Why Is The IRS Looking At Restaurant Tips (Again)?

I recently visited one of our clients. He owns a restaurant/bar. That is a tough business under the best of circumstances.  It is a business where almost all your profit comes from paying attention to the nickels and dimes.

Is there anything new out there, he asked?

We talked about the IRS’ recent interest in employee tips and gratuities. What is the difference?

• A tip is an amount determined by the patron

• A service charge is an amount agreed upon by the restaurant and patron

The IRS has long defined a tip as:

1. Paid free from compulsion
2. Determinable by the customer
3. Not dictated by the restaurant/employer
4. The recipient of which is identified by the customer

You may know that restaurant employees are paid a lower minimum wage, as a substantial part of their income is expected to come from tips. The employees are supposed to report their tips to the restaurant, which in turn withholds the employee’s share of the taxes. The restaurant also pays employer FICA on the base wages and tips.

The IRS has long believed that there exists substantial noncompliance with tip reporting by restaurant employees, and it has rolled out a number of “programs” over the years with the intent of increasing compliance. I have been through several of these, and my conclusion is that the IRS just wants money, even if it takes a work of fiction to get there. For example, if the IRS feels that the cash tip rate is too low, they will simply propose a higher rate, and call upon the restaurant (which then means me) to prove otherwise. Failure to do so means the restaurant is writing a tidy check for those actual taxes on proposed tips.

It is unfortunately too common that a server will be under-tipped if he/she is serving a large party. As a defense mechanism, many restaurants have imposed a service charge policy (also known as an auto gratuity or “auto-grat”) on that table or tables. The policy has worked fine for years.

But not for the IRS. They have recently clarified that they don’t believe auto-grats count as a tips, as the customer does not have the option of changing the amount or directing who is to receive it. I have to admit, the IRS has a point. However, are they making things worse by pressing the point? Let’s go through a few issues:

• The auto-grat will be on the server’s paycheck, rather than cashed out at the end of the shift. This is not a big deal in the scheme of things – except perhaps to the server.

• Restaurants are allowed to claim a tax credit for employer FICA paid on tips in excess of the amount necessary to get a server to minimum wage.

a.     Reduce the amount considered to be tips and you reduce the credit available to the restaurant.

b.     Meaning more tax to the restaurant.

• An auto-grat is considered revenue to the restaurant. Tips are not. States with a gross revenue tax – such as Ohio with its CAT – will now tax those auto-grats.

a.     Meaning more tax to the restaurant.

• Following on the same vein as (3), the customer will pay more sales tax, as the auto-grat is included in sales.

a.     Meaning more tax to the customer.

• How does one (I don’t know: say my accounting firm) figure out what rate of pay to use if the employee works overtime?

a.     Remember, service charges are resetting the base rate of pay.

b.     What if they server works tips and auto-grat tables over the course of one shift? Do they have one rate of pay or two? How would you even calculate this?

• Let’s throw a little SALT (State And Local Tax) into the mix: some states do not follow the federal definitions. For example, New York will consider auto-grats to be considered tips if they are separately stated on the receipt or invoice. New Jersey and Connecticut follow this line also.

a.     The good thing is that auto-grats will not be subject to New York sales tax.

b.     The bad thing is the accounting required to figure this out.

How long do you think it will be before the attorneys eviscerate some restaurant chain for violations of FLSA and overtime regulations? Remember, a service charge can change a server’s base pay, something a tip cannot do. On the other hand, the odds of overtime under the current economy are pretty low.

What about discrimination? How long before someone sues for being scheduled insufficient/excessive service -charge/non-service-charge shifts?

You know what I would do? I would do away with service charges altogether. I am not bringing that tiger to the party. Tips only at my restaurant.

Is it good for the servers? Since when does any of this care whether it is good for the employee?

It is about one thing: more money to the IRS. There may have been a time when I would have been sympathetic to the government’s position, but in this day of credit and debit cards, I am cynical about how much “unreported” income there is left to squeeze out of this turnip. I am also concerned that some restaurants may impose a service charge and then keep a portion of it for themselves rather than pass it along in full to the servers and others.  I am unhumored by the IRS, but I would be beyond unhumored by a restaurant that did that to its employees. 

Tarpoff, Payroll Taxes and Responsible Person Penalties

John Tarpoff was the head cattle buyer at Gateway Beef, LLC (Gateway). Gateway was formed in 2003 by Gateway Beef Cooperative and Brach’s Glatt Meat Markets (Glatt). Glatt was owned by Sam Brach (Brach).  The co-op sold cattle to Gateway, which then produced kosher beef for Glatt.

In addition to buying cattle, Tarpoff did the following:

·         Filed Gateway’s articles of incorporation, signing as “organizer’

·         Was a signatory on two Gateway checking accounts

o   When opening the accounts, he presented company resolutions which he signed above lines that said “secretary” or “member.”

·         With the resolutions he could open accounts and withdraw funds

Brach was the wallet and financed Gateway. The bookkeeper, Marsha Caughron (Marsha), handled accounts receivable and payable, payroll, and some sales. She received all the mail, including bills and any notices from the IRS. She would print checks, attach the bills and initially send them to Brach. He would sign some, sometimes not all, and send them back. Brach was pretty strict that nothing could be paid without his permission.

Procedures changed and Tarpoff started signing all Gateway checks from January to May 2004 and most checks after that through July 2004. Once again, he signed nothing without Brach’s permission. Some of the checks he signed were for delinquent 2003 taxes, although he could not easily recognize them as such. He would review invoices to be sure they matched the check, but that was pretty much all. He did not even know whether Gateway had sufficient funds to cash the checks. Remember: he was the head cattle buyer, not the accountant.

Tarpoff explained to the Court:

            Whatever checks were given to me, I would look at them, glance at them and sign them.”

He could not recall ever refusing to write or sign a check.  

Gateway was a shooting star, living a short life and burning through a lot of money. At some point, Brach stopped paying the payroll taxes. The bookkeeper, Marsha, would calculate the taxes, attach checks and send them to Brach. Brach would not sign or return the checks. When she pressed, he told her to speak with his accountant, Michelle Weiss. Brach also instructed Marsha to fax all IRS notices to Michelle. Tarpoff was unaware of these faxes.

Tarpoff wrote at least 10 checks that bounced. One (for approximately $49,000) must have been pretty important, as he tried to get it paid. Meeting with resistance, he paid it out of personal funds. He said this was the only bad check he was aware of. He was never repaid his $49,000 and ultimately had to refinance his home because of it.

Gateway finally folded in July 2004. Tarpoff left. After learning that some vendors had not been paid, he suspected shenanigans with the payroll taxes. He was informed that Brach had not paid the taxes and the bookkeeper (Marsha) told him she had been receiving IRS notices. That was the first he learned of the matter.

The IRS came in. They wanted the payroll taxes. They also wanted almost $67,000 in penalties from Tarpoff for quarters March and June, 2004.

The IRS said that Tarpoff was responsible because:

·         He held himself out as secretary or manager.

·         He attended board of directors meetings.

·         He was the organizer of Gateway Beef, LLC.

·         He could open accounts and withdraw funds.

·         He signed over 1,800 checks.

·         He could hire and fire employees.

·         He could refuse to sign checks.

·         He invested approximately $50,000.

·         He knew the government had not been paid.

·         Even if he did not know the government had not been paid, he could have deduced it. He had paid payroll taxes in the past (at another company), and he signed enough checks to realize that all taxes had not been remitted.

·         The company was losing money; he was in a position to know and review the books and records to be sure taxes were being paid.

·         He used monies to pay creditors ahead of the government

                       

The Court held the following:

·         Other than puffery, the only evidence of officer status was preprinted checks. He did not write any business title himself.

·         He never attended a board of directors meeting.

·         He only looked at the checks and invoices to see that they matched. He could not pay anything without Brach’s permission.

·         He could interview prospective employees and he handled relations with the union, but he could not hire or fire without Brach’s permission.

·         Perhaps he could have refused to write checks, but Brach would have signed instead. Brach had previously signed checks.

·         He did not “invest” $50,000. To the contrary, he had so little control he could not get his own money back.

·         He did not know about the payroll issues and did not receive IRS notices. They went instead to the bookkeeper and then to Brach’s accountant.

·         Saying that he knew in general about an employer’s responsibilities over payroll taxes is not the same as saying he willfully and consciously failed to remit Gateway taxes.

·         There was no evidence he knew the company was losing money, and he did not have authority to look at the company books.

·         He paid creditors ahead of the government because he did not know about the payroll taxes until after he left Gateway.

Tarpoff finally won, but in Court and after much time and expense.

I am curious why the IRS did not go after Brach. From reading the case it seemed quite clear that he had more control than Tarpoff. The IRS thought they saw the fact pattern they like: looks like an officer, makes business decisions, pays bills, writes checks, decides who gets paid, “in the loop” enough to know that the IRS is getting ignored.

From what I see Tarpoff was in a terrible position. He was associated with a money pit, had responsibility but no authority, was intimidated by a boss (Brach), reached into his own wallet (I can only imagine he was preserving his business reputation) and lost the money, and at the end was hounded by the IRS. Frankly, I am cynical about Brach’s behavior in this matter, as I sense that Tarpoff was set-up as a “fall guy.”

If there was a truck or dog or past girlfriend in the story, one could write a country song.

Seriously, be very careful if you have some of the “sexy” fact patterns the IRS likes and you are somehow associated with payroll at a struggling company. The IRS has a track record on this issue. You do not want to run on this track. In some areas you can work with the IRS. This is not one of them.

The Payroll Tax Two-Month Holiday (Continued)

Here is the IRS announcement last Friday (December 23) about the two-month payroll tax holiday.

IR-2011-124, Dec. 23, 2011

WASHINGTON — Nearly 160 million workers will benefit from the extension of the educed payroll tax rate that has been in effect for 2011. The Temporary Payroll Tax Cut Continuation Act of 2011 temporarily extends the two percentage point payroll tax cut for employees, continuing the reduction of their Social Security tax withholding rate from 6.2 percent to 4.2 percent of wages paid through Feb. 29, 2012. This reduced Social Security withholding will have no effect on employees’ future Social Security benefits.

Employers should implement the new payroll tax rate as soon as possible in 2012 but not later than Jan. 31, 2012. For any Social Security tax over-withheld during January, employers should make an offsetting adjustment in workers’ pay as soon as possible but not later than March 31, 2012.

Employers and payroll companies will handle the withholding changes, so workers should not need to take any additional action.

OBSERVATION: Kruse & Crawford CPAs is one of the “employers and payroll companies” that will handle the withholding changes. So, we have a payroll tax holiday that does not last all the months in a quarter. Apparently Congress realized that the servicers may not have been prepared for this, so Congress decreed that we have an additional month to get it right.

Under the terms negotiated by Congress, the law also includes a new “recapture” provision, which applies only to those employees who receive more than $18,350 in wages during the two-month period (the Social Security wage base for 2012 is $110,100, and $18,350 represents two months of the full-year amount). This provision imposes an additional income tax on these higher-income employees in an amount equal to 2 percent of the amount of wages they receive during the two-month period in excess of $18,350 (and not greater than $110,100).    

This additional recapture tax is an add-on to income tax liability that the employee would otherwise pay for 2012 and is not subject to reduction by credits or deductions. The recapture tax would be payable in 2013 when the employee files his or her income tax return for the 2012 tax year. With the possibility of a full-year extension of the payroll tax cut being discussed for 2012, the IRS will closely monitor the situation in case future legislation changes the recapture provision.

OBSERVATION: If you think about this, there is a certain amount of sense. The FICA wage base for 2012 is $110,100. Since the holiday is for less than the entire year, Congress felt it necessary to prorate the wage base, as otherwise one could “game” the system. One would do that by taking his/her first $110,100 of payroll in the first two months of the year. That would require noncommon fact patterns, but it could and would happen. I know that we – as tax planners - would have taken advantage of it where possible for our clients.

OBSERVATION: How is the tax preparer to know if someone received more than $18,350 of payroll in the first two months? Will there be yet another “box” on the 2012 W-2 for this?

COMMENT: I suspect that Congress will extend the holiday for the full year, and the clawback provision will be deleted at that time.

Status of the Payroll Tax Cut

The Senate today approved a two-month extension of the employee Social Security tax cut.

You will recall that the employee FICA rate was cut from 7.65 to 5.65 percent, but only for 2011. The FICA tax is composed of two parts: a social security tax of 6.2 percent and a Medicare tax of 1.45 percent. Together they add-up to 7.65 percent and are referred to as FICA. The social security portion was reduced in 2011 by 2 points – from 6.2 to 4.2 percent. It is this portion that we are discussing.

A number of economic and financial commentators have pointed out that 2011 economic growth has been roughly equivalent to this payroll tax cut.  Add to the mix an upcoming election year and the issue of extending the cut has become quite electric.

The bill will next go to the House, where there has been some activism to cut the tax for all of 2012, not just two months.

The President has indicated his intention to sign the bill when it arrives.

My take?

Payroll is reported to the IRS on a quarterly basis. The first quarter is January through March. Accountants and payroll services now have to subdivide the quarter to determine which tax rate to apply to the payroll. Would it have been that difficult - especially since nothing has been accomplished anyway – to have the payroll tax cut run the full quarter?

Payroll Tax Cut Voted Down

I was reading this morning that the Senate was unable to pass a payroll tax cut bill yesterday. There were two bills and neither passed.

You may recall that the employee share of FICA was reduced from 6.2 to 4.2 percent for 2011. The balance of 1.45 percent for Medicare was untouched. The purpose was to stimulate, or at least not depress, the economy.

The problem is that the 2 percent reduction expires at the end of 2011.

The politicians now want to extend the program. The Senate Democrats proposed a plan to reduce the 6.2 percent withholding to 3.1 percent. In an unanticipated move, the Democrats proposed this be paid for by a tax increase on the wealthy.

The Republicans proposed extending the tax cut at 2 percent and paying for it by freezing federal salaries and streamlining the federal workforce by 10 percent. This was predictably described as extreme.

The President demanded action and announced his next vacation.

The House is taking up the issue next.

Employee or Contractor? There Is a New IRS Program

One of my individual tax clients came in around ten days ago. He brought his 2010 tax information, including a cleaning business reported as a proprietorship (technically it is a single-member LLC). I noticed that his payroll stopped somewhere during quarter 4, 2010. This of course prompted the question: why?

I suppose I did not need to ask. I have heard it before: the payroll taxes, including workers compensation, were becoming expensive. He consequently moved everyone over to a “Form 1099,” figuring that would solve his problem.

Let’s go through the steps: (1) If you can control and direct them, they are not contractors – they are employees; [2] removing them from payroll does not make them contractors; [3] issuing a 1099 at the end of the year (which he did not do, by the way, because I would have done it) does not make them contractors; and [4] a very important person – the IRS – may disagree with your opinion that they are contractors. If they disagree, the IRS may want the payroll taxes from you anyway. You would have gained nothing except an IRS audit and my professional fee for representing you.

Yep, I got stern with my client. I do not like dumb, and what he did was dumb. Payroll tax problems can get very messy – and absurdly expensive - very fast. I told him to restart the payroll.

The reason for this story is that the IRS came out this month with a “Voluntary Classification Settlement Program.” The program allows employers a chance to reclassify independent contractors and limit their resulting federal payroll taxes. To participate one must have consistently treated the individuals as contractors (that would eliminate my client) and have filed all Forms 1099 (again eliminating my client). One cannot currently be under audit, as there is a separate program for those under audit. One also has to agree to extend the statute of limitations assessment period for each of the three years going forward.

In return, one gains a substantial tax break. Before explaining, I would like to review Section 3509 of the Internal Revenue Code:

3509(a)In General.— If any employer fails to deduct and withhold any tax  … with respect to any employee by reason of treating such employee as not being an employee for purposes of such chapter or subchapter, the amount of the employer's liability for—

3509(a)(1)Withholding taxes.— Tax … for such year with respect to such employee shall be determined as if the amount required to be deducted and withheld were equal to 1.5 percent of the wages…paid to such employee.

3509(a)(2)Employee social security tax.— Taxes … with respect to such employee shall be determined as if the taxes imposed under such subchapter were 20 percent of the amount imposed under such subchapter without regard to this subparagraph.

Let’s go over the math:

                                Employer share of FICA                             7.65%

                                Employee share of FICA                            1.53%  (i.e., 7.65% times 20%)

                                Employee federal income tax                  1.50%

                                                                                                      10.68%

So that reclassification is going to cost you an immediate 10.68%, plus penalties and interest.

The new program will allow one to

·   pay 10% of the tax otherwise due, which is 1.07% (10.68% times 10%)

·   limited to one year

·   no interest or penalties, and

·   the IRS will not conduct an employment tax audit with respect to one’s worker classification for prior years.

This is a pretty good deal.

Remember that the IRS’ new position (although they deny it) is that virtually anyone who does anything for anybody is an employee. Please remember to fork-over that social security tax, thank you. If you are “walking the line” on worker classification, please consider this program.

President’s “Plan For Economic Growth and Deficit Reduction”

I was reviewing the tax provisions of the President’s “Plan for Economic Growth and Deficit Reduction.” It is possible that the “Super Committee” may adopt some of the tax provisions, so perhaps it is worthwhile to review the proposals.

(1)  Extend through 2012 the 100% bonus first-year depreciation.

(2)  Reduce the employer portion of the social security tax from 6.2% to 3.1%.

a.       This would cap-out at $5 million in payroll.

b.      Therefore the maximum cut would be $155,000 ($5,000,000 times 3.1%).

(3)  Create a tax credit for hiring employees who have been out-of-work for more than 6 months.

(4)  Create a tax credit to offset the increase in social security tax attributable to payroll increases over the corresponding period of the preceding year.

a.       So if your payroll was $1 million last year and $1.5 million this year, you would receive a credit for the social security taxes on the $0.5 million increase.

b.      There is a cap of $50 million.

c.       The credit would be good for the last quarter of this year and all of 2012.

(5)  The pre-EGTRAA tax rates would return for those making over $200,000 and $250,000.

OBSERVATION: Senator Schumer thinks these limits should be higher for New Yorkers. He is the senator from … New York.

(6)  Limit the tax rate at which high-incomes can reduce their tax to 28% for itemized deductions, excluded foreign income, health insurance and other selected deductions.

OBSERVATION: Right… make the calculation so complicated that even tax software won’t be able to get it right. Perhaps Congress and the WH should start with eliminating the phase-outs for personal exemptions, itemized deductions, student loan interest, education credits, child credit, AMT exemption and etc that would make this a circular calculation to stress even a mathematics graduate student.

(7)  Reduce the employee social security tax from 6.2% to 3.1%.

OBSERVATION:  Read this in conjunction with (2) above.

(8)  Repeal last-in first-out accounting (LIFO).

OBSERVATION: There is no accounting reason for this, as LIFO is considered to be a generally accepted accounting principle. It forms the tax accounting backbone of virtually every vehicle dealership in the nation.

(9)  Repeal the use of lower-of-cost –or-market inventory accounting.

OBSERVATION: Again, there is no accounting reason for this.

(10)  Increase the net FUTA tax from 0.6% to 0.8%.

OBSERVATION:  FUTA was increased on a “temporary” basis from 0.6% to 0.8% in 1976, although it went back to 0.6% this year. Does that sound “temporary” to you?

(11)  Eliminate the percentage depletion and intangible drilling cost provisions for oil and gas companies.

(12)  Eliminate coal activity expensing of exploration and development costs, as well as percentage depletion for hard mineral deposits and capital gains for royalties.

(13)  Modify the transfer-for-value exception on life insurance contracts.

OBSERVATION: Seems the viatical industry has drawn attention to itself.

(14)  Require business jets to be depreciated over 7 years rather than 5.

(15)  Revise the rules on transfers of intangibles to controlled foreign corporations.

OBSERVATION:  Think Google.

(16)  Revise the rules on the deductibility of interest paid to foreign persons.

I leave it to you to deem how serious you consider these proposals.

Hiring Your Child

If you own a business, would it make sense to hire your child? There are different facets to this question, and the one we will discuss today are the tax consequences.

Income Taxes

You can pay your child up to $5,800 without either of you incurring an income tax liability. As long as the wages are reasonable for the work performed, the wages are deductible to your business and taxable to your child. The child’s standard deduction of $5,800 can reduce the child’s taxable income to zero, effectively sheltering the wages.

Is the “kiddie tax” a consideration? The answer is no, as the kiddie tax applies to the transfer of passive income, such as interest and dividends. The income we are discussing is earned income, and the kiddie tax does not penalize earned income.

How much can you save? Well, that depends on your tax rate. If you are in the 35% tax bracket, then you are saving $2,030 in federal income taxes alone ($5,800 times 35%). This amount may be less if there is social security or you as employer have to pay federal unemployment tax. What are the rules for those taxes?

Social Security Tax

The social security consequence will vary depending on the age of the child and whether you are self-employed.

The first requirement is that the child must be under the age of 18.

If you are self employed (which is to say, you are unincorporated and file a Schedule C), you do not have to withhold or pay FICA taxes on a child under the age of 18. If you are under the FICA limit for 2011, this may be an immediate tax savings of 14.13% (15.3% times .9235). If you are over, then the FICA savings reduce to 2.68% (2.9% times .9235).

If you are incorporated, then there are no social security savings, as a different rule applies.

What if you are a partner in a partnership (or a member in an LLC)? If the only partners (or members) are the parents, then you do not have to withhold or pay FICA. Otherwise the corporate rule applies.

Federal Unemployment Tax

The same rule as for FICA applies here, with one exception. If the child works for your unincorporated business, or in a partnership (or LLC) where you and your spouse are the only partners (or members), then the wages will not be subject to FUTA. Otherwise, FUTA will apply.

The exception is the age cutoff. For FUTA, the child must be under age 21.

Income Tax Withholding

Usually, an employee who had no income tax liability for the prior year and expects none for the current year can claim exempt status and have no federal income tax withholding. There is a different rule for children who can be claimed as dependents on their parents’ return. That child cannot claim exempt status if his/her income will exceed $950 AND include more than $300 of interest, dividends and passive income of that nature.

Mind you, it is possible that you will get back the withholding when your child files his/her individual income tax return.