PRESENT LAW AND BACKGROUND RELATING

TO THE TAX TREATMENT OF TIP INCOME

Scheduled for a Public Hearing

Before the

SUBCOMMITTEE ON OVERSIGHT 

of the

HOUSE COMMITTEE ON WAYS AND MEANS

on July 15, 2004

Prepared by the Staff

of the

JOINT COMMITTEE ON TAXATION

July 13, 2004

JCX-48-04
ii

CONTENTS

Page

INTRODUCTION .......................................................................................................................... 1

I. BACKGROUND AND PRESENT LAW ................................................................................... 2

A. Reporting of Tip Income..................................................................................................... 2

B. Credit for Employer Portion of FICA Taxes on Tips ......................................................... 4

II. LEGISLATIVE PROPOSALS.................................................................................................. 5

A. Description of H.R. 2034 (Mr. Herger) .............................................................................. 5

B. Description of H.R. 2133 (Mrs. Johnson)........................................................................... 5

C. Description of H.R. 118 (Mr. Hefley)................................................................................. 5
1

INTRODUCTION

The Subcommittee on Oversight of the House Committee on Ways and Means has 

scheduled a public hearing for July 15, 2004, on the Internal Revenue Service’s (“IRS”) 

enforcement of the tax laws with respect to tip income. This document,1 prepared by the staff of 

the Joint Committee on Taxation, provides a description of the present law and background 

relating to the tax treatment of tip income and recent developments. 

 

1

 This document may be cited as follows: Joint Committee on Taxation, Present Law 

and Background Relating to the Tax Treatment of Tip Income (JCX-48-04), July 13, 2004.
2

I. BACKGROUND AND PRESENT LAW

A. Reporting of Tip Income

In general

All tips received by an employee are taxable income, not gifts.2 Employee tip income is 

also treated as employer-provided wages for purposes of the Federal Insurance Contributions Act 

(“FICA”). Customers may tip service providers in a variety of ways, such as direct cash 

payments, additions to credit card receipts, or through non-cash items (such as tickets to sporting 

events). In addition, the amount tipped may vary significantly from customer to customer. 

These variations can present significant challenges to service providers and their employers in 

keeping appropriate records and in complying with their tax obligations as well as to the IRS in 

enforcing the tax laws. Special statutory rules and administrative measures described below 

have been developed to improve compliance with these tax obligations.

Statutory reporting requirements

The Code requires employees who receive tips in a calendar month to provide a written 

report of such tips to their employer no later than the 10th day of the following month.3 Special 

rules apply to large food or beverage establishments (where tipping is customary and which 

normally employed more than 10 employees on a typical business day in the preceding calendar 

year).4 These establishments must allocate5 among employees the excess of eight percent6 of 

gross receipts over the aggregate amount reported as tips by employees during the payroll period. 

These establishments must also report annually to the IRS: (1) the gross receipts of the 

establishment; (2) the total charge receipts; (3) the total tips shown on charge receipts; and (4) 

the total tips reported to the employer.7 The employer must also provide each employee with an 

annual statement that includes the name and address of the employer, the name of the employee, 

and the amount of tips allocated to the employee.8 

 

2

 Roberts v. Commissioner of Internal Revenue, 176 F.2d 221 (9th Cir. 1949); Olk v. 

United States of America, 536 F.2d 876 (9th Cir. 1976).

3

 Sec. 6053(a).

4

 Sec. 6053(c).

5

 The allocation must be made on the basis of a good faith agreement by the employer 

and the employees, or under regulations prescribed by the Secretary. Sec. 6053(c)(3).

6

 This percentage may be reduced to as low as two percent with the approval of the IRS. 

7

 Sec. 6053(c)(1).

8

 Sec. 6053(c)(2).
3

Tip agreements

In 1993, the IRS introduced its Tip Rate Determination/Education Program (“TRD/EP”), 

designed to enhance tax compliance among tipped employees through taxpayer education and 

voluntary advance agreements instead of traditional audit techniques.9 The TRD/EP currently 

offers employers the opportunity of entering into one of two types of agreements, the Tip Rate 

Determination Agreement (“TRDA”) and the Tip Reporting Alternative Commitment 

(“TRAC”). 

The TRDA requires an employee to enter into a Tipped Employee Participation 

Agreement (“TEPA”) with the employer. The TRDA requires the IRS to work with the 

establishment to arrive at a tip rate for the various restaurant occupations. The TRDA requires 

that at least 75 percent of the employer’s employees sign TEPAs and report tips received at or 

above the rate determined to be appropriate for that occupation. The TRDA provides that if 

employees fail to report tips received at or above that determined rate, the employer will provide 

to the IRS the names of those employees, their social security numbers, job classification, sales, 

hours worked, and amount of tips reported. 

The TRAC does not require the employer to establish tip rates, and employee 

participation agreements are not required. In this program, the employer agrees to institute and 

maintain a quarterly education program for directly and indirectly tipped employees. The 

employer also agrees to establish formal tip reporting procedures. Employers assume 

responsibility for having their employees report tips, and the IRS agrees not to assess the 

business employment taxes on unreported tips unless the employees are audited first. This 

method is available for food and beverage employees only. The IRS may not threaten to audit 

any taxpayer in an attempt to coerce the taxpayer into entering into a TRAC agreement.10

In 2000, the IRS introduced a modified variation of the TRAC, the Employer-Designed 

Tip Reporting Alternative Commitment (“EmTRAC”), available only to employers in the food 

and beverage industry that have employees who receive both cash and charged tips. EmTRAC 

retains many of the provisions contained in the TRAC agreement. The employer must establish 

an educational program to train employees that the law requires them to report all their cash and 

charged tips to their employer. The educational program must be furnished to newly hired 

employees and quarterly for existing employees. The EmTRAC program provides an employer 

with significant latitude in designing its educational program and tip reporting procedures. 

Participation in either the TRDA or the TRAC assures the employer that any prior tax 

period will not be examined as long as participants comply with the requirements under the 

agreement.

 

9

 Internal Revenue Service, Notice 2001-1, 2001-1 C.B. 261.

10 Sec. 3414 of the IRS Restructuring and Reform Act of 1998 (July 22, 1998), Pub. L. 

No. 105-206.
4

Recent Supreme Court case

On June 17, 2002, the Supreme Court, in United States v. Fior D’Italia, Inc.,

11 held that 

the IRS may determine (on an aggregate basis) and assess against the employer, the FICA tax on 

tips that the employees did not report to the employer. The IRS estimated the unreported tips of 

the restaurant’s employees for FICA tax purposes by calculating an average tip percentage from 

credit card receipts and applying that percentage to the restaurant’s total sales. The restaurant 

argued that the IRS was not authorized to use this method of aggregate estimating; instead, the 

restaurant argued that the IRS was required to develop individual estimates for each employee’s 

tip income to calculate the total FICA liability of the employer. The Court held, however, that 

the IRS was clearly authorized to estimate FICA tax liability, and found that the restaurant failed 

to show that the method used by the IRS to estimate such liability was unreasonable. The Court 

affirmed that the IRS could use the aggregate estimation method to determine tip income by 

aggregating all the tips that the restaurant’s customers paid its employees.

B. Credit for Employer Portion of FICA Taxes on Tips

Present law provides a business tax credit equal to an employer’s FICA tax obligation 

(7.65 percent) attributable to certain tips treated as paid by the employer for FICA tax purposes 

(regardless of whether the tips are reported).12 The credit is available only with respect to tips 

received from customers in connection with the providing, delivering, or serving of food or 

beverages for consumption if the tipping of employees receiving such tips is customary. In 

addition, the credit is available only with respect to the extent such tips exceed the amount of tips 

that are used by the employer to meet the minimum wage requirements for the employee under 

the Fair Labor Standards Act. No deduction is allowed for any amount taken into account in 

determining the credit.

 

11 536 U.S. 238 (2002).

12 Sec. 45B.
5

II. LEGISLATIVE PROPOSALS

A. Description of H.R. 2034 (Mr. Herger)

H.R. 203413 prohibits the Secretary of the Treasury from issuing a notice and demand to 

an employer for FICA taxes with respect to tips received by an employee until the Secretary has 

determined the amount of tips received by the employee. The legislation has the effect of 

overturning the Supreme Court decision in United States v. Fior D’Italia, Inc.

B. Description of H.R. 2133 (Mrs. Johnson)

H.R. 213314 extends to employers of cosmetologists the credit for a portion of FICA taxes 

paid on tips and requires the education of cosmetologists to better comply with the tax code. The 

bill expands the present-law business tax credit with respect to certain employer FICA taxes paid 

with respect to tips.15 The bill also expands the scope of the present-law information reporting 

requirements16 to require persons receiving rent for space in a cosmetology facility to provide 

annual information reports to the cosmetologists who rent the space. The bill requires everyone 

(such as an employer) who provides information reports to a cosmetologist also to provide to the 

cosmetologist a publication designated by the Secretary of Treasury that describes the tax and tip 

reporting obligations of employees and the tax obligations of independent contractors or 

proprietorships.

C. Description of H.R. 118 (Mr. Hefley)

H.R. 11817 states that the Internal Revenue Code must be applied without regard to 

United States v. Fior D’Italia, Inc.

 

13 H.R. 2034 was introduced on May 8, 2003, by Mr. Herger (for himself and Mr. 

Tanner). The bill is effective on the date of enactment.

14 H.R. 2133 was introduced on May 15, 2003, by Mrs. Johnson (for herself, Mr. 

Hayworth, Mr. Lewis (of Kentucky), Mr. Ramstad and others). The bill is effective for calendar 

years after 2003.

15 Sec. 45B.

16 Present law requires reporting with respect to both employees and independent 

contractors.

17 H.R. 118 was introduced on January 7, 2003, by Mr. Hefley. The bill is effective on 

the date of enactment.