4.23.7. Employment Tax on Tip Income

(1) The mission of Employment Tax National Tip Reporting Compliance Program (NTRCP) Territory is to develop and implement policies and strategies for tip income filing, payment (withholding), and reporting compliance.

(2) Tipping has been a historical area of underreporting and is subject to unique laws and regulations. Traditional examinations often are burdensome to both the taxpayer and the IRS. NTRCP has developed voluntary tools, most predominantly tip agreements, which address employer and employee compliance.

(3) This section provides guidance on general tip examinations and voluntary compliance tools for taxpayers in the tipping industry. Examiners should also refer to tip training materials for additional guidance.

(1) Employment tax provisions are found at Internal Revenue Code Subtitle C:

1. Chapter 21, Federal Insurance Contributions Act (FICA)

2. Chapter 22, Railroad Retirement Tax Act (RRTA)

3. Chapter 23, Federal Unemployment Tax Act (FUTA)

4. Chapter 24, Federal Income Tax Withholding (FITW)

5. Chapter 25, General Provisions relating to employment taxes and collection of income taxes at source

(2) NTRCP is governed by Policy Statements and other internal guidance that apply to all IRS personnel regardless of operating division. The Policy Statements found in IRM 1.2.1, Servicewide Policy Statements, apply to all employment tax issues and examinations. Reviewers should review these Policy Statements to properly perform their examination duties.

(3) A website, IMDD Search Servicewide Delegation Orders, provides a searchable list of Servicewide Delegation Orders issued by the Commissioner of the Internal Revenue, or on their behalf by the deputy commissioner. Delegation Orders pertaining to each IRS business process can be found in IRM 1.2.2, Servicewide Delegations of Authority.

(4) IRM 4.23.7.10.6, Gaming Industry Tip Compliance Agreement (GITCA), provides Servicewide instructions for all operating divisions with employees involved with tip rate reviews, allowing for improved consistency of tip administration of employment taxes.

(1) Director, Specialty Examination, is the executive responsible for the procedures and updates addressed in this IRM.

(2) Chief, Employment Tax Examination, is responsible for operational compliance related to tip filing and reporting.

(1) Program Goals: The processes and procedures provided in this IRM are consistent with the objectives or goals for National Tip Reporting Compliance. The mission of NTRCP is to establish effective policies and procedures for tip income filling, payment, and reporting compliance. This is accomplished through enforcement and compliance programs such as tip examinations and tip rate reviews.

(2) Program Effectiveness: Adherence to quality standards and attributes are measured by Employment Tax Embedded Quality (EQ) Performance Reports. Progress toward business results is measured by Performance Planning and Analysis (PPA) Exam reports.

(1) The following table lists commonly used acronyms and their definitions:

(1) The following table lists the primary sources of guidance:

(2) Other helpful information sources include:

• SB/SE Employment Tax Small Business Knowledge Base Homepage,

• Specialist Referral System (SRS) Homepage,

• Employment Tax Policy Contacts provides a list of SB/SE Employment Tax Policy Analysts, their contact information and program assignments, and

• Program Manager and Analyst Contact List provides the NTRCP Program Manager and analysts' contact information and program assignment.

(3) The Taxpayer Bill of Rights (TBOR) lists rights that already existed in the IRC, putting them in simple language and grouping them into 10 fundamental rights. Employees are responsible for being familiar with and acting in accord with taxpayer rights. See IRC 7803(a)(3) . For additional information about the TBOR refer to Taxpayer Bill of Rights Homepage.

(4) The Taxpayer Advocate Service (TAS) is an independent organization within the IRS, led by the National Taxpayer Advocate, that helps taxpayers and protects taxpayer rights. TAS offers free help to taxpayers when a tax problem is causing a financial difficulty, when they’ve tried and been unable to resolve their issue with the IRS, or when they believe an IRS system, process, or procedure just isn't working as it should. TAS strives to ensure that every taxpayer is treated fairly and knows and understands their rights under the TBOR. TAS has at least one taxpayer advocate office located in every state, the District of Columbia, and Puerto Rico.

(5) Employment tax examiners should consider the disclosure provisions when preparing agreed and unagreed case reports. For further information, see the Privacy, Government Liaison and Disclosure (PGLD) knowledge base.

(6) Overall responsibility for civil penalty programs is assigned to Office of Servicewide Penalties (OSP). OSP is charged with coordinating policy and procedures concerning the civil penalty program administration, ensuring consistency with the penalty policy statement, reviewing and analyzing penalty information, researching penalty effectiveness on compliance trends, and determining appropriate action necessary to promote voluntary compliance. For further understanding of the civil penalty program and penalty relief refer to the Penalties Knowledge Base Homepage.

(7) TE/GE employees must refer to IRM 4.70.14.2.1.4.5, TE/GE - Tip Compliance Agreements, and IRM 4.70.18, Tip Compliance Agreements, for guidance and procedures for the TE/GE tip program.

(1) All information management systems have safeguard measures in place that address key components of Information Technology (IT) security requirements to restrict access to sensitive data.

(2) The Employment Tax program has established a separation of duties of users’ roles.

• Policy and procedures – Employment Tax Policy is within SB/SE Specialty Exam Policy

• Tip policy and procedures – National Tip Reporting Compliance Program is within SB/SE Specialty Examination

• Tip Field Exam Case Selection – Employment Tax – Workload Selection and Delivery is within SB/SE Examination Case Selection

• Tip Underreporting Campus Exam Case Selection – National Tip Reporting Compliance Program is within SB/SE Specialty Examination

• Examination - Employment Tax Examination is within SB/SE Specialty Exam

• Quality and review - Embedded Quality is within SB/SE Field and Specialty Exam Quality

(3) The Issue Management System (IMS) is required to be used during employment tax tip cases by examiners assigned to Specialty – Employment Tax Operations.

(4) Unless instructed otherwise, examiners will use the ETLS - Employment Tax Lead Sheets developed specifically for employment tax tip cases.

(5) SB/SE ET examiners working ET Large Cases will use Large Case Lead Sheets (LCLS). LCLS are developed specifically for large case employment tax cases. Examiners working ET Large Cases will follow workpaper preparation, specific audit techniques, and case closing procedures unique to these types of audits including tip cases.

(1) Form 4137 is designed to be used exclusively by employees to calculate the social security and Medicare taxes on unreported tips. Prior to 2007, Form 4137 was also used by individuals to report Form 1099 income that they believed were wages rather than non-employee compensation. Starting with tax year 2007, Form 8919, Uncollected Social Security and Medicare Tax on Wages, is used for that purpose.

(2) Form 4137 shows the individual EIN(s) and the employee's unreported tips for each of the employers for whom the employee worked for during the year. Form 4137 allows the IRS to aggregate unreported tips reported on Forms 4137 for each employer. This allows the IRS to provide each employer with a Section 3121(q) Notice and Demand for the employer’s share of the applicable FICA due on the tips their employees reported to the IRS but did not report to the employer.

(3) IRC 3121(q) provides the authority for the IRS to issue a Section 3121(q) Notice and Demand to an employer for the employer’s share of FICA tax on unreported tips – determined either by tip examination or from Forms 4137 filed by employees. Detailed guidance related to the Section 3121(q) Notice and Demand process for tip exams is covered in IRM 4.23.7.7.4, Section 3121(q) Notice and Demand Procedures.

(4) The Form 4137 Compliance Program is designed to determine the total tips shown as unreported on Form 4137 for each employer and then issue a Section 3121(q) Notice and Demand for the payment of the employer’s share of FICA tax on those tips. This program is administered by NTRCP within SB/SE Employment Tax.

(5) The Section 3121(q) Notice and Demand process related to Form 4137 is not considered an examination. The employer's (taxpayer’s) books and records are not examined. The Section 3121(q) Notice and Demand process is a collection program – collecting the employer’s share of FICA taxes related to unreported tips shown on the Forms 4137 with each respective employer through a current period liability to the employer’s Form 941, Employer’s Quarterly Federal Tax Return. No specific format is required for the notice and demand, but the IRS has developed correspondence for making the notice and demand.

(6) Each case is established on AIMS using the following codes:

• Project Code 1034: 4137 Tip Correspondence Contacts

• Tracking Code 7887: 4137 Leads

(7) Examiners must use Letter 4520-P, Pre-notice for Employer Share of Tax Based on Form 4137, to provide the employer with advance notice of the IRC 3121(q) FICA tax liability. Generally, the IRS will send the employer the pre-notice at least thirty days prior to issuing the Section 3121(q) Notice and Demand to allow the employer sufficient time to gather the necessary funds for making a timely tax deposit.

(8) There are four attachments to Letter 4520-P:

1. Tax calculation worksheet: Summarizes the IRC 3121(q) FICA tax liability due,

2. Form 4137 detail spreadsheet: Lists information from each of the Form(s) 4137 filed under the employer’s EIN (employer identification number),

3. Publication 5080 FAQs: Provide guidance for the most commonly asked questions, and

4. Notice 609: Informs individuals of their privacy rights in non-criminal cases.

(9) In general, no sooner than thirty days after sending Letter 4520-P to the employer, the IRS will send Letter 4520, Section 3121(q) Notice and Demand. This letter will explain how the employer should report the IRC 3121(q) FICA tax liability to avoid penalties and interest.

(10) There are two attachments to Letter 4520 based on Forms 4137:

1. Tax calculation worksheet: Summarizes the IRC 3121(q), FICA tax liability, and

2. Form 4137 detail spreadsheet: Lists information from each Form 4137 filed under the employer’s EIN (employer identification number).

(11) The employer must report the IRC 3121(q) FICA tax liability on the Form 941 for the quarter corresponding to the date of the Section 3121(q) Notice and Demand. This Form 941 is referred to as the "reporting Form 941." The date of the Section 3121(q) Notice and Demand will be the last business day of the quarter in which the Letter 4520 is issued, not the mailing date of the letter.

(12) If the employer fails to report the IRC 3121(q) FICA tax liability on the reporting Form 941, that quarter will be opened for a limited scope examination initiated on the missing IRC 3121(q) FICA tax liability. This limited scope exam will address the non-reporting of the IRC 3121(q) FICA tax liability only. The exam group should use the following codes to establish these limited scope exams on AIMS:

• Project Code 1118: Limited Scope Exam – Unreported IRC 3121(q) Tax

• Tracking Code 7887: 4137 Leads

(1) Treas. Reg. 31.6053–3 requires certain large food or beverage establishments to make an information return with respect to tips. The employer is required to file a separate information return for each calendar year in which the employer has employees. The information return will contain the following:

• The employer's name, address, and employer identification number

• The establishment's name, address, and identification number

• The aggregate gross receipts (other than nonallocable receipts) of the establishment from the provision of food or beverages

• The aggregate charge receipts (defined as charge receipts with charged tips)

• The aggregate of charged tips on those charge receipts

• The aggregate of tips reported to the employer by the tipped employees

• The aggregate amount the employer is required to report under IRC 6051 with respect to service charges of less than ten percent

(2) Large food or beverage establishments use Form 8027, to make annual reports to the IRS on its food or beverage operations receipts and employees' reported tips.

(3) A "large food or beverage operation" is defined as one which normally employs more than ten employees on a typical business day during the preceding calendar year, food or beverage is consumed on premises, and is an operation in which the tipping of food or beverage employees is customary. See Treas. Reg. 31.6053–3(j)(7).

(4) The phrase "more than ten employees on a typical business day" is defined in Treas. Reg. 31.6053–3(j)(9). This test is met if one-half of the sum of the average number of employee hours worked per business day during the calendar month in which the aggregate gross receipts from food or beverage operations were the greatest, plus the average number of employee hours worked per business day during the calendar month in which the aggregate gross receipts from food or beverage operations were the least, is greater than 80 hours. This test includes all employees of a food or beverage operation not only food or beverage employees.

(5) A food or beverage employee is an employee who provides services in connection with the provision of food or beverages. Such employees include, but are not limited to; waiters, waitresses, busboys, bartenders, hostesses, maitre d's, dining room captains, wine stewards, cooks, and kitchen help. See Treas. Reg. 31.6053-3(j)(10). Employees who are not food or beverage employees include, but are not limited to, managers, coat check staff, doormen, and parking attendants.

(6) A separate Form 8027 must be filed for each location under common ownership or control. If the total hours of all locations exceed the 80 hours computation, then each location must file a separate Form 8027. This is true even if the individual locations, when considered separately, would not exceed the 80 hours test.

(7) For information about the requirement to file Forms 8027, see Instructions for Form 8027 and Pub 1239, Specifications for Electronic Filing Form 8027, Employer’s Annual Information Return of Tip Income and Allocated Tips.

(1) An employer who operates a large food or beverage establishment is required to allocate among tipped employees an amount equal to the excess of eight percent of the gross receipts of such establishment for the payroll period over the aggregate amount of tips reported by employees at such establishment to the employer. See Treas. Reg. 31.6053–3(d).

(2) This results in an allocation of a percentage of gross receipts to tipped employees. The individual allocation is entered as an information item on the employee's Form W-2 Box 8. There are no taxes withheld from allocated tips because tips were not reported by the employee to the employer in a written statement. Employees must report the allocated tips from their Form(s) W-2, Box 8, on a Form 4137, Social Security and Medicare Tax on Unreported Tip Income, which must be attached to their Form(s) 1040 unless they can establish with adequate records that they received a lesser amount. Employees use Form 4137 to compute their share of social security and Medicare tax on these unreported tips. Employees use Form 8959, Additional Medicare Tax, to compute Additional Medicare Tax on these unreported tips. Form 4137 and Form 8959 are filed with Form 1040, Individual Income Tax Return.

(3) The employer is not required to report its share of social security and Medicare taxes on allocated tips because these tips were not reported in a written statement by the employees receiving the allocated tip amounts. However, if unreported tips are determined in the course of a tip audit or through the Form 4137 Compliance Program, the employer is liable for its share of social security and Medicare taxes on the tips that were not reported by employees when notified by the IRS .

(4) Examiners should consider whether to assert any penalties for an employer’s failure to file Form 8027 and/or failure to report tip information on Form W-2 as required. See IRM 20.1.7, Information Return Penalties.

(1) Certain payments to drivers of taxicabs, limousines, tour buses, and other modes of transportation may have been mis-characterized by employees, employers, or business owners as tips.

(2) This may occur in situations that involve drivers who are employees of companies engaged in the business of transporting passengers for a fare (for example, limousines and taxicabs). The drivers pick up and transport passengers to their requested destinations. Typically, the driver collects the fares from the passenger. It is customary for the passenger to tip the driver an amount in addition to the fare for the transportation provided. At issue are other payments the driver may receive in addition to the tips from the passenger.

(3) Some business establishments such as adult entertainment clubs, restaurants, nightclubs, and other service establishments have a practice of making payments to drivers who bring passengers to their establishments.

1. Generally, the service establishment’s personnel will not render payment to the driver until the passenger first pays a cover charge or otherwise indicates in some manner that they are patrons of the service establishment.

2. Payments by establishments to drivers are usually made in cash, although some establishments issue vouchers to the drivers that can be exchanged for cash at a later time.

3. The amount of the cash or voucher payment may or may not bear any relationship to the transportation fare, may vary depending upon the number of patrons, and may be far greater than either the fare or the customary tip for the transportation.

4. In many situations, one or more passengers are transported from a location such as a hotel directly to the establishment. In some cases, the driver may make agreements with certain hotel personnel so that when a guest wants to go to an establishment (for example, hotel guest informs hotel personnel that they are interested in finding an adult entertainment club), the hotel personnel will summon the driver with whom they have an agreement from the hotel’s transportation queue and the driver will split the payment from the establishment with the hotel personnel.

5. In some cases, the passenger may not request a particular destination and the driver or hotel personnel will recommend an establishment that will pay the highest amount for delivering the passenger/patron.

6. Many establishments advertise in local magazines, specifically targeted at drivers in the transportation industry. The ads indicate that the establishment will pay a "referral fee," "tip," or "incentive" for delivery of passengers/patrons.

(4) Generally, the drivers do not report the payments to their employer as tips. Thus, the employers are not treating the payments as wages subject to employment taxes. The absence of reporting on either Forms 1099 or Forms W-2 may result in some drivers not reporting the payments as income on their income tax returns.

(5) Chief Counsel Advisory (IRS CCA 201106010, dated 12-01-2010), provides that under the facts and circumstances described in the CCA (similar to the situations described above), the payments from the establishments to the drivers are not tips received in the course of employment with the transportation company, but are considered payments for services separate and distinct from those the drivers perform for their transportation company employer. In addition, if the payments to one driver equal or exceed $600 in a calendar year, the business making the payment is required to report these payments on Forms 1099.

(6) When examining service businesses (such as restaurants, night clubs et al.), examiners need to investigate the existence of payments of this type which are usually paid in cash or by a voucher that can be converted to cash at a later date. Various techniques may be used to identify the existence of and deduction for such payments (including observation of drop-off locations of transportation companies at the establishment and inquiries regarding the establishment’s business deductions.)

(7) The reporting requirements applicable to the payments made by the establishments described above are provided in IRC 6041(a). This section requires all persons engaged in a trade or business and making payment in the course of such trade or business to another person of rent, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, or other fixed or determinable gains, profits, and income of $600 or more in any taxable year, to file an information return with the IRS and to furnish an information statement to the payee. Payments are fixed when they are paid in amounts definitely predetermined. Income is determinable whenever there is a basis of calculation by which the amount to be paid may be ascertained. Treas. Reg. 1.6041-1(c). Payments that are fixed or determinable must be reported on Form 1099. See Treas. Reg. 1.6041-1(a)(2).

(8) If the payments at issue are for the separate and distinct services of delivering patrons, the service establishments are required under IRC 6041 to file a Form 1099 with the IRS for each person (driver) to whom they paid $600 or more during the calendar year. If the establishments do not file Form 1099, examiners should consider assertion of penalties under IRC 6721 and IRC 6722. Penalty assertion should be discussed with the examiner’s manager.

(9) Backup withholding should also be considered if the payor fails to secure a Taxpayer Identification Number (TIN) from the service provider individual (in this case, the driver). The payor is required to back-up withhold a percentage on the payment amount (24 percent). If the payor fails to withhold the current applicable backup withholding percentage from the service provider, the payor becomes liable for the backup withholding under IRC 3406. See IRM 4.23.8.13, IRC 3406 - Backup Withholding.

(10) Pub 4904, How to Report Driver Referral Fees, Incentive Payments, and Other Income You Receive, can be used to educate business owners of their reporting, filing, and payment obligations on payments for services.

(1) Tips are not defined in the IRC or Treasury Regulation. Rev. Rul. 2012-18, 2012-26 I.R.B. 1032, provides criteria for determining whether a payment is a tip or a service charge. Service charges are frequently referred to as "auto-gratuities" in the hospitality industry. Rev. Rul. 2012-18 uses the criteria provided in Rev. Rul. 59-252, 1959 C.B. 215. We rely on Rev. Rul. 2012-18 in making the distinction between a tip and a service charge (or auto-gratuity). Examiners should verify that distributed service charges are properly characterized as wages subject to withholding, and not as tips.

(2) Rev. Rul. 2012-18 provides specific examples of amounts characterized as tips and service charges to illustrate the application of factors relevant to distinguishing a tip vs. a service charge. Example A in Q and A 1 of Rev. Rul. 2012-18 illustrates a service charge paid by a large party when the menu specifies that a fixed charge will be added to all bills for parties of 6 or more customers. Example B illustrates a tip in a situation where the credit card charge receipt shows sample tip calculations.

(3) The incorrect characterization impacts the withholding rules and affects a number of forms and credits:

• Form 8027, Employer’s Annual Information Return of Tip Income and Allocated Tips,

• Form 8846, Credit for Employer Social Security and Medicare Taxes Paid on Certain Employee Tips, for the IRC 45B credit, and

• Form 3800, General Business Credit.

(4) The criteria of Rev. Rul. 2012-18 should be applied to determine whether the payment made is a tip or a service charge. Q and A 1 of Rev. Rul. 2012-18 provides that the absence of any of the following factors creates a doubt as to whether a payment is a tip and indicates that the payment may be a service charge:

1. The payment must be made free from compulsion,

2. The customer must have the unrestricted right to determine the amount,

3. The payment should not be the subject of negotiation or dictated by employer policy, and

4. Generally, the customer has the right to determine who receives the payment.

(5) A contractually fixed gratuity for catering, banquets, weddings, transportation, baggage handling and other events or items is generally considered to be service charges if the amount is distributed or paid to the service staff. A non-contractually fixed gratuity, or "auto-gratuity," that is the policy of the employer is generally considered to be a service charge. If these amounts are distributed or paid to the employees, then the amounts are non-tip wages subject to withholding. Examples of employer policy driven service charges:

1. Employer sets a fixed charge or "auto-gratuity" for all purchases in the food or beverage establishment regardless of amount of sale or number of guests.

2. Auto gratuity added for a large party of customers.

3. Bottle service fees or cork fees in night clubs or restaurants.

4. Delivery fees in the pizza industry or other delivery service industries.

(6) Examinations performed in industries where tipping is customary should include the following:

1. An evaluation of the employer’s policy for customer gratuities,

2. The internal controls for payments received by the establishment or the employee as gratuities,

3. The splitting or pooling of gratuities,

4. The employee’s reporting of gratuities to the employer under IRC 6053(a), and

5. The distribution of gratuities from the employer to the employees.

(7) The employer’s characterization of a payment as a "tip" is not determinative. The fact that the employee may have reported the payment as a "tip" to the employer is also not determinative. When performing a tip examination, examiners must ensure that distributed service charges are properly characterized as wages subject to withholding and not as tips. Distributed service charges that have been characterized as tips should generally be re-characterized and an adjustment made to the Form 941, Employer's Quarterly Federal Tax Return, under examination and reported on employment tax report Form 4666, Summary of Employment Tax Examination, and Form 4668, Employment Tax Examination Changes Report.

(8) Amounts determined to be service charges and not tips are not eligible for the IRC 45B credit claimed on Form 8846, (and thus are not eligible for the General Business Credit claimed on Form 3800.)

(9) When calculating the amount of unreported tips for an employer-only assessment under IRC 3121(q), examiners must ensure they do not include service charges in the Section 3121(q) Notice and Demand.

(10) A review of the correct characterization of service charges does not constitute a "tip examination" within the meaning of a voluntary tip agreement. Establishments possessing a tip agreement can be contacted to review the tip vs. service charge issue. The examiner must take caution against making an adjustment for unreported tips and focus on the correct characterization and reporting of service charges.

(11) A tip rate review of an employer participating in a voluntary tip compliance agreement should also include an evaluation of the items in the preceding paragraph.

1. Service charges should not be included in any calculation that arrives at an hourly tip rate, tip rate calculated on a percentage of sales, or any other rate determination method when preparing a voluntary tip compliance agreement.

   Note: Examiners must consider if sales with a related service charge must be excluded from the tip rate calculation.

2. Examiners should note in their work papers and appendices that service charges were not included in the tip rate computations.

3. The tip agreement should also instruct the employer how to account for and report service charges.

   Note: The examiner must refer to IRS training course number 28136-B002, Employment Tax Tip Rate Reviews (Student Guide) (Catalog Number 93915C), on treatment of service charges and preparation of tip agreement when service charges are imposed by the employer.

(1) Cases classified for a "tip examination" should not be limited in scope to tip related issues only. Examiners should perform the required filing checks to ensure the taxpayer is in compliance with other filing, payment, and reporting obligations. Other common issues such as fringe benefits and unreported or underreported compensation should be considered and added to the examination plan when appropriate.

(2) Examiners should conduct the examination to a point where the reported employment tax liability is determined to be substantially correct. Examiners must determine whether information returns such as wage and tax statements have been correctly filed and whether all applicable Federal return requirements have been met. See IRM 4.23.3.6.3.2, Scope of Employment Tax Examination, for further details.

(1) The Supreme Court determined in U.S. v. Fior d’Italia, Inc. 122 S.Ct. 2117, the IRS has the authority to assess the employer’s share of social security and Medicare taxes due on employees’ tip income using an aggregate estimation method. In light of this case, the IRS may generally conduct tip examinations and make assessments for social security and Medicare taxes on employers only, without first examining the tip records of the individual employees.

(2) As it is critical that examiners meet with the employer to arrive at the correct tip income and to determine the factors affecting how this income is to be reported on the employer’s tax returns, the examiner should contact the employer to schedule an appointment. This is done by mailing Letter 3850, Employment Tax Appointment Letter, or Letter 3851, Employment Tax Call-in Appointment Letter. For more information regarding scheduling an initial appointment refer to IRM 4.23.3.6.4, Scheduling the Initial Appointment. The examiner must enclose an Information Document Request (IDR) with the examiner's confirmation/appointment letters. The IDR should be tailored for the particular taxpayer and should be separated by topic and recipient.

(3) Examiners should establish on AIMS all periods for which books and records are examined, generally all four quarters in a tax year. To ensure proper tracking of audit results, use Project Code "0673" and Activity Code "465" when establishing the employer’s returns on AIMS. Refer to the most recent Project/Tracking Code list from Employment Tax Policy to confirm that the appropriate tracking code is used to identify the examination.

(4) When tip income is an issue, the examiner should determine whether employees are reporting tips to their employer and if the employer is withholding employment taxes as required. The examiner should determine if the amount of tip income reported is reasonably correct. At a minimum, the examiner should consider the following:

1. Nature of the establishment. Employees of fine dining restaurants generally receive more tips than those of less expensive restaurants since tips are generally a percentage of the customer's bill. The same would apply to tips paid to employees of expensive hotels, beauty shops, etc.

2. Method of payment. Does the establishment accept cash, checks, credit cards, debit cards, or charge accounts? Are all types of payment reported as tip income by the employee?

3. Geographical location of the establishment. Different areas have varying tipping habits.

(5) When the examiner determines it is necessary to pursue the unreported tip income issue, the "McQuatters Formula" provides a method of reconstructing tip income that has been accepted by the courts. It specifically addresses factors to be considered in determining a tip rate and the types of items used for making a reduction, such as tip outs and stiff rates. See McQuatters v. Commissioner, T.C. Memo, 1973–240. In McQuatters, the stiff rate (term used when a customer does not tip the server) was applied to the gross sales. With the increased use of credit cards and debit cards, the volume of charge sales that include a tip have also increased. Therefore, applying a stiff factor to gross sales would not be appropriate. In tip examinations, the examiner should apply the stiff rate only to cash sales and charge sales that did not have a tip added to the bill. The stiff factor should not be applied to charge sales including a tip amount. To obtain an electronic version of the calculation worksheet to use, contact an analyst with NTRCP. However, where the "McQuatters Formula" cannot be applied, the examiner may use any method deemed reasonable to arrive at the correct income. See IRC 446(b).

(6) In general, for tip examinations, examiners should consider expanding the examination to include the prior and subsequent tax periods.

(7) If the employer is participating in a tip agreement described in IRM 4.23.7.10 and is complying with the commitments under this agreement, then any social security and Medicare tax assessments made against the employer must mirror those first made from additional tips self-reported by an employee (that is, Form 4137, Social Security and Medicare Tax on Unreported Tip Income) or assessed through an audit. Form 14439, Employee Data Report, is for collecting the tipped employee information (for both tip examinations and reporting agreement non-participants). Information on audited individual tipped employees come from other exam areas of the IRS, such as Campus Audit. As a general rule, Employment Tax Specialists do not perform the tipped employee Form 1040, Individual Income Tax Return, examinations. The information gathered from the Form 14439 of the examined employees is used to determine the employer’s social security and Medicare tax assessment. The examination must be in Status 90 prior to sending the NTRCP analyst a copy of the Form 14439. However, if the employer is not in compliance with the commitments under the agreement, then tax assessments may be made against the employer without first examining the tip records of the individual employees, but only if the tip agreement has first been terminated.

(8) If the tip examination case resulted from a classification activity, and is a large food or beverage establishment, the case file should contain a simulated Form 8027 for each establishment under the employer’s EIN and an IRC 3121(q) Pre-Audit FICA Tax Calculation Worksheet that will provide the examiner with an estimate of the potential IRC 3121(q) liability. It is the examiner’s responsibility to review this information and validate the amounts shown on the Form 8027 using the employer’s books and records. The examiner will then prepare an Examination IRC 3121(q) FICA Tax Calculation Worksheet that will be included with the Section 3121(q) Pre-Notice and Notice and Demand letters sent to the employer.

(9) NTRCP has developed worksheets to assist the examiner in arriving at the correct unreported tip amount and correct tax liability. This worksheet is attached to Letter 3264, Pre-notice for Employer Share of Tax due on Unreported Tips, as well as the Section 3121(q) Notice and Demand, Letter 3263-E, Notice and Demand - Employer Only, or Letter 3263, Section 3121(q) Notice and Demand.

(10) The worksheets accommodate tip computations that may not have been based on the "McQuatters Formula" (for example, Tip per Product)and also allow the examiner to consolidate tip computations from multiple venues or establishments. The worksheet is available in two versions:

• Single establishment, and

• Multiple establishments or venues.

(1) There are unique report writing procedures for employment tax examinations where underreported tip income earned by employees is an issue. These examinations are often referred to as IRC 3121(q) cases. These procedures ensure that tip examinations meet the quality standards and conform to general employment tax report writing procedures. See Exhibit 4.23.7-2, Chart of Tip Report Writing Instructions, for a summary of scenarios.

(2) The examination of tip related and other employment tax issues involves inspection of an employer’s book and records. The examiner must issue an examination report or no-change letter at the conclusion of each examination. An employment tax liability resulting from a tip examination is considered a current period liability when the notice and demand is issued to the taxpayer. Taxpayer liabilities generated under the authority of IRC 3121(q) require slight deviations from the common report writing procedures.

(3) At the conclusion of an employment tax examination, the examiner will issue Form 4666, Summary of Employment Tax Examination, to the taxpayer. The Form 4666 should address all examined issues, regardless of determination.

(4) In addition to report Form 4666, the examiner may need to issue Letter 4840, Unreported Tips and No Change for Other Examined Issues. Letter 4840 is used when, in addition to the issue of unreported tips, other employment tax issues were examined, resulting in an adjustment to employment tax due to unreported tips; but no adjustment made to the other examined employment tax issues. In addition, Letter 4840 lets the taxpayer know that while there was no adjustment made to taxes for the year of examination, there is a liability due on the unreported tips to be reported as a current period liability. The letter explains when and how the IRC 3121(q) FICA tax liability must be reported.

(5) If the only issue examined is unreported tips and no adjustment is warranted, the examiner issues Form 4666 and Letter 3401-A, Employment Tax No Change Transmittal Letter. Under these circumstances, no specialized report writing procedures are required. The examiner would follow normal employment tax report writing procedures as discussed under 4.23.10.5, Notification Letters in No-Change or No-Liability Cases. The examiner will prepare the final no-change letter, Letter 3381, No Change Letter for Employment Taxes. After the manager has signed the letter, the examiner will mail the letter to the taxpayer and the taxpayer’s authorized representative and document the activity record with the date sent and to whom. A copy of the letter will be uploaded to the ‘Correspondence Letters’ section in IMS.

(6) If the only issue examined is unreported tips and an adjustment to unreported tips is warranted, the examiner will prepare Form 4666 and Letter 3264 to be included with the examination report package issued to the taxpayer. The examiner will not enter any dollar amount on Form 4666 under column c. This is because the IRC 3121(q) FICA tax liability owed by the taxpayer is reported on the current Form 941 for the quarter corresponding to the date of the Section 3121(q) Notice and Demand. Letter 3264 gives the taxpayer a brief overview of the process for reporting the IRC 3121(q) FICA tax liability and will include a detailed calculation of the additional taxes that will be shown on the Section 3121(q) Notice and Demand. Form 4666 should include the following when the only issue examined was unreported tips and the taxpayer owes additional tax on these unreported tips:

(7) If there is a determination that all tips were correctly reported but adjustments are warranted to other employment tax issues identified during the course of the examination, the examiner will issue Form 4666 and follow the employment tax report writing and closing procedures in 4.23.10, Report Writing Guide for Employment Tax Examinations. Under these circumstances, no specialized tip report writing procedures are required.

(8) If other employment tax issues in addition to tips were examined but adjustments are warranted only to unreported tips, the examiner should issue Form 4666 and Letter 4840, Unreported Tips and No Change for Other Examined Issues. When listing the examined issues on Form 4666, the examiner will not enter any dollar amount for the IRC 3121(q) tips issue. Form 4666 should include the language provided below. Letter 4840 informs the taxpayer that the only examined issue that warranted an adjustment was on the unreported tips. Letter 4840 also informs the taxpayer that Letter 3264 is enclosed with the examination report package. Letter 3264 gives the taxpayer a brief overview of the process for reporting the additional tax and should include a detailed calculation of the additional taxes to be included in the Section 3121(q) Notice and Demand. Add the following language to Form 4666 when, in addition to unreported tips, other employment tax issues were examined but the only issue adjusted is unreported tips:

(9) If the examination results in adjustments to other employment tax issues and adjustments to unreported tips, the examiner must prepare Forms 4666 and 4668. When listing the examined issues on Form 4666, you will not enter any dollar amount for the IRC 3121(q) tips issue. Form 4666 should include the language provided below in the "Other Information" section. The examiner should also include Letter 3264. Form 4666 gives the taxpayer a brief overview of the process for reporting the additional tax and should include a detailed calculation of the additional taxes to be included in the Section 3121(q) Notice and Demand.

(10) If the examination of the taxpayer’s books and records did not include the examination for employment tax purposes of whether any individuals should be treated as employees of the taxpayer for the purposes of Section 530 of the Revenue Act of 1978, as amended, a statement to that effect should be included on any Form 4666 and/or Form 4668 issued to the taxpayer. See IRM 4.23.10.10.3, Employment Tax No-Change Report.

(11) Section 3121(q) Notice and Demand Procedures and Case Closing are discussed in IRM 4.23.7.7.4, Section 3121(q) Notice and Demand Procedures.

(1) When an employee fails to report tips to the employee’s employer, the employer is not liable for its share of the social security and Medicare taxes on the unreported tips until the IRS makes notice and demand to the employer. See IRC 3121(q).

(2) The employer is liable for the employer’s share of social security and Medicare taxes for tips even though the employees failed to provide the employer with written statements. The additional tax liability may be based upon the employer’s records for the tax year and/or on Form 4137 filed by employees. The additional tax liability is not due until the IRS issues a Section 3121(q) Notice and Demand (even though the tips were paid to employees in prior years).

(3) No specific form is required for a Section 3121(q) Notice and Demand, but the IRS has developed correspondence. The first letter to be issued is Letter 3264 which is sometimes referred to as a "pre-notice letter."

(4) Generally, the IRS will send the taxpayer the pre-notice Letter 3264 at least thirty days prior to issuing the Section 3121(q) Notice and Demand to allow the taxpayer sufficient time to gather the necessary funds for making a timely tax deposit. Examiners must use Letter 3264, to notify the taxpayer of the IRC 3121(q) FICA tax liability.

1. At the time the pre-notice is issued, the examiner should emphasize to the taxpayer that if a payroll service is used, the taxpayer should immediately notify the payroll service of the IRC 3121(q), FICA tax liability. This is to provide the payroll service provider sufficient time to make the necessary payroll deposit and to help reduce or eliminate any interest or deposit penalties.

2. It is recommended that examiners issue the Section 3121(q) Notice and Demand within the first 60 days of the quarter to give the taxpayer sufficient time to gather the necessary funds to make the tax deposit and to have sufficient time to notify its payroll service, if there is one, to ensure a timely tax deposit. If the employer reports the IRC 3121(q) FICA tax liability on the line titled "Section 3121(q) Notice and Demand - Tax due on unreported tips" on the Form 941 for the quarter corresponding to the date of the Section 3121(q) Notice and Demand and makes a timely deposit based on the date of the Section 3121(q) Notice and Demand, the tax due on this liability is interest and penalty free.

(5) Generally, at least thirty days after the Pre-Notice letter is sent to the taxpayer, the IRS will send the Letter 3263, Section 3121(q) Notice and Demand. This letter will explain how the employer should report and pay the IRC 3121(q) FICA tax liability to avoid penalties and interest.

1. The employer must report the IRC 3121(q) FICA tax liability on the Form 941 for the quarter corresponding to the date of the Section 3121(q) Notice and Demand. This Form 941 is referred to as the "reporting Form 941."

2. If the employer fails to report the IRC 3121(q) FICA tax liability on the reporting Form 941, the examiner will initiate an examination of the reporting Form 941 in order to assess the IRC 3121(q) FICA tax liability. This, in essence, constitutes an unagreed report and the examiner then adheres to normal unagreed procedures and reports. Rev. Rul. 2012-18, provides guidelines for IRC 3121 Notice and Demand procedures.

(6) The examiner must post-date the Section 3121(q) Notice and Demand to account for mailing delays and to provide sufficient time following receipt to allow employers to adjust their deposit amounts accordingly. A Section 3121(q) Notice and Demand should not be issued or dated on a Saturday, Sunday, or federal holiday. Therefore, the date on the Section 3121(q) Notice and Demand should be post dated with the last day of the quarter.

(7) There are two Section 3121(q) Notice and Demand letters for use in employer tip examinations:

1. Letter 3263-E is used for employer-only examinations where the audit results are not dependent on any audits of the employer’s tipped employees.

2. Letter 3263 is used for employer tip examinations where the employer has signed a tip compliance agreement. Any assessment against the employer must mirror that first made against the individually audited tipped employees.

(8) For assessments based on the results of the employees' examinations, the examiner may disclose certain information on employee returns in the Section 3121(q) Notice and Demand issued to the employer. This information may be disclosed only if it is necessary to substantiate the employer's share of social security and Medicare taxes on the unreported tip income. The information may be disclosed because it "directly affects" or "directly relates to" the resolution of an issue and there is a transactional relationship between the employer and the employee. See IRC 6103(h)(4)(B) and IRC 6103(h)(4)(C).

(9) When the employer's liability is dependent on the outcome of the tipped employees' audits, then the examiner should attach a spreadsheet (Form 14439) to the Section 3121(q) Notice and Demand explaining the tax liability. The examiner may also attach this spreadsheet to the Pre-Notice and Demand. The Form 14439 should include information such as the following:

• Employee name, social security number, job position, dollar amount of sales or the number of hours worked,

• Tip rate used in the calculation,

• Tips reported by the employee, and

• Unreported tips by the employee.

(10) For employer-only audits, there is no requirement to provide a breakdown of the audited employees’ assessments. However, the examiner will attach the McQuatters calculations, or other calculation spreadsheet if McQuatters was not used, to the Section 3121(q) Notice and Demand to show how the liability (aggregate assessment) was determined. When examining a casino, the examiner will attach a spreadsheet showing the unreported tip amounts broken down by the tipped occupational categories.

(11) After the examiner issues the Section 3121(q) Notice and Demand, all quarters examined are closed using Disposal Code "01", No-Change with Adjustment, unless other adjustments were made to the return. This disposal code should be used regardless of the agreement or lack of agreement by the taxpayer to the proposed IRC 3121(q) FICA tax liability.

(12) The examiner can generally close the exam to the group manager 20 days after the Section 3121(q) Notice and Demand (Letter 3263-E or Letter 3263) was issued to the taxpayer. Once the examiner issues the Section 3121(q) Notice and Demand and the case is ready to be closed, the Form 5344, Examination Closing Record, is prepared. See IRM 4.23.7.7.3 , Report Writing Procedures for Tip Examinations, for procedures when other employment tax issues warranted adjustments. If other employment tax issues are examined and an adjustment made, use the primary issue disposal code.

(13) For each quarter examined, complete Form 5344, "Item 418 - 3121(q) Amount," to capture the IRC 3121(q) FICA tax liability. Generally, the IRC 3121(q) FICA tax liability should be spread among all the examined periods in a year in a ratable manner - thus, the amount to enter for each quarter is the social security and Medicare tax amount shown in the Section 3121(q) Notice and Demand divided by the number of quarters examined. For example, if the IRC 3121(q) FICA tax liability is $4,000 and only one year was examined, you would enter $1,000 for each of the four quarters examined for the tax year.

1. On Form 5344, if case is closed agreed, enter on Line 12 Transaction Code "300" with "0" for the dollar amount.

2. "0" is entered because the additional tax is treated as a current period liability.

3. The Form 941 quarter to be established for the Unagreed Report is the quarter corresponding to the date of the Section 3121(q) Notice and Demand.

(14) On the Form 3198, Special Handling Notice for Examination Case Processing, under "Letter Instructions for CCP," the examiner will check the Other Instructions box and notate: "Please validate that the amount on Form 5344, Line 418, matches the amount on the enclosed Section 3121(q) Notice and Demand, Letter 3263." A copy of the Section 3121(q) Notice and Demand (Letter 3263 or Letter 3263-E ) will be sent to Centralized Case Processing (CCP) with all other closing documents.

(15) Each group must monitor the Form 941 for the quarter in which the Section 3121(q) Notice and Demand was dated (also known as the "reporting Form 941") and must maintain a spreadsheet containing details of monitoring activity and time spent monitoring the reporting Form 941. Make the information available to your manager as needed. Time spent monitoring the filing or assisting the taxpayer in the resolution of an incorrect or non-reporting of the IRC 3121(q) FICA tax liability is recorded under Activity Code 575-5XX, depending on the type of tipped industry being examined. For example, time spent monitoring a restaurant tip case would be recorded as 575-518. (For additional information on applicable time codes see IRM 4.9.1-1, Definitions of Miscellaneous Examination Activity Codes and IRM 4.9.1-2, Direct Examination/ Compliance SSCs).)

(16) After the reporting Form 941 has posted, generally within two to six weeks following the close of the quarter, the examiner must check IDRS/BRTVU to confirm that the employer properly reported the IRC 3121(q) FICA tax liability shown in the Section 3121(q) Notice and Demand.

1. For tax years after December 31, 2010, the IRC 3121(q) FICA tax liability is reported on the reporting Form 941, on the line titled "Section 3121(q) Notice and Demand—Tax due on unreported tips."

Note: For Section 3121(q) Notice and Demands issued during tax years 2009 and 2010, this amount was reported on line 7c - "Current quarter's adjustments for tips and group-term life insurance." For Section 3121(q) Notice and Demands issued during tax years 2005, 2006, 2007, and 2008, the amount was reported on line 7e -"Prior quarter's social security and Medicare taxes."

2. If IDRS research shows that the amount was accurately reported, no further action is needed.

3. If the tax was not reported, the examiner will first contact the taxpayer to determine if the non-reporting was simply an oversight. The examiner should instruct the employer to file a Form 941-X, Adjusted Employer's QUARTERLY Federal Tax Return or Claim for Refund, for the quarter of the reporting Form 941 and pay the tax with the form. If the examiner is unable to resolve the reason for the non-reporting then they will establish the reporting Form 941 on AIMS. A limited scope exam, using Project Code "1118", will be conducted to address the non-reporting of the IRC 3121(q) FICA tax liability. Follow normal employment tax unagreed procedures at IRM 4.23.10.16, Unagreed Employment Tax—Examination Reports.

(1) If unreported tip income is identified as a result of an employer tip examination, then the employee and employer are liable for FICA tax on the unreported tip income. The employee is also liable for income tax on the unreported tip income.

(2) Generally, examiners will collect employee information in the form of an "employee record layout spreadsheet". The spreadsheet includes pertinent information regarding the employer’s tipped employees such as the total tips per examination and the potential unreported tips for each tipped employee. Check with the designated NTRCP analyst to get an electronic copy of the latest version of the employee record layout spreadsheet. The examiner will forward this information and a copy of the McQuatters formula or other calculation showing how the tip rate was determined to the SBSE NTRCP analyst who will complete the exam referral.

(3) Indian Tribal Government (ITG) examiners are required to prepare an employee calculation spreadsheet for all tipped employees in each occupational category showing unreported tips. A copy of the spreadsheet should be sent to the ITG tip coordinator at the time the employer tip audit is closed.

(4) If the examiner initiates the employee examinations, the employee returns will be established on AIMS . Use Activity Codes 530 through 536. To ensure proper tracking of audit results, use the following project codes:

• 360: Gaming industry employees (all venues, including food and beverage),

• 364: Food and beverage industry employees, or

• 672: Barber and cosmetology industry employees.

(5) Generally, Employment Tax Specialists do not perform the tipped employee Form 1040 examinations. The employee's tax adjustments are made on forms prescribed for individual income tax examinations. Procedures for adjustments to an employee’s tax for tips not reported to the employer are discussed in IRM 4.23.10.18, Procedures for Employee Tax Adjustment on Tip Income Not Reported to Employer.

(6) Advance payments received for employment tax cases should be reported in accordance with the taxpayer's instructions. Absent instructions, the payments will be reported first as if they were for income tax and the balance will be reported as social security and Medicare taxes.

(7) If the case is unagreed, Letter 525, General 30-Day Letter, is issued for both the social security and Medicare taxes and income tax. Form 2504-S, Agreement to Assessment and Collection of Additional Tax and Acceptance of Overassessment (Employment Tax Adjustments Not Subject to IRC 7436; Worker Classification or Section 530 Issues Not Addressed in this Exam), is generated along with the 30-day letter showing the separate computation for the social security and Medicare taxes due. The taxpayer is notified in the report that the social security and Medicare taxes are not included in the deficiency notice and are stated separately on Form 2504-S. If the employee requests an Appeals conference, the employee’s case should be forwarded to Appeals using normal procedures.

(8) If the employee fails to respond to the 30-Day letter, the case should be closed for the issuance of a Statutory Notice of Deficiency on the income tax deficiency and related penalty only. Social security and Medicare taxes, unlike income tax, may be assessed without issuing a Statutory Notice of Deficiency. If a Statutory Notice of Deficiency is to be issued for income tax, the social security and Medicare taxes on the unreported tip income and the related penalty will not be included in the audit report. However, the notice to the taxpayer will include a statement concerning the related social security and Medicare taxes and penalty liability.

(9) Examiners must remember to properly code the tip audit adjustments on the Form 5344 or for TE/GE, the RCCMS Closing Record tabs. The IRS submits this information electronically to the Social Security Administration. The codes can be found in the AIMS Processing Handbook, IRM 4.4.12, Examined Closings, Surveyed Claims, and Partial Assessments, and IRM 4.5.1, TE/GE AIMS Processing. If these codes are not entered properly, the tipped employee's social security and Medicare wages will not show increase in wages due to the adjusted tip income and the employee will not receive social security credit.

(1) Form 1040 is a multi-purpose tax return reporting both income and FICA taxes (that is, social security tax, Medicare tax, and Additional Medicare Tax). If the employee:

• Did not report any FICA taxes on the return (that is, the employee did not attach Form 4137 and make an entry on Form 1040 to report FICA tax (Line 23 for 20220 Form 1040)), or

• Did not attach Form 8919, Uncollected Social Security and Medicare Tax on Wages, and make an entry on Form 1040 to report FICA tax (Line 23 for 2022 Form 1040), or

• Did not attach Form 8589, Additional Medicare Tax, and make an entry on Form 1040 to report FICA tax (Line 23 for 2022 Form 1040).

(2) The period of limitations does not begin to run and an assessment of FICA taxes may be made at any time. Therefore, social security tax, Medicare tax, and Additional Medicare Tax on unreported tips can be assessed even if the statute of limitations has expired for the assessment of income taxes. (See Rev. Rul. 79–39).

1. Form 872, Consent to Extend the Time to Assess Tax, or Form 872–A, Special Consent to Extend the Time to Assess Tax, is used to extend the statute for assessing FICA taxes on tips if those forms specify that they relate to those specific taxes. Thus, the kind of tax to specify on the consent is "Social Security and Medicare tax on tips." If Additional Medicare Tax applies, specify "Social Security tax, Medicare tax, and Additional Medicare Tax on tips" on the consent

2. If income tax and FICA taxes were reported on the same return, the statute for assessment of additional FICA taxes is the same as the statute for the income tax.

3. If FICA taxes were not reported on the return, there is no statute on the assessment of FICA taxes and an extension is not necessary in order to assess FICA taxes. See Rev. Rul. 79–39.

(3) Use Form 872 (or Form 872-A) to extend the statute for assessing both income tax and FICA taxes on the employee's unreported tip income if the tipped employee reported any FICA taxes on the employee's Form 1040 and the assessment statute of limitations must be extended. See IRM 25.6.22.6.10.2, FICA Tax on Tips Not Reported to Employer. For additional details on employee tip examinations and statute extensions, see IRM 4.19.15.26, Correspondence Exam Tip Program.

(1) There are specific tip compliance agreements for the food and beverage, cosmetology and barber, and gaming (casino) industries. There are also generic tip agreements that permit all other tipping industries to participate in the program. The TRDA and TRAC agreements are available to employers in all industries, including restaurants and bars, salons and barber shops, taxicab and limousine companies, airport skycap companies, car wash operations, and tour guide companies. The GITCA is available only to employers in the gaming industry. The EmTRAC is available only to food and beverage employers.

(2) Some employers will find one agreement more beneficial, some will prefer another agreement, and some will choose not to participate in the program at all. As this is a voluntary program, employers do not have to participate. Those who choose to participate may participate in only one agreement at a time.

(1) IRS employees will under no circumstances use or imply the threat of an audit when soliciting participants to sign up for any tip compliance agreement. Section 3414 of the IRS Restructuring and Reform Act of 1998 specifically prohibits the threat of an audit to coerce taxpayers into signing a TRAC agreement.

(2) The mission of the IRS is to provide taxpayers with top quality service by helping them understand and meet their tax responsibilities and to apply the tax law with integrity and fairness to all. The purpose of a tip compliance agreement is to educate employers in industries where tipping is customary on their tip income reporting responsibilities, and to promote tip reporting compliance among their tipped employees.

(3) There are pre-qualification procedures to follow before the agreement can be approved:

1. When assigned a tip agreement request, read the entire agreement and understand the commitments specified for the IRS and for the employer.

2. Contact the employer and review the "Employer Commitment" sections of the agreement. The employer needs to demonstrate that everything is in place to satisfy these commitments, before the IRS will approve the agreement.

3. Evaluate the employer’s level of compliance and ensure that all federal reporting, filing, and payment compliance are current.

4. If the employer is a large food or beverage establishment, request the most currently filed Form 8027, Employer’s Annual Information Return of Tip Income and Allocated Tips.

5. If the employer is not a food or beverage establishment, request the previous tax year’s report for charged sales and tips and cash sales and tips. Compare to tips reported by employees through the W-3 filing to determine substantial tip reporting compliance.

(4) After the analysis of the information, if the IRS representative determines that the request cannot be approved, contact the taxpayer to explain why. Follow up the telephone contact with Letter 4761, Agreement Request Denial. Letter 4761 explains to the taxpayer why the request to participate in a tip compliance agreement is not being approved. The letter will give the reason or reasons.

(5) With the consent of the IRS, any tip employer may participate in a tip agreement. Either the IRS or an employer may suggest the employer’s potential participation in the program. The IRS’s decision to refuse participation by any employer in this program is not subject to review.

(6) The person designated by the employer to sign a tip agreement must have the authority to legally bind the company. The person is also responsible to ensure all internally affected employees are notified of the agreement and the requirements.

(7) If a taxpayer expresses an interest to enter into a voluntary tip compliance agreement during the course of an ongoing examination, the examination must first be completed prior to discussing participation in the program. The taxpayer must understand that where the tax has been determined, a tip agreement will not eliminate any balance due. At the conclusion of the examination, examiners can begin the process of implementing the tip agreement. Note that time on the case for securing an agreement is documented separately.

(8) Once the audit has been finalized, the tip agreement request can be referred to NTRCP for review and consideration.

(9) Activity Codes:

1. Employment tax examiners should use activity code "551" and Project Code "0985" to report time spent soliciting tip agreements with Source Code "99" and MFT "C0" (C zero).

2. The Tracking Code will depend on the market segment. Contact an NTRCP analyst for the list of Tracking Codes.

3. For tip agreement addendums, use Activity Code "551" and Project Code "0986".

4. For time spent performing compliance reviews on agreement participants, use Activity Code "551" and Project Code "1104".

5. Compliance reviews are discussed later.

(10) The authority to approve a Tip Reporting Alternative Commitment (TRAC) agreement or a Tip Rate Determination Agreement (TRDA) is found in SB/SE Delegation Order No. 1-23-20. The Authority to approve a Gaming Industry Tip Compliance Agreement (GITCA) is found in Order No. 4-34 (rev. 1).

(11) For tribal agreements, ITG group managers are authorized to sign the tip agreements under Delegation Order 4-34 (rev. 1).

(1) A TRDA requires the employer to work with the IRS to arrive at a tip rate for the various worker occupations in the establishment.

(2) At least 75 percent of tipped employees must agree to participate by signing a Tipped Employee Participation Agreement (TEPA) with the employer.

(3) Participating employees comply by reporting tips at or above the rate determined in the agreement for their job category. However, if the employee keeps an actual log of tips, the employee is then only required to report the actual tips received.

(4) If employees fail to report tips at or above the determined rate, the IRS may audit those employees’ tax returns.

(5) The TRDA does not have any specific education requirement, but the IRS provides assistance to help employees understand their tax responsibilities and emphasizes benefits for complying.

(6) TRDA is available for all industries where tipping is customary.

(1) Under the Tip Reporting Alternative Commitment (TRAC) agreement, the employer agrees to institute and maintain an employee educational training program with respect to their tip reporting obligations. Unlike a TRDA, a TRAC agreement does not require that the employer work with the IRS to arrive at a tip rate for any of the worker occupations in the establishment. However, during the meeting with the employer to discuss the agreement, the IRS representative responsible for executing the agreement, should jointly review the employer’s books and records to identify the average tip rates for cash and charged tips being received by the tipped employees. This includes a discussion with the directly tipped employees to arrive at tip out percentages (tips shared with other workers) and stiffs (term used when a customer does not leave a tip). This will show the employer and the employees if the employees are reporting their tips accurately. Inform the employer and employees that the IRS will monitor tip reporting on the Form 941, Employer's Quarterly Federal Tax Return and on Form 8027 if pertaining to a food or beverage business. A TRAC requires employers to:

• Establish a reasonable procedure for accurate tip reporting by all tipped employees,

• Institute a training program to educate employees of their tax reporting obligations as they relate to tips, and

• Comply with all federal tax requirements regarding the filing of returns, paying and making tax deposits, and maintaining required records.

(2) TRAC's were originally offered to the food and beverage industry but have now been extended to all industries where tipping is customary. A specific TRAC agreement is available for the cosmetology and barbering industry containing characteristics unique to this industry.

(3) A TRAC affects all employees. As long as both the employer and employees are complying with the requirements under the agreement and all tips are being reported accurately, no tip audits will be initiated on either the employer or the employees. The IRS will only terminate a TRAC agreement if the employer fails to meet the terms of its commitment.

(4) To qualify for a TRAC agreement, the business must have charge receipts that show a charged tip. That is, a reasonable amount of the business’s gross receipts must be from charged receipts that included a charged tip. There is no set percentage - as long as the amount of charged receipts with a charged tip is sufficient to determine the average charged tip rate.

(5) If the reporting of tip wages by tipped employees has not improved after six months from securing the TRAC agreement, the employer will be notified. Specific taxpayer correspondence will notify the employer of any shortfalls in satisfying the agreement commitments and remind the employer about tip reporting obligations and the consequences for failing to comply with the law.

(6) If the underreporting occurs because of the employer’s system, the employer will be offered suggestions for improvements or changes needed to be made to the procedures. If, after a reasonable period the employer has not corrected the procedures, the employer may be referred for a tip examination and/or the agreement may be terminated. Implementation of these follow-up procedures allows the establishments to gauge how well their education requirement is being fulfilled and whether the employees are complying with their tip reporting requirements.

(1) The Employer-designed TRAC (EmTRAC) program retains many of the provisions available under the TRAC agreement. The employer must establish an educational program that trains employees that the law requires them to report all their cash and charged tips to their employer. Education must be furnished for newly hired employees and quarterly for existing employees. The EmTRAC program provides an employer with considerable latitude in designing its educational program and tip reporting procedures, which the employer may combine.

(2) The EmTRAC program is available only to employers in the food and beverage industry.

(3) Procedural and other information regarding the EmTRAC program can be found in Notice 2001-1.

(4) Rules for terminating or revoking an EmTRAC are the same as for a TRAC agreement.

(1) The Gaming Industry Tip Compliance Agreement (GITCA) Program was designed to promote compliance by gaming industry employers and employees with the provisions of the Internal Revenue Code relating to tip income and to reduce disputes under Section 3121(q). The Gaming Industry Tip Compliance Agreement Program was established in May of 2003 by Rev. Proc. 2003-35, 2003-20 I.R.B. 919. The model GITCA used by the IRS and gaming industry employers was updated in 2007 and is now administered under Rev. Proc. 2007-32, 2007-22 I.R.B 1322, and Rev. Proc. 2020-47, 2020-48 I.R.B. 1121. The new model GITCA agreement was revised to enhance administration of the GITCA program by both the employer and the IRS and to facilitate and promote the use of current financial information technology in the tip reporting process. Please see Rev. Proc. 2020-47 for an update to potentially lengthen the term of the initial rate review agreement to up to five years.

(2) The Gaming Industry Tip Compliance Agreement offers the following:

1. A two-tiered participation requirement,

2. Safe harbor from tip-related examinations for participating tipped employees and employer,

3. Electronic filing of Form 8027 or substitute form used to provide the Form 8027 required data,

4. No allocated tip requirement for participating employees,

5. Flexibility due to economic considerations, and

6. A self-certification option which reduces the burden of reporting individual payroll and tip information.

(3) The gaming industry offers many unique occupations and terminology. For more information on gaming occupations, see the following Bureau of Labor Statistics website: Bureau of Labor Statistics

1. Select "Occupational Outlook Handbook" (under Publications)

2. Select "A-Z Index"

3. Select (G) "Gaming Services Occupations"

(1) This subsection of the IRM provides procedures to perform a tip agreement Compliance Review.

(2) Examiners may be assigned cases to conduct a compliance review to determine if the employer is meeting the terms of the tip agreement and, for GITCA/TRDAs, applying the correct tip rates or, for TRACs, capturing and reporting all tips received.

(3) Examiners will provide recommendations based on the results of the compliance review. The recommendations will either be:

• No Change of the tip agreement,

• Change the tip agreement, or

• Revocation of the tip agreement.

(1) All compliance reviews must be established on ERCS and set up in the IMS. Form 5345-NTRC, NTRC Request for ERCS Examination Non-AIMS DET Item, must be completed for a case to be input on ERCS. Use the following codes to document time spent on these compliance reviews:

• MFT "C0"(C zero)

• Source Code "99"

• Project Code "1104"

• Activity Code "551"

(2) All compliance review case files will be set up in IMS and workpapers uploaded to IMS per IRM 4.23.4.5, Guide for Examiners Using Issue Management System (IMS). For the list of mandatory items to be uploaded into IMS see IRM 4.23.4-4, Mandatory Items and Standard Naming Convention Location for ET Tip Agreement Program.

(1) If potential non-compliance is identified and the examiner is assigned a compliance review, the case will include:

• Form 8027, Employer’s Annual Information Return of Tips and Allocated Tips, for the current and two prior years,

• Annual and Quarterly Employee Reports, and

• Time and Attendance Reports.

(2) In addition to the electronic case file, the examiner must also refer to Form 14515, Compliance Review Routing Checksheet and the Tip ETLS Compliance Review Lead Sheet (Series 510).

(1) The compliance review will be assigned to an examiner to conduct the review which consists of the following phases:

• Pre-Contact Analysis,

• Taxpayer Contact,

• Compliance Review, and

• Case Summary and Disposition.

(1) The examiner needs to address the taxpayer (tipped employee) issue and update the comments section for that taxpayer.

(2) If the examiner receives a Form 1040-X, Amended U.S. Individual Income Tax Return, the examiner will review and ensure that the amended tax return is correct.

1. If the amended return is not correct, the examiner will provide the taxpayer with an opportunity to revise. The examiner will copy the Form 1040-X for the case file, mail the form back to the taxpayer with Letter 5237, Tipped Employee Soft Notice Final Letter, and advise the taxpayer that the Form 1040-X is incomplete along with actions needed to correct the form. The taxpayer sends the corrected Form 1040-X back to the examiner.

2. If the Form 1040-X is correct, the examiner will make a copy of the tax return for their case and mail the Form 1040-X with Form 3210, Document Transmittal, to the Fresno Service Center. If the taxpayer sent a payment, the examiner will prepare Form 3244, Payment Processing, and submit with the payment to the IRS teller as soon as possible. Copies of Forms 3210 and 3244 along with the check must be added to the case file. The examiner will close their case file, update the spreadsheet with the Form 1040-X information, and date the case was closed.

(3) If the taxpayer calls the examiner in response to Letter 4884 the examiner will answer any questions and provide details on information needed. The examiner will update their inventory list with the necessary information including a summary of the discussion. The examiner will mail Letter 5237 by adding information or documentation needed in the "Other" section of the letter.

(4) If the taxpayer sends correspondence, the examiner will determine what course of action needs to be taken. The examiner will update their inventory list with any comments and send Letter 5237 and add information needed in the "Other" section of the letter.

(5) Examiner questions for unresolved case issues should be submitted first to the lead or group manager. If the lead or group manager cannot answer the questions, the information will be forwarded to the NTRCP analyst for resolution.

(6) If the taxpayer mails an original tip diary to the IRS, the employee must make a copy of the tip diary for the case file. The employee will add the total tips from the tip diary and compare that amount to the amount reported by the taxpayer to determine if there are any discrepancies. The examiner will ensure that the tip diary is complete and appears to have been kept on a contemporaneous basis.

(7) If the tip diary is not complete or does not appear to be accurate, the examiner will send the original tip diary back to the taxpayer with Letter 5237 explaining the reasons the IRS is not accepting the tip diary and provide detailed information needed to assist the taxpayer. This letter must be sent by certified mail as these are original documents being returned to the taxpayer.

(8) If the review of the tip diary shows that the information appears to be correct, the examiner will mail the original tip diary back to the taxpayer with Letter 6561, Tipped Employee – Soft Notice Accepted Documents. This letter must be sent certified to the taxpayer.

(9) When the taxpayer does not respond to Letter 4884, the examiner will use a Word document of Letter 5244, Soft Notice Follow-Up, to generate the letters for mailing. The examiner will use the mail merge process to mail second letters with the enclosures Form 14352, Notice 609, and a return envelope. IRS generally allows 75 days after the date on Letter 4884 to provide a reasonable opportunity for the taxpayer to respond. The examiner will update their inventory spreadsheet for all actions taken.

(10) If the taxpayer responds to Letter 5244, the examiner will follow the same steps in IRM 4.23.7.12 (10) and IRM 4.23.7.12.1 (1) thru 4.23.7.12.1 (8).

(11) If the taxpayer does not respond to Letter 5244, the examiner will use a Word document to prepare Letter 5237 through the mail merge process to issue the final letters with no enclosures to the taxpayers. Letter 5237 requests the taxpayer to respond within 15 days. IRS generally allows 45 days after the date on Letter 5244 to provide a reasonable opportunity for the taxpayer to respond. If the taxpayer does not respond, the employee will update their inventory list and close their case to the group manager.

(12) If the taxpayer responds to Letter 5237 timely or prior to closing the case to the group manager, the examiner will follow the same steps in IRM 4.23.7.12.1 (10) and (11). The examiner will allow the taxpayer to respond to a letter if additional information is needed. The examiner will keep the case open until the issue is resolved as long as the taxpayer remains actively engaged.

(13) If the taxpayer responds to Letter 5237 after the case is closed, the examiner will document Form 9984 and the inventory spreadsheet with details about what was received and what actions were taken. The examiner will add any documentation to the case file. The case file should remain closed as the taxpayer was mailed three letters requesting information which was not received until after the case was closed. The examiner will send a letter advising the taxpayer what is needed to resolve the issue.

(14) The examiner will ensure that all case files contain copies of each letter mailed to the taxpayer along with a copy of Form 14352, correspondence sent by the taxpayer, Form 9984 that has been updated with all actions taken by the examiner, and any other necessary documentation received or associated with the case file. The case file will be closed to the group manager.

(1) IRM 8.13.1.3.4, Guidelines for Preparing Closing Agreements, provides specific guidelines for preparing a Form 906 including identification of parties, arrangement of content, and the effective date. IRM 8.13.1.3.5, Execution By Taxpayer, provides the specific guidelines for the signature page.

(2) The corrected tax liability calculation must be approved by the examiner’s manager and a NTRCP analyst.

(3) Form 4222, Closing Agreement Checklist, must accompany any closing agreement to Tech Services.

(4) Documented approval from Counsel of the Closing Agreement wording must be provided to Tech Services with the agreement and checklist.

(5) The examiner that executes the Closing Agreement is the "Receiving Official."

(6) The guidance on electronic digital signatures applies to the Form 906.

(7) The Tech Services office for Employment Tax Closing Agreement is Cincinnati. Contact the NTRCP analyst for the most current contact information.

(1) Examiners will follow IRM 4.23.25.10, Procedures for Processing Payments for Barred Years.

(2) Inform CCP of any closing agreements related to tipping agreements as this unique situation is not on AIMS, has an MFT "C0", and the payment is not an assessment.

(3) Depending on the amount of check, the payment is processed using the Form 3244-A, Payment Posting Voucher - Examination, for each tax period (per the instructions in IRM 4.20.1.3.1.2, Complete Form 3244-A, Payment Posting Voucher, the amounts are posted to the last quarter of each tax year affected). Enter the dollar amount for each tax period next to TC 670, subsequent payment (with a 99 DPC).

(4) A Form 3210, Document Transmittal, is sent with the check and payment posting voucher(s).

(5) Payment Mailing Address are the following.

• Remittances less than $100,000 are sent to:
  Internal Revenue Service
  Mail Stop 1999
  1973 North Rulon White Blvd.
  Ogden, UT 84201

  Note: Inside envelope label address will include "Attn: Receipt & Control Operations Manager"

• Single remittances of $100,000 or greater are sent to:
  Internal Revenue Service
  Mail Stop 2003
  1973 North Rulon White Blvd.
  Ogden, UT 84201

  Note: Inside envelope label address will include "Attn: Receipt & Control Operations Manager".

  Note: When a remittance of $100,000 or greater is sent an email notification is sent to &CTR ODN Ogden Tellers.

(6) Copies of the check, Form 3210, and Form 3244-A will be sent to Tech Services along with the signed copy of the closing agreement and Form 4222, Closing Agreement Checklist.

(1) If the taxpayer concurs with the terms of the Form 906 closing agreement, the examiner will notify CCP to adjust the taxpayer’s account.

1. The examiner will follow IRM 4.23.25.10, Processing Payments for Barred Years.

2. Email is sent to CCP program analyst notifying them that the unique submission has been requested.

3. The examiner will monitor the posting of the TC 670 and TC 570 transaction codes indicating that the money is a subsequent payment for the Taxpayer and that the money is to be frozen on the module and not refunded.

4. Once the payment has posted, the examiner will notify CCP by preparing a Form 3870, Request for Adjustment, to adjust the employer’s account. The examiner will include the following instructions on the Form 3870: "The payment was agreed to as part of a form 906 closing agreement. The TC 670 posted on (date) in the amount of ($XX.XX) should be moved to excess collection."

5. Once the Form 3870 has been sent, the examiner will email CCP program analyst notifying them that the unique submission has been requested.

6. A Form 3870 must be completed for the last quarter of the tax year affected.

(2) If the employer is unwilling to remedy the underpayment, revocation of the agreement must be considered and discussed with management.

(1) It is important to note that the information being reviewed is to be evaluated only in terms of granting a rate reduction below 8 percent and the burden of demonstrating the need for such a reduction is on the petitioner/taxpayer. This is strictly a discretionary area and mechanical formulas using point systems should not be used as the only criteria in making these determinations. Employment Tax personnel reviewing rate reduction petitions should not hesitate to request further information from the petitioner/taxpayer, if needed. If the examiner is unfamiliar with the area or wants to observe the petitioner/taxpayer's operation, a visit to the establishment should be considered.

(2) If an examiner determines that a rate less than 8 percent is applicable, a determination letter must be sent to the taxpayer. Letters to be used for notifying the taxpayer are:

• Letter 8027-A, Determination Letter for Approved Tip Allocation Rate Reduction - less than 10 Employees

• Letter 8027-B, Determination Letter Approving Specified Lower Rate

• Letter 8027-C, Determination Letter when Business Meets Cafeteria Style Establishment

• Letter 8027-D, Tip Rate Reduction Request Denied

(3) Employers requesting tip rate reductions are required to submit certain information, as described in Rev. Proc. 86–21, if applicable, with their tip rate reduction request to the address given in the Instructions for Form 8027. Studies indicate that a tipping rate of 8 percent is low for most types of restaurants and bars, and the need for any reduction below 8 percent allocation rate must be fully supported by the information submitted.

(4) The following are guidelines reviewers may use in evaluating tip rate reduction petitions (the sections refer to Rev. Proc. 86–21 sections).

1. Sections 3.01(a) through 3.01(c)(5), section 3.01(c)(7), and section 3.01(d) of Rev. Proc. 86-21 request a basic description of the establishment and its operations. This description gives information on items that can affect the tipping rate. In establishments where less than full table service is provided, such as self-service or cafeteria type of establishments, the tipping rate may be very low. Another major consideration is the establishment's location and type of clientele. Establishments near college campuses, for instance, may have mostly student customers who may tip at a lower rate. Other factors that may affect the tipping rate include rural versus urban location, full menu versus specialty (such as pizza parlors), and open for lunch only versus open for all meals.

2. Section 3.01(c)(6) requests financial information about the establishment that may be useful for determining the actual tip rate. For instance, the total sales subject to tipping can be computed by taking the gross sales and deducting carry-out sales and sales with a service charge. Dividing the total sales subject to tipping into the total tips reported to the employer by the employees will provide the tip rate reported by the employees. The total charge tips divided by the total charge receipts with charge tips may give a more reasonable estimate of the establishment's tip rate.

(5) The Instructions for Form 8027, Employer's Annual Information Return of Tip Income and Allocated Tips, give specific details on the information the taxpayer must submit with the written petition for the tip rate reduction. If the taxpayer has not submitted this information, contact the taxpayer and reference the Instructions for Form 8027 for the information that must be submitted.

(6) The NTRCP Program Manager will assign the case to an NTRCP field group. The case will include a routing checksheet for processing the request.

(7) Time for processing a tip rate reduction petition is applied to Activity Code "551" and Tracking Code "6451". The routing checksheet provides additional details.