Tip Allocation in Large Establishments

April 13, 2006

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Okay, you've determined that, according to the IRS, you are indeed a large food or beverage establishment. What does this mean to you as an employer? Well, it means that you have the same general obligations with regard to tips that other employers have and then some. Your employees must report tips received to you. You, in turn, report this information to the IRS.

What's unique to large establishments is that if your employees don't report total tips equal to at least 8 percent of your gross receipts for a payroll period, you must also allocate some extra tips to employees, so that this 8 percent floor is achieved. (Operations outside the United States, that is, the 50 states and the District of Columbia, are not subject to these requirements.) You do not pay any payroll taxes on these allocated tips — they are reported to the IRS for information purposes only.

Gross receipts are all receipts (except nonallocable receipts from carryouts or services with gratuities added) from the provision of food or beverages, including cash sales, charged sales, and the retail value of any complimentary food or beverages served, but excluding tips and state or local taxes.

Burton's Bar and Grill has gross receipts of $10,000 for a payroll period. Employees report tips for that period totaling only $500. The amount allocated to employees is therefore $300 ($10,000 X 8% = $800; $800 - $500 = $300).

What can you do if you feel that the percentage of gross receipts you must use to determine the tip allocations doesn't accurately reflect the tips your employees are actually getting? You do have a course of action available. Either an employer or a majority of directly tipped employees can petition the IRS District Director (of the district in which a food or beverage establishment is located) to lower the percentage of gross receipts used to determine tip allocations to a percentage that will better reflect the tips actually paid in the establishment. If convinced, the District Director can lower the percentage to as low as 2 percent.

You can't use a reduced percentage before receiving notice in writing from the IRS that the petition is approved.

Good faith agreements. One option you have for allocating tips to individual employees is on the basis of a "good faith agreement" between you and your employees. That means a written agreement consented to by you as the employer, and at least two-thirds of the members of each occupational category of tipped employees (waiters, busboys, maitres d') employed in the establishment when the agreement is adopted. (Keep in mind, employees who receive less than $20 per month in tip income are not considered "tipped employees.")

A good faith agreement must contain the following four elements:

It must provide for an allocation that, together with reported tips, reflects a good faith approximation of the actual distribution of tip income.
It must become effective prospectively on the first day of a payroll period but no later than the first day of the succeeding calendar year.
It must be adopted when tipped employees are employed in each occupational category of tipped employees affected by the agreement.
It must allow for prospective revocation of the agreement by a written instrument adopted by at least two-thirds of the tipped employees affected by the agreement at the time of revocation. (A revocation can be effective only at the beginning of a payroll period.)

Allocations without an agreement. What do you do if you don't have a good faith agreement in place? In that case, you must allocate tips to each "directly tipped" employee who has a reporting shortfall for the payroll period. Directly tipped employees are any tipped employees who receive tips directly from customers, including employees who turn all tips over to a tip pool. Indirectly tipped employees are tipped employees who do not ordinarily receive tips directly from customers, such as busboys, service bartenders, and cooks. No allocations are made to indirectly tipped employees. Employees who receive both direct and indirect tips, such as a maitre d', are treated as directly tipped employees.

Here's how you would perform the allocation, step-by-step:

Step 1: Multiply your establishment's gross receipts for the payroll period by 8 percent (.08).

Step 2: Subtract from this amount the total tips reported for the payroll period by indirectly tipped employees.

Step 3: Allocate the remainder to directly tipped employees by multiplying the remainder by the percentage of gross receipts attributable to each employee. To calculate that percentage, divide the gross receipts attributable to each employee by the gross receipts attributable to all tipped employees. (Alternatively, the basis for allocation can be the number of hours worked by each employee for a payroll period, but only if you employ less than the equivalent of 25 full-time employees at your establishment during the payroll period. To qualify, the average number of employee hours worked per day at your establishment during the period must be less than 200.)

Step 4: Subtract the tips reported by each directly tipped employee from the amount allocated to each employee in Step 3. Any remainder is the employee's shortfall for the payroll period.

Step 5: Subtract the total tips reported by all directly and indirectly tipped employees for the payroll period from 8 percent of gross receipts for the period (which is calculated in Step 1).

Step 6: Allocate the remainder from Step 5 to directly tipped employees who had a shortfall for the payroll period by multiplying the remainder by the pro rata share of the total shortfall attributable to each such employee.

For more details, see our case study showing how the tip allocation process actually works.