IF IT LOOKS LIKE A TIP AND FEELS LIKE A TIP – IS IT A TIP?

by apexcpas | Jul 4, 2018 | Tax Planning

The IRS has updated its rules concerning businesses whose employees receive tips from customers as part of their compensation – primarily affecting restaurants and certain other businesses.

As a general rule, employees who receive tips must pay income tax on the amounts they receive. In addition, employees are supposed to report tips to their employer so the employer can withhold the appropriate amount for income taxes, Social Security taxes and Medicare taxes.

Although employers normally pay an amount equal to the amount the employee pays into the Social Security and Medicare systems, in most cases, employers receive a credit against their income tax to offset their share of the Social Security and Medicare taxes applied to tips. An exception applies, and the employer must pay the taxes, to the extent the employee’s total compensation is less than $5.15 per hour.

In the new guidance, the IRS reiterates the fact that a customer payment is a tip only if four conditions are met:

The payment is made free of compulsion.
The customer has an unrestricted right to determine the amount.
The payment is not the subject of negotiation, nor is it dictated by employer policy.
The customer has the right to determine who receives the payment.

As an example, the IRS guidance addresses a situation in which a restaurant automatically adds an 18 percent “tip” for parties over a certain number of persons. The restaurant then takes this amount and distributes it among employees who served the party.

In this situation, the IRS restates its previous position that this type of “service charge” is not a “tip.” As such, the restaurant is liable for its share of the Social Security and Medicare taxes on the amounts distributed to employees.

The IRS also issued a memorandum to its field examiners specifying that, in limited circumstances, the examiner may apply the “service charge” rule prospectively to amounts paid after Jan. 1, 2013, to allow businesses not currently in compliance additional time to amend their business practices and make needed systems changes.

However, the additional time is small comfort to businesses that all along have correctly complied with the service charge rule. The IRS will not allow them to apply for a “refund” of their previously paid Social Security and Medicare taxes, even though businesses out of compliance were able to receive – and keep – credits to offset those taxes.