Tips to employees, such as waiters and waitresses in restaurants, are taxable income. These employees are required to report their tip amounts to their employers, who are then required to report the amount of the tips to the Internal Revenue Service (IRS). Traditionally, a significant amount of non-compliance occurs in tipping-related industries. A recent IRS study determined that the amount of tip income voluntarily reported in 1993 was less than half of the true tip amount, leaving over $9 billion of unreported tip income.

To address non-compliance, the IRS began the Tip Rate Determination and Education Program (Tip Program) in October 1993. This program is intended to be a non- enforcement method to increase tip-reporting compliance. The program is designed to have IRS field personnel make contact with individual restaurants in order to secure Tip Rate Determination Agreements (TRDA) or Tip Reporting Alternative Commitment (TRAC) Agreements. The TRDA requires the IRS and employer to work together to determine a mutually agreed upon amount of tips that employees generally receive and should report. TRAC Agreements require employers to emphasize education on the responsibilities of tip reporting to their employees.

The IRS identified the Tip Program as one of its seven National Compliance Strategies in 1997, and this strategy has continued through 2001. The Tip Program has three objectives:

• To increase the filing of Employer’s Annual Information Return of Tip Income and Allocated Tips (Form 8027).
• To increase tip reporting by employers on their Employer’s Quarterly Federal Tax Return (Form 941), and by employees on their Individual Federal Income Tax Return (Form 1040).
• To increase collection results from improved reporting.

The objectives of our review were to determine whether the Tip Program achieved its goal of effectively increasing taxpayer compliance, and whether the program violated taxpayers’ rights.

The amount of tip income reported to the IRS has consistently increased during the past 5 years. While we identified no instances in which the program violated taxpayers’ rights, additional enhancements could be made to increase compliance, provide more consistent use of the program, ensure that the program is properly implemented in the new IRS organization, and expand the program to other industries.

According to statistics gathered by the IRS’ Office of Employment Tax Administration and Compliance, total tips reported on both Forms 941 and 8027 grew dramatically from 1994 to 1998, reaching $11.9 billion in 1998 on Forms 941and $7.03 billion on Forms 8027. During that same period, the number of Form 8027 filers grew slightly. While other reasons, such as an improved economy and more restaurants, likely contributed to the increase, the program appears to have had an impact on increased compliance. However, the IRS has no method to determine what amount of the increase was actually due to the implementation of the program.

The IRS has no process in place to identify all business entities that may be required to file Form 8027. These businesses are also required to file Form 941 and include the amount of tip income received by employees. The Form 8027 is the recommended tool to identify restaurant establishments where tipping is customary and to ensure continued compliance in tip reporting. Through September 7, 2000, taxpayers filed 57,902 Forms 8027 for calendar year 1999. Because of late filings and filing errors, 3,091 (5 percent) of these forms were not included in the database distributed to the Examination function’s district offices. Therefore, these filers will not be included in the subsequent year’s Form 8027 database, which the district offices use to identify potential non-compliant taxpayers.

The accuracy and completeness of two of the databases the IRS used to monitor the results of the program could be improved. In particular, there were 672 establishments listed as having agreements in the Form 8027 database, which were not listed as having an agreement in the separate National TRAC/TRDA database. Inaccurate and incomplete management information can adversely affect program decision-making.

Use of the Tip Program varies by district depending upon the resources applied to the program, district management prioritization, and practices used. Specifically, the number of restaurants with agreements ranged from 77 in 1 district to 613 in another district, and the number of examinations of employee tax returns ranged from 1 to 176. One of the three districts reviewed did not use the Form 8027 database as a primary source in determining potential non-compliance as recommended. One district only offered the TRAC but did not offer the TRDA Agreements, while the other two districts offered both types of agreements; however, one of those districts has not secured a TRAC or TRDA agreement in over two years. A contributing factor to these inconsistencies is that program oversight was limited to two National Headquarters program analysts, one responsible for the restaurant industry and the other for the hair and beauty industry. Without a consistent approach to using agreements and conducting examinations when necessary, the success of the program is not being maximized and taxpayers are not treated equally.

The newly established Small Business/Self-Employed (SB/SE) Division includes a Taxpayer Education and Communication (TEC) function that is responsible for outreach activities relating to developing new, and maintaining existing, voluntary agreements for small business taxpayers. However, the TEC function has neither immediate plans nor adequate personnel to ensure the smooth transition of the Tip Program from the Division’s Compliance function. In addition, TEC function officials do not know who will monitor and solicit future tip agreements that affect other IRS operating divisions. Finally, the TEC function anticipated hiring 215 employees by January 2001, and plans to be fully staffed by October 2002. At least some of these employees will be immediately responsible for assisting taxpayers during the "filing season" (the first three and one-half months of each calendar year), thus limiting their ability to solicit new and monitor existing agreements during this period.

The IRS would like to further extend the Tip Program to all other industries where tipping is customary; however, actual time frames are yet to be determined for initiating these other programs. A significant challenge this expansion faces is that current activities within the Tip Program generally overlook contacting and executing agreements with small establishments, as this process is time and labor intensive. There is no national policy concerning a minimum employee threshold level. In fact, our review identified one district excluding restaurants with less than 50 employees from participation in the program. This practice of excluding very small restaurant businesses seems to contradict the stated expansion plans of the program to other industries, such as beauty and hair care, which are usually very small business establishments with few employees. Additionally, only restaurants with 10 or more employees are required to file Form 8027. These systemic limitations will further complicate the ability to identify non-compliant businesses that are small.

The Commissioner, SB/SE Division should work with the Business Systems Modernization Office’s Change Control Board to include an automated reconciliation of Forms 941 and 8027 data to identify non-compliance in tip reporting and improve the accuracy of management information data. In addition, the importance of the Tip Program needs to be re-emphasized and adequate oversight needs to be provided. The Directors for TEC and Compliance need to develop a detailed plan to ensure the smooth transition of the Tip Program from the Compliance function to the TEC function in order to maintain continuity of the program and avoid taxpayer burden. Finally, the Commissioner, SB/SE Division should address concerns with the future strategy on expanding the Tip Program to other industries which customarily receive tips.

Management’s Response: IRS management agreed with our recommendations and has initiated corrective actions that address the issues we identified. A complete copy of the response is attached to this report in Appendix IV.