IRS scrutinizes food service industry: are employees reporting tips?

Properly reporting tip income has presented difficulties for the food service industry and the Internal Revenue Service for many years. The problems are attributable to a number of factors, including widespread misunderstanding of what actually is required to be reported and a perceived absence of vigorous IRS enforcement.

According to the U.S. Statistical Abstract, there were 391,500 eating and drinking establishments in the United States in 1990, with a payroll of $46.1 billion. Recent IRS analysis of filings of Form 8027, Employer's Annual Information Return of Tip Income and Allocated Tips, highlighted some serious concerns, including the number of forms filed compared with the known number of establishments required to file, the significant number of restaurants reporting tips received on charge sales in excess of total tips reported by employees and the reported tip rates.

Reporting Tips

Tips are compensation for services rendered and are fully reportable by recipients under Internal Revenue Code section 6053. Tips also are subject to the full range of employment and withholding taxes. Both the employer and employee portions of Social Security taxes must be paid on tip income.

In 1987, the Omnibus Budget Reconciliation Act extended the employer tax to the full amount of employees' tips by amending IRC section 3121(q), which holds employers liable for Federal Insurance Contributions Act taxes attributable to tip income not properly reported by tipped employees. Section 3121(q) creates the potential for significant contingent tax liabilities to accrue against restaurants or similar establishments. The statute of limitations does not begin to run until gratuities are reported by an employee or until the IRS calculates, through some reasonable means, the proper tax liability and gives notice and demand to the employer.

Employer liability is determined through a simple analysis of charge invoices and employee interviews. Applying methods such as the so-called McQuatters formula (in McQuatters vs. Commissioner [TC Mem. 1973-240] the court said it was reasonable for the IRS to reduce the charge tip rate by 2% to calculate the cash tip rate) long has been held by the Tax Court to be a reasonable basis for calculating the proper amount of tip income and the related employment tax liability. Other reasonable methods also are acceptable.

Employers who operate large food or beverage establishments must file from 8027. If a taxpayer owns more than one restaurant, a form must be filed for each establishment. A large food or beverage establishment is one that provides food or beverages for compensation on premises where tipping is customary and that generally has more than 10 employees.

IRS efforts

The IRS is initiating program to address the high lev of noncompliance in the food service industry. In addition to analyzing form 8027 filings, it sampled specific taxpayers. Numerous examples of apparent nonfiling were encountered.

The IRS program relies heavily on voluntary compliance. Each district office works with restaurants that come forward on their own or by invitation to address their tip rates (both cash and charged). The objective is to have tipped employees report and pay employment taxes accurately and in a timely fashion. The IRS intends to work with employers to calculate the correct tip rate to be reported. Once agreement is reached on that rate, the IRS agrees that, as long as at least 75% of an establishment's tipped employees report at or above the calculated rate, it will not raise the issue in future examinations of the establishment.

The decision by restaurant owners to participate and encourage their employees to comply restricts their establishments' liability under IRC section 3111. This program enables the IRS to focus the limited resources available for enforcement on the segment of the food service population that chooses not to do so.

Financial reporting implications

In instances of known potential tax liability, the IRS reviewed entities' financial statements to see if these contingent tax liabilities were disclosed; no disclosures were found. When charged tips exceed total reported tips, an obvious potential tax liability exists that should be acknowledged in the entities' audited financial statements. Similarly, nonfiling of form 8027 and large discrepancies between charged tip rates and cash tip rates could indicate to auditors potential understated tax liabilities.

Urging compliance

CPAs have a vested interest in urging their clients to comply with these rules. CPAs expressing opinions on financial statements of companies with contingent liabilities also may have a potential liability if clients do not comply and do not disclose the potential liability in the statements. Practitioners can educate clients to the potential tax exposure and help them develop compliance strategies that will meet IRS guidelines.