Are Tips a Trap? – (Tips and Traps of Compensation – Part V)

Posted by Tyler Starr, CPA

The most common error found during the audit of an employee benefit plan is the incorrect definition of compensation being used for contribution purposes. Whether the error is related to payroll coding issues or not fully understanding the plan provisions, plan compensation can be one of the biggest traps for plan sponsors, especially when employees receive cash tips.

Restaurants, bars, casinos, hotels, parking, transportation, beauty salons, and barbershops have to deal with reporting requirements of tipped employees. Tips are discretionary payments that employees receive from customers. Tips include cash tips, electronic tips made through any electronic payment method, noncash tips (such as tickets or other items of value), and tips received from other employees paid out through tip pools or tip splitting. All cash and noncash tips an employee receives are considered income and are subject to federal income taxes, as well as Social Security and Medicare taxes, except for an employee’s tips from any month that do not total at least $20.

Employers who operate a large food or beverage establishment may be required to allocate tips to employees. Employers are deemed to operate a large food or beverage establishment if tipping is customary, the employer provides food or beverages for consumption on the premises, and the employer normally employs more than ten people who collectively work more than 80 hours on a typical business day. If total tips reported by all employees at a large food or beverage establishment are less than 8 percent of gross receipts (or a lower rate approved by the IRS), the employer must allocate the difference between the actual tip income reported and 8 percent of gross receipts among employees who received tips. The allocation may be based on total hours worked or on some other written agreement between the employer and employees. This allocated tip income for large food or beverage establishments is reported in Box 8 of the employee’s Form W-2, and is NOT included in Boxes 1, 3, 5, or 7.

In other industries, tips reported to the employer by the employee are included in Box 1 (wages, tips, and other compensation, Box 5 (Medicare wages and tips), and Box 7 (Social Security tips) of the employee’s Form W-2. If a plan’s definition of compensation is Box 1 of the W-2, and the plan document does not list exclusions for tip income, then tips should be considered for the allocation of contributions.

One trap related to tips that are eligible compensation is that once the employee has the cash in hand, deferrals cannot be withheld from those amounts. The trap is that employees can still elect to defer a set percentage of total compensation, so if an employee elects to defer 3% of total eligible compensation, 3% of tip income must be withheld from the employee’s regular pay, since the employee has already received the cash tips. This is another reason why tips should be accurately and timely reported by employees to the employer.  In the case of pooled or allocated tip-sharing arrangements, employers have more control of retaining enough tips to cover the deferral withholdings.

Some plan sponsors may want to avoid this trap altogether by excluding tips from the definition of eligible compensation in the plan document, but it may not be that easy. A hidden trap, in that case, is the IRC section 414(s) compensation ratio test, which ensures plans do not carve out certain types of compensation in a way that disproportionately benefits the highly compensated employees (HCEs). In most scenarios, the HCEs are owners or members of management that do not receive any tip income. Thus, excluding tip income from plan compensation would usually be considered discriminatory to non-highly compensated employees (those receiving tips), and favoring the HCEs. Plan sponsors should consult with their third-party administrator and document provider about compliance issues. In most situations, the only solution to escaping the tips trap is to withhold deferrals from and match tip income.

The accurate inclusion or exclusion of tip income in accordance with plan provisions is important when calculating employee deferrals, allocating employer contributions, and testing contributions for plan compliance purposes. If the correct definition of plan compensation has not been correctly used, corrections may be needed to fix the mistake. Plan sponsors should perform annual reviews of all definitions of compensation in the plan document and ensure that the person in charge of determining eligible compensation is properly trained, in addition to making sure that procedures are put in place to ensure the accurate reporting of all compensation types to employees.

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Photo by Randy von Liski (License)