The IRS considered any tip income received as income by a taxpayer to be compensation for services rendered and must be included in the taxpayer’s gross income. The most important part of tip income is the recording of the tips by the taxpayer throughout the year. This is a requirement by the IRS and cannot be avoided. In the event the taxpayer does not record their tip income throughout the year, the IRS will use measures to reconstruct the income and assess tax against the taxpayer.
Reconstructing Tip Income
A common technique used by the IRS to reconstruct tip income is to estimate the aggregate tips received by all employees by determining the total amount of tips reported on credit card transactions. Once they have determined this amount, they will combine it with the cash sales, using a discount to reflect the fact that the tip rate on cash sales is likely to be less than that on credit card sales.
Once the aggregate amount is determined, each individual employee’s pro rata share is calculated based on the relative number of hours worked.
It is important not to underestimate the IRS and their ability to properly estimate the tip income received by all employees of an establishment. The IRS has worked on many cases in the past and knows the ins and outs of properly determining the tip income received by a taxpayer.
Often a business will be audited that uses tips as a normal course of business for their employees to make more money. If the IRS conducts an audit of the business and determines the tip income distribution of all their employees, they then will be able to check all the tip income that has been reported personally by those same employees.
In the event that the IRS determines one or more of the employees have misstated their tip income on their personal returns, the IRS will then issue another audit of those employees.
Burden of Proof
It is important to understand that even though a taxpayer may be correct in there estimation of their tip income, the burden of proof is on them to prove it to the IRS. Without proper records, it can be hard for at taxpayer to prove that their estimations are correct.
An example of this would be if the taxpayer is claiming that his section of the business receives fewer tips than another section of the business. This may be true and fine but without convincing proof, the IRS will disallow the argument and the taxpayer will be forced to report the higher amount.