Employees in the restaurant industry and other service industries (e.g., beauty and barber shops, casinos, etc.) receive billions of dollars each year in tip income. Unfortunately, statistics suggest that less than half of all tip income is reported to the Internal Revenue Service (“IRS”), leaving an estimated $9-$12 billion in unreported income. This can lead to trouble for employers who could be audited and billed for FICA taxes on tip income their employees allegedly failed to report.
In response to this problem, the IRS developed the Tip Rate Determination and Education Program, a series of educational programs designed to increase tax compliance in this area. As of 2004 (the most recent year for which data is available), over 15,000 employers had entered into tip agreements under these programs, representing nearly 47,000 individual establishments. One of the more popular programs is known as TRAC (Tip Reporting Alternative Commitment). Since the TRAC program began in the mid-1990s, over 14,000 employers have participated by signing TRAC agreements with the IRS. While the effort has led to increased tip reporting in recent years, nearly doubling the amount of tip income reported before the program began, hundreds of thousands of eligible businesses still do not participate in the TRAC program. Further, the IRS is expected to continue increasing its audit activity in this area, so restaurant owners and managers would be well advised to consider participating in the TRAC program.
Under a TRAC agreement, an employer agrees to do the following:
- Educational Programs. The employer agrees to start and maintain quarterly educational programs that explain tip reporting obligations to employees. This could be accomplished through regularly scheduled staff meetings.
- Tax Returns and Records. The employer must timely file IRS Forms 941 (Employer’s Quarterly Federal Tax Return), Form 8027 (Annual Information Return of Tip Income and Allocated Tips) if required, and Forms W-2. The employer also must agree to comply with requirements for paying and depositing taxes due, maintain certain records, and make quarterly totals available to the IRS upon request.
- Tip Reporting Procedure. The employer must agree to set up a tip reporting procedure for directly and indirectly tipped employees (e.g., tips from cash and credit card sales).
In exchange for an employer establishing and fulfilling its obligations under a TRAC agreement, the employer is protected from “employer-first” and “employer-only” audits (i.e., the IRS promises not to charge the employer for underreported tips without first establishing that FICA taxes are owed by individual employees).
Employers should understand that signing a TRAC agreement is no guarantee that they will never be audited. The TRAC agreement only provides that if the IRS audits the employer and issues an assessment for FICA taxes on unreported tips, the assessment will be based on its examination of employees, not solely the employer.
The procedure for participating in the TRAC program involves filing an application with the IRS District Director for the district in which the employer is located. For an established business, a new TRAC agreement would go into effect at the start of the calendar quarter after the TRAC agreement is signed by the IRS District Director.
A U.S. Supreme Court decision in 2002 underscores the potential benefit of participating in the TRAC program. InU.S. v. Fior D’Italia, the IRS won a major victory over a restaurant owner in a dispute that possibly never would have arisen had the taxpayer been a TRAC participant. The employees at the restaurant in question reported tips of $247,181 in 1991, and the restaurant reported this amount on IRS Form 8027. The same Form 8027, however, reported tips on credit card slips alone of $346,786. The IRS applied the credit card tip rate (14.49%) to cash sales. The use of this “aggregation estimation method” resulted in a total tip amount of $403,726. The IRS assessed additional employer FICA tax on the difference between the two amounts.
The restaurant owner challenged the IRS’s methodology in court, and the case was ultimately decided by the U.S. Supreme Court. The Court confirmed IRS authority to use an aggregate method to estimate employer FICA taxes on unreported tips. Siding with the IRS, the Court cited Internal Revenue Code Section 6201(a), which provides that the IRS is “authorized and required to make the inquiries, determinations, and assessments of all taxes…which have not been duly paid.” The Court was clear, however, that employers could, with appropriate documentation, rebut the accuracy of the IRS’s estimation methods. Thus, after this decision, many employers began to consider more closely the benefits of the TRAC program and other IRS-approved tip reporting programs (e.g., the TRDA and emTRAC programs) and, at the least, started to more closely monitor tip-reporting procedures.