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.
Employee Related Q&A Regarding Tips and Service Charges
Q5. If an employee fails to report tips to his or her employer, is the employee liable for the employee share of FICA taxes on those unreported tips?
A5. Yes. The employee is liable for the employee share of FICA taxes on the unreported tips. The employee pays his or her share of FICA taxes by completing Form 4137, Social Security and Medicare Tax on Unreported Tip Income, and filing it with Form 1040 (or other applicable return in the Form 1040 series) for the year in which the tips are actually received by the employee.
Q6. Which year’s social security and Medicare rates and social security contribution and benefit base apply to compute the employee’s FICA tax liability on unreported tips?
A6. 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 employee’s FICA tax liability. Form 4137 includes the applicable social security and Medicare rates and social security contribution and benefit base. The employer is not liable to withhold and pay the employee share of FICA taxes on the unreported tips.
Q7. Are employees who fail to report tips to their employers subject to a penalty?
A7. Yes. Under section 6652(b) of the Code, an employee who fails to report tips required to be reported to an employer is subject to a penalty equal to 50 percent of the employee share of FICA taxes on those tips, unless the employee can provide a satisfactory explanation showing that the failure was due to reasonable cause and not due to willful neglect. The explanation must be made in the form of a written statement setting forth all the facts alleged as a reasonable cause. This statement can be attached to the employee’s Form 1040 (See Form 4137). If the statement is submitted in response to a notice regarding a proposed penalty assessment, the statement must contain a declaration that it is made under the penalties of perjury.