Our business service department receives many questions regarding tips versus service charges. The IRS has put out a question and answer format for employers and employees regarding taxes imposed on tips under the Federal Insurance Contributions Act (FICA). This ruling provides guidance for employers and employees, including information on the difference between tips and service charges. We have divided up the Q&A into 3 sections for you. Working with your tax advisor is important in making sure your reporting is correct.
General Questions Regarding Tips and Service Charges
Q1. Is the characterization of a payment as a “tip” by the employer determinative for FICA tax purposes under section 3121 of the Code?
A1. No. The employer’s characterization of a payment as a “tip” is not determinative. For example, an employer may characterize a payment as a tip, when in fact the payment is a service charge. The criteria of Rev. Rul. 59-252, 1959-2 C.B. 215, should be applied to determine whether a payment made in the course of employment is a tip or non-tip wages under section 3121 of the Code. The revenue ruling provides that the absence of any of the following factors creates a doubt as to whether a payment is a tip and indicates that the payment may be a service charge: (1) the payment must be made free from compulsion; (2) the customer must have the unrestricted right to determine the amount; (3) the payment should not be the subject of negotiation or dictated by employer policy; and (4) generally, the customer has the right to determine who receives the payment. All of the surrounding facts and circumstances must be considered. For example, Rev. Rul. 59-252 holds that the payment of a fixed charge imposed by a banquet hall that is distributed to the employees who render services (e.g., waiter, busser, and bartender) is a service charge and not a tip. Thus, to the extent any portion of a service charge paid by a customer is distributed to an employee it is wages for FICA tax purposes.
The application of the factors is illustrated by the following two common examples:
Example A: Restaurant W’s menu specifies that an 18% charge will be added to all bills for parties of 6 or more customers. Customer D’s bill for food and beverages for her party of 8 includes an amount on the “tip line” equal to 18% of the price for food and beverages and the total includes this amount. Restaurant W distributes this amount to the waitresses and bussers. Under these circumstances, Customer D did not have the unrestricted right to determine the amount of the payment because it was dictated by employer policy. Customer D did not make the payment free from compulsion. The 18% charge is not a tip within the meaning of section 3121 of the Code. The amount included on the tip line is a service charge dictated by Restaurant W.
Example B: Restaurant X includes sample calculations of tip amounts beneath the signature line on its charge receipts for food and beverages provided to customers. The actual tip line is left blank. Customer G’s charge receipt shows sample tip calculations of 15%, 18% and 20% of the price of food and beverages. Customer G inserts the amount calculated at 15% on the tip line and adds this amount to the price of food and beverages to compute the total. Under these circumstances, Customer G was free to enter any amount on the tip line or leave it blank; thus, Customer G entered the 15% amount free from compulsion. Customer G and Restaurant X did not negotiate the amount nor did Restaurant X dictate the amount. Customer G generally determined who would get the amount. The amount Customer G entered on the tip line is a tip within the meaning of section 3121 of the Code.
Q2. What tips must be reported to the employer?
A2. All cash tips received by an employee are wages for FICA tax purposes and, therefore, must be reported to the employer unless the cash tips received by the employee during a single calendar month while working for the employer total less than $20. If an employee works for more than one employer during a month and receives less than $20 in tips while working for each employer, no tips are required to be reported to any of the employers. Cash tips include tips received from customers, charged tips (e.g., credit and debit card charges) distributed to the employee by his or her employer, and tips received from other employees under any tip-sharing arrangement. Thus, both directly and indirectly tipped employees must report tips received to their employer. Non-cash tips (i.e., tips received by an employee in any other medium than cash, such as passes, tickets, or other goods or commodities) from customers are not wages for FICA tax purposes and are not reported to the employer. All cash tips and non-cash tips are includable in an employee’s gross income and subject to federal income taxes.
Q3. How are tips reported by the employee to the employer?
A3. The employee must give the employer a written statement (or statements) of cash tips by the 10th day of the month after the month in which the tips are received. Form 4070, Employee’s Report of Tips to Employer, is available for this purpose and may be found in Publication 1244, Employee’s Daily Record of Tips and Report to Employer. The statement may be furnished on paper or transmitted electronically. See § 31.6053-1(b) of the regulations.
Q4. How are FICA taxes paid on tips which are reported to the employer by the employee?
A4. The employer withholds the employee share of FICA taxes on the reported tips from the wages of the employee (other than tips) or from other funds made available by the employee for this purpose. See section 3102(c) of the Code and §§ 31.3102-3 and 31.3402(k)-1(c) of the regulations. The employer pays both employer and employee shares of FICA taxes in the same manner as the taxes on the employee’s non-tip wages and includes the reported tips on the employee’s Form W-2, Wage and Tax Statement. The employer makes a current period adjustment on Form 941, Employer’s QUARTERLY Federal Tax Return, to reflect any uncollected employee FICA taxes on reported tips. The employer reports any uncollected employee FICA taxes on the employee’s Form W-2, Wage and Tax Statement. The employee must report these amounts as additional tax on the employee’s Form 1040, U.S. Individual Income Tax Return (or other applicable return in the Form 1040 series).