The Treasury Inspector General for Tax Administration (TIGTA) released an audit report on Sept. 28, 2018 (TIGTA Rep't No. 2018-30-081, Billions in Tip-Related Tax Noncompliance Are Not Fully Addressed and Tip Agreements Are Generally Not Enforced), examining tip-related tax noncompliance and making nine recommendations to the IRS.
Like other wages, tips are subject to employment taxes under the Federal Insurance Contributions Act (FICA), the Federal Unemployment Tax Act, and federal income tax withholding. The IRS estimated that for 2006, a $235 billion "tax gap" existed between the income that individual taxpayers should have reported and what they actually reported, and that approximately 10% of the tax gap ($23 billion) was due to employees' unreported tip income. TIGTA undertook the audit "to determine whether the IRS is using the National Tip Reporting Compliance Program (NTRCP) to provide balanced and adequate reporting compliance oversight of taxpayers in industries in which tipping is customary."
The audit found that:
- The NTRCP had renewed many more "lower risk Gaming Industry Tip Compliance Agreements (GITCA) and Tip Rate Determination Agreements (TRDA) [than] higher risk compliance reviews of Tip Reporting Alternative Commitment (TRAC) agreements and tip examinations."
- Most of these renewals did not result in higher tip reporting compliance rates.
- Even when the NTRCP found a reason to revoke a tip agreement, few tip agreements were actually revoked.
TIGTA's audit report makes nine specific recommendations to help the NTRCP improve its administration of tip agreements and examinations. The IRS reportedly agreed with the recommendations and said it planned to take corrective actions.
The nine recommendations follow, along with the IRS management response to each.
Recommendation No. 1: Use a risk-based approach to more effectively prioritize the use of field examination resources for the NTRCP. The risk-based approach should prioritize higher-risk work with the greatest impact to tip reporting compliance.
Management's response: IRS management will review the current process to determine whether improvements are needed for identifying higher-risk work with the greatest effect on tip reporting compliance.
Recommendation No. 2: Ensure that NTRCP examiners consider extending the renewal term for employers with GITCAs when annual monitoring indicates they are compliant with payment and reporting requirements, so that resources can be used for higher-risk work.
Management's response: IRS management will issue an interim guidance memo (IGM) regarding the option of extending the renewal term, as appropriate, when employers with GITCAs are compliant with payment and reporting requirements.
Recommendation No. 3: Use data analysis and sampling to monitor tip agreement compliance and identify taxpayers for which compliance should be reviewed. The IRS could concentrate on tip agreements with a large amount of projected unreported tips.
Management's response: IRS management will review the current process to determine whether data analysis and sampling techniques can better monitor tip agreement compliance and identify taxpayers whose compliance should be reviewed.
Recommendation No. 4: The IRS should develop a risk-based case selection methodology using historical statistics and data analysis to identify the highest-risk tip examination cases annually. For example, the IRS could focus on taxpayers with large amounts of projected unreported tips. The cases could then be classified based on field resources available for tip examinations.
Management's response: IRS management will review the current process to determine whether improvements are needed for identifying higher-risk tip examinations, taking into consideration historical statistics and annual data analysis. However, management disagreed with TIGTA's estimate that NTRCP's working 670 additional cases with projected unreported tips of over $1 billion could generate $86.7 million more in FICA tax revenue, stating that figure does not account for revenues that would be lost from diverting resources from other examination programs.
Recommendation No. 5: Use the NTRCP Centralized Employment Tax Operation (CETO) function to complete the notice and demand letter process for closed tip examinations when field examination resources are limited. CETO already uses this process for Form 4137, Social Security and Medicare Tax on Unreported Tip Income.
Management's response: IRS management will review the current process for working Sec. 3121(q) notices and demands for closed tip examinations to determine whether CETO resources can be used to supplement field resources.
Recommendation No. 6: Update the Internal Revenue Manual (IRM) to clarify the requirements for making a determination and documenting the reasons to expand or limit the scope to prior and/or subsequent years. The documentation should include the use of further analysis to justify the reason for expanding or limiting the scope of the audit.
Management's response: IRS management will issue an IGM to clarify the requirements for making a determination and documenting the reasons to expand or limit the scope to prior and/or subsequent years. It will include the use of further analysis to justify the reason for expanding or limiting the scope of the audit.
Recommendation No. 7: Consider reducing the number of approvals necessary to revoke tip agreements with noncompliant employers.
Management's response: IRS management will review the delegation order for revoking tip agreements to determine whether any revisions are needed.
Recommendation No. 8: Update the IRM to provide more specific criteria and examples of when to revoke a tip agreement if an establishment is substantially noncompliant with the commitments of the agreement and to provide more specific criteria and examples on how to perform compliance reviews, including analysis of unreported tips on Form 8027, Employer's Annual Information Return of Tip Income and Allocated Tips. Provide employee training on the changes to the IRM.
Management's response: IRS management will issue an IGM to provide more specific criteria and examples of when to revoke a tip agreement if an establishment is substantially noncompliant with the commitments of the agreement and to provide more specific criteria and examples on how to perform compliance reviews, including the Form 8027. Training workshops will be held to ensure that employees understand and implement the IGM.
Recommendation No. 9: The IRS should ensure that Form 4137 compliance cases are addressed in the CETO function's annual work plans, including certain Tax Exempt and Government Entities Division cases for tax years 2013 through 2015 involving more than $1.5 million in potential increased FICA tax revenue, which TIGTA found were not being worked.
Management's response: IRS management stated that filters used to identify higher-risk fiscal year 2016 Indian tribal government Form 4137 compliance cases will be applied to the fiscal years 2013 through 2015 cases. Indian tribal government higher-risk cases will be included in the CETO work plan as resources permit. However, IRS management disagreed with TIGTA's estimated increased revenue amount, stating it does not account for revenues that would be lost from diverting resources from other examination programs.
TIGTA's recent audit findings and recommendations could well spark changes in the way the IRS manages tip agreements. Accordingly, employers with tip agreements should review their compliance performance and work closely with IRS examiners to resolve any issues that might result in the revocation of those agreements.
Michael Dell is a partner at Ernst & Young LLP in Washington.
For additional information about these items, contact Mr. Dell at 202-327-8788 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP. Ernst & Young previously published versions of these items as Tax Alerts.