

The employer is also required to report specific aggregate gross sales and tip income data for each establishment on an annual basis. It is unfortunate, but inevitable, that the employer’s report will highlight underreporting of tip income by employees, facilitate audits and lead to greater tax liability for employees and employers.

Voluntary compliance agreements

The IRS has established voluntary compliance agreements for industries, such as the restaurant industry, where tipping is customary. These agreements are designed to enhance tax compliance among tipped employees through taxpayer education, instead of through traditional enforcement actions, such as tip examinations. The following programs are available:
 

  • Tip Reporting Alternative Commitment (TRAC)

Doesn’t require that a tip rate be established but it does require the employer to: Establish a procedure where a directly tipped employee is provided a no less than monthly written statement of charged tips attributed to the employee, implement a procedure for the employees to verify or correct any statement of attributed tips and adopt a method where an indirectly-tipped employee reports his or her tips no less than monthly.

  • Tip Rate Determination Agreement (TRDA)

Has no specific education requirement but does require the employer to: Work with the IRS to arrive at a tip rate for its various occupations, requires 75 percent of the employees to sign a Tipped Employee Participation Agreement (TEPA) and report at or above the determined rate and provide detailed information of employees that do not meet the established requirements to the IRS.

  • Employer-designed Tip Reporting Alternative Commitment (EMTRAC)

The IRS developed the EmTRAC Agreement program in response to employers in the food and beverage industry who expressed an interest in designing their own TRAC programs. EmTRAC Agreements are available to employers in the food and beverage industry whose employee receive both cash and charged tips. This program retains many of the provisions in the TRAC agreement.

  • Attributed Tip Income Program (ATIP)

In July 2006, the Internal Revenue Service released formal guidance on its new tip reporting procedure, the Attributed Tip Income Program (ATIP). ATIP expanded the existing IRS tip reporting and education program by offering employers in the food and beverage industry an additional tip reporting program.

Employers who participate in ATIP report the tip income of employees based on a formula that uses a percentage of gross receipts, which are generally attributed among employees based on the practices of the restaurant.

Some general requirements of participating restaurants include:

  • the employer annually elects to participate in the program
  • employers establishment must have at least 20 percent of gross receipts as charged receipts that reflect a charged tip
  • at least 75 percent of tipped employees must agree to participate
  • employer reports attributed tips on employees’ forms W-2 and pays taxes using the formula tip rate
  • the formula tip rate is the charged tip rate minus 2 percent – the 2 percent takes into account a lower cash tip rate
  • the charged tip rate is based on information from the establishment’s Form 8027.

Who is covered?

Employers covered by this law are those who operate food or beverage establishments where tipping is customary and that normally employ more than 10 employees, including both tipped and non-tipped, on a “typical” business day during the preceding calendar year. Such employers operate “large food or beverage establishments” for the purposes of this law.

A food or beverage establishment is defined in the regulations as any business activity that provides food or beverages for consumption on the premises.

The regulations say that an employee who receives less than $20 per month in tip income would not be considered as customarily receiving tip income. Though not specifically stated, it follows that if employees of an establishment generally receive less than $20 per month in tip income, tipping is not customary. Generally speaking, tipping isn’t customary in fast food or cafeteria-style operations, or in an operation where at least 95 percent of the total sales are subject to a mandatory service charge of 10 percent or more.

A cafeteria-style operation is considered one that is primarily self-service where the total cost of food and beverages selected by a customer is paid before the customer is seated, or is stated on a check provided to the customer before the customer is seated, and is paid by the customer to a cashier. Cafeteria lines, buffets and smorgasbords are classified as primarily self-service.

If, after a customer is seated, an employee delivers items, such an item that requires additional preparation after being selected by a customer, at no additional cost to that customer, an operation’s status as primarily self-service would not be affected.

An operation is a fast food operation only if customers order, pick up and pay for food or beverages at a counter, window, etc., and then carry the food or beverage to another location, either on or off premises.

How to count employees

In counting the number of employees, all employees (not just tipped employees) at all of the employer’s food or beverage operations, and all corporations that are members of the same controlled group of corporations, are included. The only exception applies to a 50 percent or more owner of an incorporated restaurant; he or she is not considered an employee. 

The regulations provide a formula to calculate whether a business employs more than 10 employees on a typical business day during the preceding calendar year.

In brief, use the month with the greatest amount of gross receipts from the previous year and divide the total hours worked by all employees that month by the number of days the establishment was open. Next, determine the month with the lowest amount of gross receipts and divide the total hours worked by all employees that month by the number of days the establishment was open. Add the results from both of these months and then divide the total by two. If the result is more than 80 hours, then the establishment is subject to the tip reporting requirements.

Form 8027: Identifying information

Each year, employers must file a financial data information return, Form 8027, with the IRS for each affected food or beverage establishment. If an employer is filing more than one return, then the employer must attach transmittal form 8027T. Returns are due on the last day of February following the year for which the return applies.

The identifying information that must be included on Form 8027 includes:
 

  • Name and address of establishment and Employer Identification Number (EIN)

The EIN should be the same as the number on the W-2 forms that the employer gives to employees and should be the same as the number on the employer’s Form 941 (the Employer’s Quarterly Federal Tax Return) that is filed to report wages and taxes for employees working for the establishment.
 

  •  Type of establishment


You may designate the establishment as one of the following:
 

  1.  an establishment that serves evening meals only (with or without alcohol beverages)
  2. an establishment that serves evening and other meals (with or without alcohol beverages)
  3. an establishment that serves only meals other than evening meals (with or without alcohol beverages)
  4. an establishment that serves food — if at all — only as an incidental part of the business of serving alcohol beverages.
  5. Employer’s name and address. This is the name and address of the entity or individual whose EIN is shown above.
  6. Establishment number. Enter a five-digit number to identify the individual establishments that is reported under the same EIN. Give each establishment a separate number. For example, each establishment could be numbered consecutively, starting with 00001.

In addition, the employer must answer the following questions or check the appropriate boxes:
 

  • does the establishment accept credit cards, debit cards or other charges?
  • check if amended return
  • check if final return
  • Attributed Tip Income Program (ATIP). See Revenue Procedure 2006-30 (Check the box for the election to participate in ATIP)

Form 8027: Line instructions

Line 1: Total charged tips for filing year.

Line 2: Total charge receipts with charged tips. Enter the total sales from charge receipts that had a charged tip shown. Include credit card charges and other credit arrangements. Do not include any state or local taxes in the amounts reported.

Line 3: Total amount of service charges of less than 10 percent paid as wages to employees. Enter the total amount of service charges of less than 10 percent that have been added to customer bills and have been distributed to employees for the year. In general, service charges added to the bill are not tips since the customer does not volunteer this amount. These service charges are treated as wages and must be included on W-2 forms.

Line 4a: Total tips reported by indirectly tipped employees. Enter the total amount of tips reported for the year by indirectly tipped employees, such as cooks, bussers, and service bartenders.

Line 4b: Total tips reported by directly tipped employees. Enter the total amount of tips reported by directly tipped employees, such as bartenders and wait staff.

Line 5: Gross receipts from food or beverage operations. Enter the total gross receipts from food or beverage sales for this establishment for the year. If the employer does not separately charge for providing food or beverages along with other goods or services (such as a package deal for food and lodging), the employer should make a good-faith estimate of the gross receipts from the food or beverages. This estimate must reflect the cost to the employer for providing the food or beverage plus a reasonable profit factor.

Line 6: Enter the result of multiplying Line 5 by 8 percent (.08) or a lower rate (which may be granted by the IRS).

Appeal for lowering the 8 percent requirement: An employer or a majority of the employees at an establishment may apply to the local IRS district director to have the allocation percentage reduced from 8 percent. The regulations specify that the percentage is to be the best estimate of the actual percentage of sales constituting tips, but may not be lower than 2 percent.

Applications to have the percentage reduced must be in writing and must include sufficient information to allow the district director to determine the actual tip rate of the establishment. This information must include the charged tip rate, the type of establishment, menu prices, the location of the establishment, the amount of “self-service” required, the days and hours open for business, and whether the customer receives the check from, or pays directly, the server for the meal. No specific form is required, but the employer should use the company’s letterhead stationery when making the application.

Employer petitions: In the case of employer-originated petitions, the employer must supply, in addition to the information described above, copies, if any, of Form 8027 filed with respect to the establishment for the three immediately preceding calendar years.

Multi-establishment employers may use a single application for two or more of their operators if (1) they are essentially the same types of establishments, (2) the employer has made a good-faith determination that the tip rates at the establishments are essentially the same, and (3) the establishments are located in the same Internal Revenue region.

Single applications must include the names and locations of the establishments for which a reduction is being requested. The application should be filed with the director in whose district the greatest number of establishments included in the application is located.

Employee petitions 

With respect to employee-originated petitions, more than half of all the directly tipped employees, such as waiters, waitresses and bartenders, must consent to the petition at the time it is filed. The petition must indicate the total number of directly tipped employees and the number of directly tipped employees consenting to the petition.

Employees must promptly notify their employer of any petition filed with the district director. Upon receipt of such notification, the employer must promptly submit to the district director copies of Form 8027, if any, filed with respect to the establishment for the three immediately preceding calendar years. The IRS will not disclose to the employees or their representatives any information that has been supplied by the employer during the petitioning process.

Effective Date of Percentage Reduction 

The district director determines the term for which the reduced percentage is effective. At the end of the term, the reduced percentage ceases to apply, unless previously extended by the director of the IRS district in which the establishment is located.

The reduced percentage won’t be retroactively applied to payroll periods preceding the date the petition is filed unless the establishment to which the petition relates is a new business (i.e., the employer of the operation did not operate any food or beverage establishment during the preceding calendar year).

If a lower percentage rate is granted, write the rate in the space provided for Line 6 on the Form 8027 and attach a copy of the IRS district director’s determination letter. (Caution: The 8 percent rate, or lower rate, is used for tip allocation purposes only. Using this rate does not mean that tipped employees must report only 8 percent. They should report the amount of actual tips received.)

Allocation of tips

If 8 percent, or an approved lower rate, of gross receipts (line 6) is more than the amount of tips reported by the employees, the employer must allocate the excess to those employees. Enter the excess in line 7. This may occur if the allocated tips for which wages were paid or allocated were on a quarterly basis (see Line 7a and Line 7b on methods for calculating this amount). Tip allocation is used for information purposes only and is not an amount that is taxed or deducted by the employer from the employees’ paycheck.

The allocation of tip earnings is required for each establishment at which the total tips reported by all employees do not equal 8 percent of the establishment’s gross sales during any payroll period or, in the alternative, the calendar year or any period that results from a reasonable division of a calendar year (such as monthly or quarterly).

Although the regulations allow this alternative to the payroll period allocation, if a substitute period is selected, it must be stated on the Form 8027 and used for the entire year.

Regardless of the allocation period used, employers must be consistent in allocating for either the payroll or the substitute period selected. If an employee reports tips for a period that is different from the allocation period established, the employee may specify what portion of his or her tips is attributable to a given allocation period. In the absence of any specification by the employee, the employer must convert the employee’s reported tip amount to conform to the allocation period. For this purpose, the regulations allow the employer to use either the employee’s gross sales, or hours worked, to make the conversion. The system used (gross sales or hours worked) must be used consistently in making all allocations for the entire calendar year.

If an employee works at more than one of the employer’s operations, the employee may specify what portion of his or her tips is attributable to a given operation. In the absence of any specification, the employer must use a formula similar to the above to attribute reported tips among the operations worked. (Suggestion: Insist employees report tips separately for each operation.)

This allocation requirement will have no effect on Social Security and Medicare Tax (FICA) or income tax withholding responsibilities of the employer or on the employer’s federal unemployment tax (FUTA) obligations. It is purely an informational report to IRS.

Tip estimating 

To avoid the allocation process, many employers look to tip estimating. It is important to remember that tip estimating is a part of the employee tip reporting process. It should not be confused with the allocation process.

An employer may, under existing IRS regulations, estimate tips received by employees and use the estimate for withholding tax purposes as though reported by the employee. The regulations require that such estimates ultimately be reconciled with an employee’s actual tip report, and if the estimate is too high or low, the withholding taxes, etc., must be adjusted to compensate.

This process, if properly used, might assist operators in encouraging tip reports from employees in amounts that exceed the 8-percent aggregate target. It should not, however, be considered foolproof for that purpose, nor should an employer ever imply to employees (through estimating or any other way) that they do not have to report all tips received.

Hours-worked method

Establishments that employ less than the equivalent of 25 full-time employees – both tipped and non-tipped – during a payroll period, may use the hours-worked method to allocate tips. An employer is considered to have employed fewer than the equivalent of 25 full-time employees during a payroll period if the average number of employee hours worked (both tipped and non-tipped employees) per business day during a payroll period is less than 200 hours.

To allocate tips by this method, follow the steps for the gross receipts method below. For the fraction in step “c” of the gross receipts method, substitute one in which the numerator (top number) is the number of hours worked by each employee who is tipped directly, and the denominator (bottom number) is the total number of hours worked by all employees who are tipped for the payroll period.

If an employer uses the hours-worked method, be sure to enter in the space provided the average number of employees — both tipped and non-tipped — and the hours worked per business day during the payroll period. If the establishment has more than one payroll period, the employer must use the payroll period in which the greatest number of workers — both tipped and non-tipped — were employed.

Gross receipts method

If no good-faith agreement applies to the payroll period, the employer must allocate the difference between total tips reported and the 8 percent gross receipts using the following steps:
 

  1. Multiply the establishment’s gross receipts, other than non-allocable receipts, for the payroll period by 8 percent or the lower rate.
  2. Subtract the amount figured in “step a” from the total amount of tips reported by employees who were tipped indirectly for the payroll period. This difference is the directly tipped employees’ total share of 8 percent, or the lower rate, of the gross receipts of the establishment. Indirectly tipped employees do not receive tips directly from customers. Employees such as maitre d’s, who receive tips directly from customers and indirectly through tip splitting or pooling, are treated as directly tipped employees.
  3. For each employee who is tipped directly, multiply the result in Step 2 by the following fraction: the numerator (top number) is the amount of the establishment’s gross receipts attributable to the employee, and the denominator (bottom number) is the gross receipts attributable to all directly tipped employees. The result is each directly tipped employee’s share of 8 percent (or the lower rate) of the gross receipts for the payroll period.
  4. From each directly tipped employee’s share of 8 percent or the lower rate of the gross receipts figured in Step 3, subtract the tips the employee reported for the payroll period. The result is each directly tipped employee’s shortfall (if any) for the period.
  5. From the amount figured in Step 1 (8 percent or the lower rate of the gross receipts), subtract the total tips reported by both directly and indirectly tipped employees. The result is the amount that has to be allocated among the directly tipped employees who had a shortfall for the payroll period as figured in Step 4.
  6. For each directly tipped employee who had a shortfall for the period as figured in Step 4, multiply the amount in Step 5 by the following fraction: the numerator is the employee’s shortfall (figured in Step 4, and the denominator is the total shortfall of all directly tipped employees. The result is the amount of allocated tips for each directly tipped employee.

New businesses 

The regulations also describe how and when the allocation procedure applies in the case of new businesses. In brief, if an employer did not operate any food or beverage operation at least one month in the preceding calendar year, it is a new business.

In the year a business is new, an operation is considered to be a “large food or beverage establishment” if the average number of hours worked per business day by all employees during each of any two consecutive months is greater than 80 hours.

Allocations are to begin in the first payroll period (or substitute period as discussed above) that begins after the two-month period determining coverage.

Good-faith agreement

An allocation can be made under a good-faith agreement. This is a written agreement between the employer and at least two-thirds of the employees of each occupational category of employees who receive tips working in the establishment when the agreement is adopted. The agreement must:
 

  • provide for an allocation among employees who receive tips, of the difference between the total tips received and 8 percent of gross receipts that approximates the actual distribution of tip income among the employees
  • be effective the first day of a payroll period that begins after the date the agreement is adopted, but no later than Jan. 1 of the next year
  • be adopted when there are employees in each occupational category who would be affected by the agreement 
  • allow for revocation by a written agreement adopted by at least two-thirds of the employees in occupational categories affected by the agreement when it is revoked. The revocation is effective only at the beginning of a payroll period.


Note: A sample good-faith agreement is included at the end of this Industry Insight.

Total number of directly tipped employees 

Enter the total number of directly tipped employees who worked at the establishment during the year. This is the cumulative total of all directly tipped employees who worked at the establishment at any time during the year. If the employer has a large turnover of directly tipped employees, this number may be large. An employer should not use this number to determine if it must file Form 8027 (see “How to count your employees,” above).

Filing Form 8027S

For return filing purposes, each operation under the owner’s control is considered separately. In most cases, this means a separate return for each business location.

Where more than one operation is within a single building, but in separate areas of the building, they are treated as separate operations if the gross sales from each are recorded separately.

A gourmet restaurant, a coffee shop and a cocktail lounge in a hotel would each be treated as separate food or beverage operations if the gross sales from each activity are recorded separately. Also, employers may treat different activities conducted in the same place at different times as separate operations if the gross sales from each activity are recorded separately.

A restaurant that records gross sales from its cafeteria-style lunch activity separately from the gross sales of its full-service dinner activity may treat the two as separate operations, the former not being a “large food or beverage establishment” because tipping is not customary.

Where to file: Form 8027 is filed with the Internal Revenue Service Center, Andover, MA, 05501.

Penalties

Failure to file Form 8027 results in a $50 fine per establishment. Failure to provide the proper Employer Identification Number (EIN) results in a $5 fine per establishment.

Failure to provide allocation information to employees on their W-2 forms results in a $50 fine per W-2.

For all the above penalties, the maximum fine per employer is $50,000. However, if failure to file is due to intentional disregard of the law, the penalty is 10 percent of the amounts shown on the Form 8027.

Statements of allocated amounts to employees

The regulations require employers to give each employee a written statement showing the total amount of tip income allocated for the calendar year. This amount is shown in Box 6 of the employee’s Form W-2. Employees who dispute the amount of allocated tips will be required to show satisfactory records to IRS, which may then base the employee’s taxes upon the employee’s records. IRS reserves the right to determine that the employee may indeed have received even more tip income. If an employee terminates before the end of the year and requests an early W-2, the employer is not required to show a tip allocation at that time. However, an amended W-2 must be furnished to the employee before Jan. 31 of the following year showing tips allocated for the prior year.

Employers may include on early W-2s an employee’s tip allocation (if known) or a good-faith estimate of such allocation. A good-faith estimate of an allocation must be signified by placing the word “estimate” next to the allocation on the W-2. If the estimated allocation is found to vary from the actual allocation by more than 5 percent, the employer must issue an amended W-2 to the employee before Jan. 31.

Communicating with employees

Employer preparation and communication with employees about this law and its requirements is crucial. Because employees will have questions and concerns, it is suggested that you hold a staff meeting in addition to distributing any printed material you may choose.

How an employer presents this material is up to each individual employer. It is suggested, however, that each employer be very straightforward that the law has required payment of taxes on tips for a long time and has required tip reporting since 1966. In essence, things may have been pretty good before, but Congress has mandated a change. This means that some of your employees will have to report substantially more income than ever before.

Every employee who receives $20 or more in tips during any calendar month is required by law  to report all such tips to his or her employer on or before the 10th day of the following month.

Many of the electronic systems used in restaurants today allow an employer to configure them so that when the employee clocks out, they are required to state the amount of tips received. If you do intend to use any system it is recommended you check with either your accountant or legal counsel to ensure that the proper information is included in any employee reporting system. 

Reported tips are part of an employee’s taxable wage and, as such, these earnings are subject to employer and employee FICA taxes, FUTA, federal and state income tax withholding, SUI, SDI, and ETT.

Employees are responsible for providing their employer with one or more written and signed statement reporting the total amount of tips received during a calendar month if that total is $20 or more on or before the 10th day of the following calendar month. A penalty of $50 applies when an employee fails to provide a statement of tip income to the employer.

The procedure by which the employee reports tip income is determined by the employer. Before the Tax Equity Act, employers had three basic responsibilities, which remain in force, relative to employee tip reports. Specifically to notify employees of the tip-reporting requirements, to make a means available for employees to submit tip earnings information to the employer and to withhold the proper taxes.

The employer must also submit additional tip-reporting data for each establishment to the IRS and, under certain circumstances, allocate additional tip income to individual employees.

Priority of withholding taxes on tips

Because the total of an employee’s FICA and income taxes may, in some cases, exceed the amount of cash wages paid to the employee, it is important to know which payroll deductions take priority.

The Treasury Department has issued the following list showing the priority of taxes to be deducted from the employee’s wages if wages are insufficient to cover all taxes:
 

  • the employee’s share of FICA tax required to be withheld by the employer on cash wages, exclusive of tips
  • the federal income tax required to be withheld by the employer on cash wages, exclusive of tips
  • the state and local withholding taxes required to be withheld by the employer on cash wages, exclusive of tips
  • the employee’s share of FICA tax required to be withheld as computed on tips reported to the employer
  • the federal income tax required to be withheld as computed on tips reported to the employer
  • any other payroll deductions, such as union dues or wage garnishments.

Employees have the option of providing funds to the employer to cover tip taxes. If, however, the employee does not provide such funds and the wage does not cover tip taxes, the employer does not have to collect the taxes.

For federal taxes, the employer should show any uncollected FICA and Medicare taxes in Form W-2 and Form 941.

For state taxes, the employer can supply the employee with a form DE 370 Statement of Amount Due from Worker. Completion of the DE 370 or similar statement relieves the employer of the uncollected employee liability. The DE 370 or similar statement must be issued in quadruplicate and distributed as follows: original and one copy to the worker, third copy attached to the quarterly wage and withholding report and sent to EDD and fourth copy to be retained in the employer’s records.

No single form or report is required for tip reports. However, IRS Form 4070A is available from any IRS district office for this purpose. These, and other IRS forms, can be downloaded from the IRS website.

The employee’s written statement relative to tips received must disclose:

  • Name, address, signature and Social Security number of the employee.
  • Name and address of the employer.
  • The period for which the statement is furnished and the date on which the statement is furnished. (If the statement is for the calendar month, the month and year should be specified. If the statement is for a period of less than one month, the beginning and ending dates of the period should be shown — for example, Jan. 1-8, 1988.)
  • The total amount of tips received during the period covered by the statement.

Tip earnings substantiation requirement

The IRS requires that employees maintain sufficient evidence to establish the amount of tip income received during the year. Sufficient evidence consists of either a daily record or other evidence of tip income that is as credible and as reliable as a daily record. However, neither of the above will constitute sufficient evidence if there are facts and circumstances that indicate the employee received a larger amount of tip income. Oral statements of the employee, without corroboration, will not be considered sufficient evidence.

Each day the record must show the amount of cash and charge tips received directly from customers or from other employees.

The amount of tips, if any, paid out to other employees, through tip-sharing, tip-pooling or other arrangements, must also be indicated, and the names of the employees in the arrangement provided. The record must indicate the date on which the entry is made.

IRS Form 4070A (Employee’s Daily Record of Tips) may be used by employees to maintain a daily record of their tip earnings. The employee is to prepare the record so that entries are made on or near the date the tip income is received.

A daily record made at or near the date of receipt is deemed to have a high degree of credibility as compared with a record prepared at a later date. An entry is made “near the date the tip is received” if the required information with respect to tips received” and paid out by the employee is recorded at a time when the employee has full knowledge of these receipts and payments.

Penalties for underreporting 

If IRS determines that an employee has underreported tip earnings, a 20-percent interest penalty will be applied to the tax owed. An additional 5-percent penalty may also be applied if it is determined that the employees negligently disregarded the tax rules requiring that they report their tip income. Also, in instances where IRS considers the employee to have been fraudulent in his or her tax evasion, the employee may be subject to a civil penalty of another 50 percent of the taxes owed and a charge of criminal fraud that could result in a jail sentence.

State reporting requirements

Under California’s regulations, tips received by the employee from the customer in the form of cash, checks, or any other monetary item of exchange are subject to State Unemployment Insurance, Employment Training Tax, State Disability Insurance and Personal Income Tax if the tips equal $20 or more in a month, provided the employee includes the amount in a written statement furnished to the employer.

If tips are received by the employee directly from the employer such as banquet tips or service charges, then the amount is considered regular wages and is fully subject to SUI, ETT, SDI and PIT withholding. Tips should be combined with regular wages on payroll reports.

If at the end of a collectable period the employer has not collected the contributions from the worker, the employer is liable for the contributions unless it provides a completed Statement of Amount Due from Worker, DE 370, or similar statement to the worker.

First, each employer must decide how he or she intends to handle the federal law’s allocation requirements. This process requires a thorough evaluation of each operation including such factors as the existing tip-reporting practices, employee turnover, length of service, extent of charge sales, data processing capabilities, etc. – factors that only each individual employer can readily and properly evaluate.

  • Regardless of how a covered employer decides to implement requirements of the law, it seems apparent that it will be necessary to monitor employee tip reporting consistently and be prepared to allocate tips at any time.
  • Give employees information regarding the record keeping and allocation procedures and how you intend to implement them.
  • Emphasize, particularly to bussers and bartenders, that tip reporting is mandatory and that the law requires them to report all tips received, even if the tips are received through a tip-sharing or -splitting arrangement with other employees. Remind them of the penalties for underreporting.
  • Be up front about the resulting increase in employees’ income, Social Security, Medicare and disability taxes that will result from increased tip reporting or ultimately from tip allocations.
  • Advise employees of the risk of potential audit by IRS if they fail to report all tips received – or at least 8 percent of gross sales. Caution: 8 percent is not a “safe harbor.” Although reporting 8 percent will not make an employee immune from audit, reporting less than 8 percent will increase the odds of an audit.
  • Remind employees that the report you are required to send IRS will draw attention to charged tips, which are a strong indicator of their total tip income as related to their sales.
  • Advise employees that their own individual records of cash and charge tips received from customers and tips shared with other employees, including names and amounts, maintained on a daily basis, are their best defense in the event of an audit.
  • Don’t overlook the importance of orienting newly hired employees to their tip-reporting responsibilities. Consider including tip-reporting habits as part of your probationary period review criteria.
  • And finally, emphasize that you want to work with your employees in every way possible to prevent problems with IRS. But the commitment requires cooperation of all employees — with each other as well as with you.

Every employee who, in the course of employment by an employer, receives tips in any calendar month, shall report all tips in one or more written statements furnished to his employer on or before the 10th day of the following month.

The report should be in duplicate and may be a completed Federal Form 4070 or any form that provides the following:

  • worker’s name, address and Social Security Number
  • employer’s name and address
  • calendar month or other period covered by the report
  • total amount of cash tips and cash gratuities received
  • date of the report and employee’s signature.

An employer should countersign and date the report and return the duplicate to the worker. An employer is liable for the SDI contributions from the worker at or after the time the report is made but before the tenth day following the end of the month in which the report was made, except when the employer uses the estimating method.

The employer can collect the contributions from wages payable at the time of the report or from wages that become payable during the collectable periods as stated above or the worker may furnish the amount of contributions during the collectable periods. Contributions must be collected even though the worker reports tips of less than $20 for the calendar month at the time the report is made.

If an employer has not collected all the contributions due from the worker as of the termination of the worker, the employer is liable for the unpaid contributions unless the employer furnishes a completed DE 370 to the worker. The statement should be provided on the date of termination and should not include any amounts that are unpaid and included on a prior statement already provided to the worker.

​This report was reviewed for legal accuracy and updated in 2016 by Berliner Cohen Attorneys at Law.