One of the biggest challenges facing restaurateurs is getting employees to report and pay taxes on their tips as required by the IRS. And complying with the intricacies of the tip reporting and allocation rules can be an unpleasant administrative chore.  

All tipped employees who earn cash tips of more than $20 per month are required to report their tips to their employer. On the basis of this information, the employer must withhold applicable federal income tax and FICA (and pay the employer’s share of the FICA). The difficulty lies in establishing the amount of tips employees actually receive, since some employees are reluctant to disclose the full amount of tip income in order to avoid paying taxes on it.  

Two voluntary programs

The Tip Rate Determination and Education Program was initiated by the Internal Revenue Service in 1993 to address the widespread underreporting of tip income in the food and beverage industry. It was designed to encourage employers to closely monitor their employees’ tip-reporting practices. 

The program has two different agreements—the Tip Rate Determination Agreement (TRDA) and the Tip Reporting Alternative Commitment (TRAC). Participation in the program is voluntary, and you may only enter into one of the agreements at a time. As an employer, you benefit from the program by not being subject to unplanned tax liabilities. Those who sign a TRAC or a TRDA receive a commitment from the IRS that the agency will not examine the owner’s books to search for underwithheld or underpaid payroll taxes on tip income—as long as the agreement is honored. But there are benefits to employees, too, including an increase in their Social Security, unemployment, retirement plan, and worker’s compensation benefits.

Comparison of the TRDA and TRAC Programs

Tip Rate Determination Agreement (TRDA). The IRS works with you to arrive at a tip rate for your employees. Then, at least 75% of the workers must pledge in writing to report tips at the agreed-upon rate. If they fail to do so, you are required to turn them in to the IRS. If you do not comply, the agreement is rescinded and your business becomes subject to IRS auditing.

Tip Reporting Alternative Commitment (TRAC). TRAC is less strict but requires more work on your part. It does not mandate that you establish a tip rate but requires you to work with employees to make sure they understand their tip-reporting obligations. You must set up a process to receive employees’ cash tip reports, and they must be informed of the tips you are recording from credit card receipts. 

The chart below presents an overview of how the two programs compare:

 

Characteristics	TRDA	TRAC
Legally requires restaurant to participate.	No	No
Restaurant must work with the IRS to calculate a tip rate for itself.	Yes	No
Restaurant must pay six months of back FICA taxes.	Yes	No
At least 75% of employees must agree to participate by signing agreements.	Yes	No
Employees who choose not to participate must be reported to the IRS by the employer.	Yes	No
Requires an intensive employee education program.	No	Yes
Restaurant must keep track on an ongoing basis of credit card and cash tips by employee.	No	Yes
Restaurant must notify employees of their credit card tips on a periodic basis (not less than once a month).	No	Yes
Payroll tax returns from the period prior to joining the agreement will not be examined by the IRS if the employer is in compliance with the agreement.	Yes	Yes
Current and future payroll tax returns will not be examined by the IRS if the employer is in compliance with the agreement.	Yes	No
"Employer only assessment" (assessments without auditing the employee) are prohibited during the period the program is in effect.	Yes	Yes

Deciding which program is right for you involves many variables. Therefore, it is advisable to work with an accountant who is experienced in tip taxation.

Mandatory filing

Another goal of the IRS program is to increase the filings of Form 8027, Employer’s Annual Information Return of Tip Income and Allocated Tips. Generally, an employer is required to file a Form 8027 for each establishment where food or beverage is provided for consumption on the premises, tipping is a customary practice, and more than 10 full-time employees are employed on a typical business day. An employee is defined for this purpose as:

• Waiters and waitresses
• Cooks
• Cashiers
• Dishwashers
• Bookkeeper (if on payroll)
• Musician (if on payroll)
• Owner (if incorporated and owns less than 50% of the stock)