General Explanation

The IRS has issued guidance that clarifies and updates existing guidelines on the taxation of tips (Rev. Rul. 2012-18). The guidance covers employer and employee obligations under the Federal Insurance Contributions Act (FICA) with respect to tips received by employees. It also discusses the credit for the employer share of FICA taxes paid under Code Sec. 45B(a). Finally, a selection of questions and answers is provided, addressing issues such as:

• the characterization of tips as opposed to service charges,

• the types of tips that must be reported to the employer,

• how such reporting is made,

• how FICA taxes are paid on reported tips,

• employee liability for FICA taxes on unreported tips,

• the applicable year for determining the contribution and benefit base,

• penalties for employees who do not report their tips,

• penalties for employers whose employees do not report their tips,

• employer liability for both the employer and employee share of taxes on unreported tips,

• employer liability for interest on unreported tips,

• the employer obligation to deposit taxes due on unreported tips, and

• the applicable year for use of the Code Sec. 45B credit.

In addition, the guidance reiterates the first of the question-and-answer pairs (Q&A-1), listing four factors relevant to distinguishing between tips and service charges, which are considered nontipped wages. To be a tip, the payment must be made free of compulsion; the customer must have the unrestricted right to determine the amount; the payment should not be the subject of negotiation or dictated by employer policy; and the customer must have the right to determine who receives the payment. The absence of any of these factors creates a doubt as to whether the payment is a tip and indicates that it may be a service charge.

The IRS also issued a memorandum for field examiners covering this issue. The memorandum provides that, in limited circumstances, an examiner should apply Q&A-1 prospectively to amounts paid on or after January 1, 2013, in order to allow businesses not currently in compliance additional time to amend their business practices and make needed system changes.