Tip-box cash required FICA notice and demand procedures

Plain-English summary

A taxpayer treated service providers as volunteers even though customers left cash for them in tip boxes. After determining that the workers were employees, the IRS considered how to assess the employer's FICA tax on the unreported cash. Chief Counsel concluded that the payments were tips because customers were free to decide whether to pay, how much to pay, and generally who would receive the pooled amounts. Because the workers had not reported the tips to the taxpayer, the employer's FICA liability arose only when the IRS issued a notice and demand under Section 3121(q). The tip tax therefore should not be placed in the employment-tax table of the Section 7436 worker-classification letter, leaving only the classification issue within the Tax Court proceeding described in the advice.

Ruling snapshot

• Question: Were pooled customer payments tips, and should the related employer FICA tax be included in the Section 7436 worker-classification notice?
• Outcome: Advice given that the payments were tips subject to Section 3121(q) notice and demand, not tax reportable in Table 3 of Letter 3523 at issuance.
• Key authorities: IRC §§ 3121(a), 3121(q), 6053(a), and 7436; Rev. Rul. 2012-18.

Full text (IRS public release)

Office of Chief Counsel
Internal Revenue Service
memorandum
Number: 201816010
Release Date: 4/20/2018
CC:TEGE:EOEG:ET1:Conway- Third Party Communication: None
Hataloski Date of Communication: Not Applicable
POSTN-129181-17

UILC: 3121.01-05, 7436.00-00, 7436.01-00, 7436.01-03, 7436.02-01

date: December 04, 2017

to: Division Counsel/Associate Chief Counsel
(Tax Exempt & Government Entities)
Attn: Linda Azmon

from: Paul J. Carlino
Branch Chief
CC:TEGE:EOEG:ET1
(TEGE Associate Chief Counsel)

subject: Advice on Unreported Tip Income and IRC Sections 7436 and 3121(q)

This Chief Counsel Advice responds to your request for assistance. This advice may
not be used or cited as precedent.

ISSUES

1. Whether cash amounts distributed to individuals from “tip boxes” are properly
   classified as tips under the Internal Revenue Code (Code) and subject to Federal
   Insurance Contributions Act (FICA) tax.

2. Whether cash amounts distributed to individuals from “tip boxes” are subject to
   notice and demand procedures under section 3121(q)1 or whether taxes on cash
   amounts should be included in Table 3 of Letter 3523, Notice of Employment Tax
   Determination under IRC § 7436.2

1
All section references in this memo are to the Internal Revenue Code of 1986 unless otherwise noted.
2
Letter 3523, formerly titled “Notice of Determination of Worker Classification” has been renamed “Notice
of Employment Tax Determination under IRC § 7436”. For purposes of this memo, we refer to the notice
required to be issued to a taxpayer pursuant to section 7436 as “Letter 3523.”

POSTN-129181-17 2

CONCLUSIONS

1. The cash amounts distributed to individuals from “tip boxes” are properly classified
   as tips pursuant to rules stated in Rev. Rul. 2012-183 and are wages subject to FICA
   tax.

2. The cash amounts distributed to individuals from “tip boxes” are tips and thus subject
   to notice and demand procedures under section 3121(q).

FACTS

Taxpayer engages individuals to perform services at the Taxpayer’s request and on the
Taxpayer’s premises. Taxpayer treats the individuals as volunteers and does not
directly pay the individuals any form of compensation or benefits for their services.
Taxpayer acknowledges, however, that the individuals receive cash payments from
amounts contributed by customers. The cash amounts are deposited by customers in
“tip boxes” placed by Taxpayer in the vicinity of where the individuals perform services.

Taxpayer places the “tip boxes” to encourage customers to contribute cash amounts to
the individuals. Taxpayer does not require customers to make cash contributions and
customers have discretion on how much cash to contribute (including zero contribution).

The amount of cash in the “tip boxes” is distributed at the end of each shift. Individuals
who performed services during a shift determine how to allocate the tip box amount
between all of the individuals who performed services during that shift. Although
Taxpayer is aware that customers place cash in the “tip boxes” and that the individuals
working each shift distribute the cash among themselves, Taxpayer does not have a
system in place for individuals to provide written statements reporting the cash amounts
received to Taxpayer, and there is no evidence that Taxpayer has knowledge of the
specific amount of cash received by each individual. Taxpayer does not issue Forms
W-2, Wage and Tax Statement, to the individuals and has not included any wages or
taxes in connection with their services on Form 941, Employer's QUARTERLY Federal
Tax Return.

During the course of an audit, the Service determines that Taxpayer has the right to
direct and control the individuals as they perform services and that the individuals
should be classified as employees of Taxpayer for purposes of FICA taxes. In addition
to its worker classification determination, the Service proposes a FICA tax liability
related solely to the unreported cash amount received by the individuals.4 The Service
issues Letter 3523 to Taxpayer at the conclusion of the audit, notifying Taxpayer of its
worker classification determination.

3
2012-26 I.R.B. 1032.
4
For purposes of simplicity, this memo does not address any determination made by the Service with
regard to Section 530 of the Revenue Act of 1978 or any potential Federal Unemployment Tax Act
(FUTA) or income tax withholding liability.

POSTN-129181-17 3

Your inquiry relates to whether the cash amounts are “tips” subject to notice and
demand procedures under section 3121(q) or whether tax on the tip box amounts
should be included in Table 3 of Letter 3523, which lists the proper amount of
employment tax, additions to tax, and penalties with respect to payments made to
individuals who are being reclassified as employees.

LAW AND ANALYSIS

Sections 3101 and 3111 impose FICA taxes on employees and employers, respectively.
FICA taxes are imposed on “wages” as that term is defined in section 3121(a). Section
3121(a) defines wages as all remuneration for employment with certain specific
exceptions. Section 3121(a)(12)(A) excludes “tips” from the definition of wages if paid
in any medium other than cash. Section 3121(a)(12)(B) excludes cash tips received by
an employee in any calendar month in the course of the employee’s employment by an
employer, unless the amount of the cash tips is $20 or more.

Section 3102(a) requires employers to deduct from wages and pay over the employee
portion of the FICA tax. However, section 3102(c)(1) provides a special rule applicable
to tips. It states, in relevant part, the employer’s obligation to deduct employee FICA tax
from tips which constitute wages is applicable only to such tips as are included in a
written statement furnished by the employee to the employer pursuant to section
6053(a), and only to the extent that collection can be made by the employer by
deducting the amount of the tax from wages of the employee (excluding tips) as are
under control of the employer, or from other funds made available by the employee for
this purpose.

Under section 3121(q), tips received by an employee in the course of the employee’s
employment are considered remuneration for that employment (and are deemed to
have been paid by the employer for purposes of the employer portion of the FICA taxes
imposed by sections 3111(a) and (b)). For purposes of determining the timing of the
employer’s FICA tax liability, the remuneration is deemed to be paid when a written
statement including the tips is furnished to the employer by the employee pursuant to
section 6053(a). However, if the employee did not furnish the statement, or if the
statement furnished was inaccurate or incomplete, the remuneration is deemed to be
paid on the date on which the Service issues a notice and demand under section
3121(q) for the taxes to the employer.

The characterization of a payment as a “tip” by the employer is not determinative for
purposes of determining when the employer portion of FICA arises. Section
31.3121(a)-(1)(c) of the Employment Tax Regulations provides that the name by which
the remuneration for services is designated is immaterial. Thus, designating a payment
as a tip is irrelevant if the amount is paid as compensation by an employer for services

POSTN-129181-17 4

performed by its employee. For example, Rev. Rul. 59-2525 holds that the payment by
a customer of a fixed charge imposed by a banquet hall that is then distributed by the
banquet hall to the employees who render services (e.g., waiter, busser, and bartender)
is a service charge and not a tip. To the extent any portion of a service charge paid by
a customer is distributed to an employee, it is wages for FICA tax purposes at the time it
is distributed.

Tips are not defined in the Code or regulations; however, published guidance addresses
how to determine whether a payment is a tip. Rev. Rul. 2012-18 reaffirms the factors
first stated in Rev. Rul. 59-252 which are used to determine whether payments
constitute tips. 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:

      1) 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.

Under the facts presented, the four factors set forth in Rev. Rul. 2012-18 have been
satisfied. The fact that the cash contributions are collected by the individuals who work
during the shift and pooled for purposes of distribution among them satisfies the fourth
factor. The customers generally have the right to determine who receives the payment
when the tipped amounts are pooled and the individuals working each shift distribute
the cash among themselves.

Once the amounts have been properly identified and characterized as tips, the timing of
the FICA rules for employer tax liability purposes can be applied. Because the tips have
not been reported to the taxpayer pursuant to section 6053(a), they are deemed to be
paid on the date on which the Service issues a notice and demand under section
3121(q) for the taxes to the taxpayer. Thus, the tips are not subject to the employer
share of FICA tax until the Service issues a notice and demand under section 3121(q).

The Service should issue Letter 3523 to Taxpayer based on the worker classification
determination, and should identify in Table 1 the individuals the Service determined
should be reclassified as employees. However, tax on the cash amounts received by
the individuals should not be included in Table 3 of Letter 3523 because the tips are
deemed paid only after the Service issues a notice and demand under section 3121(q).
Thus, the only issue that would be subject to Tax Court jurisdiction would be the proper
worker classification of the individuals listed in Table 1.

If an amount properly characterized by an employer as a tip was reported by the
employee to the employer in accordance with section 6053(a), it would be deemed to be

5
1959-2 C.B. 215.

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paid at the time the written statement was made and tax on the amount should be
included in Table 3 at the time Letter 3523 was issued. Similarly, if an amount
characterized by an employer as a tip was determined not to be a tip (for example, it
was a service charge) tax on the amount should be included in Table 3 at the time
Letter 3523 was issued.

CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS

This writing may contain privileged information. Any unauthorized disclosure of this
writing may undermine our ability to protect the privileged information. If disclosure is
determined to be necessary, please contact this office for our views.

Please call (202) 317-6798 if you have any further questions.