How to get tip reporting on TRAC.

In June 1995, the IRS developed the Tip Reporting Alternative Commitment Agreement (TRAC agreement) in an effort to improve employee tip reporting in the food and beverage industry. In short, the TRAC agreement obligates a restaurateur to educate employees about tip reporting responsibilities. The restaurant must develop a procedure for tracking the reporting of charge-card tips by both directly and indirectly tipped employees; it also agrees to establish a procedure to ensure that cash tips are reported by all employees. In return, the restaurant is given assurance by the Service that it will not be subject to a FICA tax audit on unreported employee tips during the period the TRAC agreement is in effect. The TRAC agreement does not, however, encompass the determination of a tip rate based on historical data and the "McQuarters Formula" as is found in the existing Tip Rate Determination Agreement. The decision to enter into a TRAC agreement is voluntarily made by an employer.

In the early 1990s Congress amended Sec. 3121(q), making employers liable for FICA taxes on reported as well as unreported employee tips retroactive to 1988. The IRS looked at the amended Sec. 3121(q) as a way to increase tip reporting by going directly to employers with the threat of a tip audit.

The execution of the TRAC agreement grants an employer a degree of audit protection. The Service promises that employers who sign and comply with the agreement will not be subject to "employer only" or "employer first" audits for FICA taxes on unreported tips both retroactively to 1988 and prospectively. Therefore, the IRS will issue a notice for employer FICA taxes on unreported tips only in two cases: (1) when the employee is audited and it is determined that the employee did not accurately report tips; and/or (2) when the employee files Form 4137, Social Security and Medicare Tax on Unreported Tip Income, in order to voluntarily declare and pay FICA taxes on previously unreported tips.

To apply for the TRAC, employers must submit a signed application in writing to their local IRS district director. Restaurants operating numerous establishments can cover any number of the establishments by filing one application in the IRS district where the company is headquartered. A standardized copy of the TRAC agreement can be found in the IRS Market Segment Understanding issued June 1, 1995.

The TRAC agreement is structured in a way that provided an incentive to sign up for the program prior to June 1, 1996. If an employer had applied for it by that date, with at least one establishment open to the public prior to June 1, 1996, the agreement automatically would have taken effect on July 1, 1996. The IRS district director has a three-month period to reject the application.

If the agreement is applied for after June 1, 1996, it will not take effect until the calendar-year quarter beginning after the IRS district director approves the application. The district director is able to take as much time as he determines is necessary in deciding whether to accept the application. However, the sooner the TRAC is approved, the sooner the employer gets the audit protection associated with the agreement.

If an employer is already covered by a TRAC agreement and decides to open a new establishment or acquire an existing one, an additional statement must be submitted to the district director. The statement should identify the number of new members participating in the agreement, and include their names and addresses. If the statement is submitted within six months following the public opening or acquisition of the establishment, the TRAC is retroactively effective on the date the establishment was opened or acquired.

The Service has the right to reject the application if the applicant has not filed the proper Federal tax returns, or failed to deposit or pay the required Federal taxes, or if the IRS believes the employer will not be able to comply with the previously discussed employer commitments listed in the TRAC agreement.

Factors Used to Determine Whether to Get on TRAC

If a taxpayer does not sign the agreement, the Service may audit the employer. Therefore, it is a good idea to evaluate the degree of compliance the employees are currently exercising and the importance of the audit protection to a particular establishment.

The TRAC tip reporting procedures may require the employer to spend extra time and money educating employees. Additionally, the employer may incur additional expenses associated with making the operational changes necessary to comply with the employer commitments. For example, the employer may have to update or reprogram its point-of-sale system to calculate "charged tip" amounts on an employee-by-employee basis.

Another reason to consider implementing a TRAC agreement is the possibility of an increased FICA business credit. Sec. 45B provides for a tax credit (as opposed to a deduction) for an amount of an employer's FICA taxes paid on employee tip income (see Form 8846, Credit for Employer Social Security and Medicare Taxes Paid on Certain Employee Tips, for computation). However, according to Temp. Regs. Sec. 1.45B-1T, the credit is not available on the employer's share of FICA taxes on tip income not timely reported by an employee. Since a TRAC agreement can result in an increase in the amount of timely reported employee tip income, it can also result in an increased tax credit for the employer. It is important to note that the food and beverage industry is opposed to the IRS's current interpretation of the law. The industry's belief is that the credit should be applicable to both timely and untimely reported employee tips and, therefore, is in the process of taking steps to combat the Service's position.

The District Court for Southern Alabama recently rendered a decision in Morrison Restaurants, Inc., 2/29/96, which has the potential to greatly limit the IRS's ability to assess FICA taxes against an employer based solely on an "employer-only audit." Hence, the audit protection provided by the TRAC agreement may lose some of its luster. Accordingly, future judicial developments with respect to the Morrison decision should be monitored.

The TRAC agreement is solely applicable to the restaurant and beverage industry at the current time. An employer in another industry that is concerned about employee tip reporting may want to contact the Service about the possibility of entering into a similar agreement.

Detailed Requirements of the TRAC Agreement

Under TRAC, the employer must develop and maintain an educational program in order to train newly hired and existing employees. The manner in which the training sessions are conducted (i.e., videotape and/or written materials) and the content are left to an employer's discretion. However, the employer-developed educational program must emphasize the following points:

* Employees are legally obligated to report the full amount of both cash tips and credit card tips.

* Employees must maintain records (i.e., daily tip-reporting record) to substantiate their tip income.

* Proper tip reporting results in future benefits to the employee (i.e., increased Social Security benefits).

The educational program must be offered each quarter of the calendar year to any individuals hired in the middle of the quarter. Additionally, the employer must maintain a less thorough update session to reeducate individuals who have previously attended the more indepth new hire session. This update session should be presented quarterly. The sessions may be held by the employer on site or off.

In addition, employers must develop and prepare a statement showing the amount of cash and charged tips attributable to each directly tipped and indirectly tipped employee. The statement must be prepared and issued on a monthly basis, at the very least. A procedure must also be put in place that allows both indirectly and directly tipped employees to verify or correct the employer-developed statement. Corrections may be necessary to reflect tip outs, tip pools and other adjustments the employer's records fail to reflect.

Under TRAC, it is important to note that the burden of tracking the amount of each employee's charged tips is on the employer. If a TRAC agreement is not executed, employees are required to track their own charged tip amounts and report those amounts to the employer. Additionally, TRAC also requires that the employer establish a procedure for employees to report cash tips to the employer. Note that the employee has the burden of tracking cash tips, regardless of whether a TRAC agreement is executed by the employer.

Furthermore, if the tip reporting procedures under the TRAC agreement are set up appropriately, an employee will be able to satisfy the current law requirement under Sec. 6053(a). The current law mandates that employees report each month's tips in writing, to the employer, by the tenth day of the following month.

Finally, the employer must uphold the following tax compliance requirements:

* The employer must file all required Federal tax forms, such as Form 941, Employer's Quarterly Federal Tax Return, Forms W-2 and Form 8027, Employer's Annual Information Return of Tip Income and Allocated Tips. It is important to note that large food and beverage establishments enrolled in the TRAC program must still comply with the requirements set forth on Form 8027. Therefore, the execution of the TRAC agreement does not have an effect on the requirement that a large food and beverage establishment must allocate tips as long as the total reported tips fall below 8% of sales. Furthermore, employers required to file a Form 8027 must send an additional copy of the form to the IRS district director. The district director can use the Form 8027 as a means to evaluate the impact of the TRAC agreement.

* The employer's Federal taxes must be timely deposited and/or paid.

* All restaurants, regardless of whether required to file Form 8027, must keep records showing gross receipts subject to tipping and charge receipts showing charged tips. These records must be held for a period of four years from the April 15 following the calendar year to which the records relate.

* At the Service's request, the employer must produce quarterly reports showing total gross receipts subject to tipping, total charge receipts showing charged tips, total charged tips reported and total reported tips.