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.

Employer Related Q&A Regarding Tips and Service Charges

Q8. If an employee fails to report tips to his or her employer, is the employer liable for the employee and employer shares of FICA taxes on those unreported tips?

A8. If an employee fails to report tips to his or her employer, the employer is not liable for the employer share of FICA taxes on the unreported tips until notice and demand for the taxes is made to the employer by the Service. The employer is not liable to withhold and pay the employee share of FICA taxes on the unreported tips.

Q9. How is notice and demand made under section 3121(q) of the Code?

A9. There is no specific form or procedure prescribed for a Section 3121(q) Notice and Demand. Notice and demand is made by the Service when it advises the employer in writing of the amount of tips received by an employee (or employees) who failed to report or underreported tips to the employer. Although no specific form is prescribed, a document will constitute a Section 3121(q) Notice and Demand if it (1) includes the words “notice and demand” and “section 3121(q),” (2) states the amount of tips received by the employee (or employees), and (3) states the period to which the tips relate. However, a document including such information will not constitute a Section 3121(q) Notice and Demand if it states that it is not a notice and demand.

Q10. How does an employer that files Form 941 report the section 3121(q) FICA tax liability after notice and demand is made?

A10. The employer reports the amount of the section 3121(q) FICA tax liability as a current period liability for FICA taxes on the employer’s Form 941 for the calendar quarter in which notice and demand is made. Employers should consult the Instructions for Form 941 to determine the correct line entry on Form 941. The employer must also include the amount of the section 3121(q) FICA tax liability on the appropriate line of the record of federal tax liability (Part 2 of Form 941 for a monthly depositor or Schedule B (Form 941) for a semi-weekly depositor) corresponding to the date of the Section 3121(q) Notice and Demand.

Q11. Which year’s social security and Medicare rates and social security contribution and benefit base apply to compute the employer’s FICA tax liability on unreported tips?

A11. The social security and Medicare rates and the social security contribution and benefit base applicable to the calendar year in which the tips were actually received apply to compute the employer’s FICA tax liability. The Service will compute the employer’s liability, and include a calculation worksheet with the Section 3121(q) Notice and Demand.

Q12. If the Service determines that an employer’s employees have unreported tips and issues a Section 3121(q) Notice and Demand to the employer, what is the period of limitations for the Service to assess the employer share of FICA taxes?

A12. Generally, the period of limitations for assessment under section 6501 of the Code is 3 years after the due date of the return or the date the return was filed, whichever is later. However, section 6501(b)(2) provides that employment tax returns reporting FICA taxes for any period ending with or within a calendar year filed before April 15 of the succeeding calendar year are deemed filed on April 15 of such succeeding calendar year.

As a general rule, the Service must assess the employer FICA taxes on the unreported tips within 3 years after April 15 of the calendar year following the year in which the Section 3121(q) Notice and Demand is made. For example, if the notice and demand is dated December 31, 2012, the liability is required to be reported on Form 941 for the fourth quarter of 2012, due on January 31, 2013. If the employer timely files Form 941, the period of limitations for assessment ends on April 15, 2016.

However, if the employer did not file its Form 941 for the fourth quarter of 2012 before April 15 of the succeeding calendar year (April 15, 2013) and instead filed on May 10, 2013, the Service must assess the employer FICA taxes by May 10, 2016, the date 3 years after the date the return was filed.

If the employer files a false or fraudulent Form 941 for the quarter in which the liability is required to be reported or fails to file Form 941 for that quarter, the Service can assess the additional employer FICA taxes on the unreported tips at any time.

These assessment periods apply whether or not the employer accurately reports the liability on Form 941 as required by Q&A 10 above.

Q13. Is the employer liable for interest on the employer’s FICA tax liability for unreported tips?

A13. Generally, no. If the employer pays the tax on or before the due date of the Form 941 for the quarter during which notice and demand is made, the employer is not liable for interest. If the employer does not pay the tax by the due date of the return, interest will accrue on the underpayment from the due date of the return.

Q14. Is the employer required to deposit FICA taxes due on the unreported tips shown on the Section 3121(q) Notice and Demand?

A14. Yes. The employer must make deposits pursuant to section 6302 of the Code and § 31.6302-1 of the regulations. For purposes of applying the deposit rules, the amount of employer FICA taxes shown on the Section 3121(q) Notice and Demand, is treated as employment taxes accumulated by the employer on the date the Section 3121(q) Notice and Demand is made, which is the date printed on the notice and demand document. The Service generally intends to notify an employer at least 30 calendar days in advance of the issuance of a Section 3121(q) Notice and Demand.

Q15. Is the section 45B credit, with respect to the tips reported on the Section 3121(q) Notice and Demand, available to the employer in the year the notice and demand is made or the year in which the unreported tips were received by the employee?

A15. The section 45B credit is applied to the taxable year that the “excess social security tax” amount is paid or incurred. The section 45B(b)(1) definition of “excess social security tax” is limited to tips that “are deemed to have been paid by the employer to the employee pursuant to section 3121(q).” Under this definition of “excess social security tax,” such tax cannot be paid or incurred prior to the time that the tip amounts are deemed to have been paid under section 3121(q), which occurs on the date on which notice and demand for the employer share of FICA taxes is made to the employer. Therefore, the section 45B credit is available to the employer in the year the Section 3121(q) Notice and Demand is made and not the year in which the unreported tips were received by the employee. The credit is claimed on Form 8846, Credit for Employer Social Security and Medicare Taxes Paid on Certain Employee Tips.