Everyone who works knows the general rule: If you make money or "earn income," you have to pay federal income taxes. For many workers, their employers withhold taxes from their weekly pay checks to cover income taxes. This is easy when the employer controls exactly how much the worker gets paid each week.
Some employers may not be able to withhold the necessary taxes because they don't have complete control over their employees' earnings. This is very common in the food industry and other businesses where the employees get tips or gratuities.
Tips are income for tax purposes, so employees must report them their on federal (and state) tax returns. If they get $20 or more in tips during the year, they also need to report their tips to you so you can pay necessary employment taxes.
What happens if an employee doesn't report or underreports tips? The IRS can hold you responsible for paying the taxes.
As an employer, you have many responsibilities when it comes to your employees' taxes. Employment taxes covers a few different taxes, but for purposes of unreported tips, the most important is the Social Security and Medicare tax. The controlling law is the Federal Insurance Contributions Act (FICA), and taxes employers are responsible for are:
- Withholding FICA taxes from your employees' paychecks, and
- Paying a certain percentage of FICA taxes for your employees
Also, unreported tips of $20 or more are subject to federal unemployment taxes, known as FUTA taxes.
What's the Connection?
Why is FICA important if your employees don't report or underreport their tips? The IRS can make you pay FICA taxes on those tips. This can be a sizeable expense for you.
Remember, you're already paying a portion of FICA for your employees, out of your own pocket. If there are underreported or unreported tips, you may have to pay additional FICA taxes on them. This expense can grow very quickly when you have several workers with unreported tips.
If the IRS discovers a worker or workers have unreported tips, it must give you "notice and demand" before you have to pay the additional FICA taxes. Essentially, the notice and demand is a written statement from the IRS that:
- Specifically states that it's a "notice and demand"
- Details the amount of tips received by an employee or employees who failed to report or underreported tips, and the period of time in which the employee(s) earned the tips
Generally, the IRS uses estimates to decide the amount of the unreported tips. That's because there usually are no accurate records for tips paid in cash or by check. There are a number of ways in which the IRS makes its estimates, but generally the IRS might:
- Compare credit card tips and cash tips over a period of time, such as a 30-day period, to see if they're the same or at least very close, and determine an average percentage of tips
- Determine your business's total tip-eligible sales for the year, and reduce that number to account for low or non-tippers, or tip-sharing between workers
- Dividing that number by the total number of hours worked by all tip-earning workers during the year to determine a sales-per-worker-hour average
- Multiply that average by the number of hours in each year that each tip-earner worked to determine each worker's yearly sales
- Multiply each worker's yearly sales by the average found in the first step to determine the yearly tip income of each worker
Paying the IRS
After you receive the notice and demand, you need to make adjustments to your Form 941. You also need to deposit the FICA tax on the unreported tips just as you deposit your other employment taxes. You can make a payment
- At a financial institution that's authorized to accept tax payments
- By making an electronic deposit
- By mailing or delivering a check, money order or cash
- By using the Electronic Federal Tax Payment System (EFTPS)
If you don't respond to the notice and demand, the IRS may assess the tax against you within three years after April 15 of the year after the notice and demand is made. You won't have to pay interest on the additional FICA taxes so long as you pay the tax on or before the due date of the Form 941 for the quarter when the notice and demand is made.
You'll be charged interest if you don't pay the tax by the due date.
Questions for Your Attorney
- Is there any way I can help to make sure that my workers accurately report their tips to me every month?
- I bought a restaurant a few months ago. Can I be liable for unreported tips that my workers earned before I bought the restaurant?
- I have employees who make tips and they work in different stores for me from time to time. If they underreport their tips, how will the IRS determine my FICA liability? Should I try to keep their tip records separate for each store?