The Treasury Inspector General for Tax Administration (TIGTA) released an audit report September 28, 2018, examining tip-related tax noncompliance and making nine recommendations to the IRS.

Background

Like other wages, tips are subject to employment taxes under the Federal Insurance Contributions Act (FICA), the Federal Unemployment Tax Act (FUTA) and federal income tax withholding (FITW). The IRS estimated that for 2006 a $235-billion "tax gap" existed between the income that individual taxpayers should have reported and actually reported, and that approximately 10% of the tax gap ($23 billion) is due to employees' unreported tip income. TIGTA undertook the audit "to determine whether the IRS is using the National Tip Reporting Compliance Program (NTCRP) 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 recommendations

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 plans to take corrective actions."

The nine recommendations follow, along with the IRS management response to each.

• Recommendation 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 impact to tip reporting compliance.

• Recommendation 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 compliance so that resources can be used for higher risk work.

• Management's Response: IRS management will issue an Interim Guidance Memo regarding the option of extending the renewal term, as appropriate, when employers with GITCAs are compliant with payment and reporting requirements.

• Recommendation 3: Use data analysis and sampling to monitor tip agreement compliance and identify taxpayers that need a compliance review. For example, the IRS could focus on the tip agreements with projected unreported tips with a high dollar value.

• Management's Response: IRS management will review the current process to determine whether improvements can be made to the data analysis and sampling techniques to monitor tip agreement compliance and identify taxpayers that need a compliance review.

• Recommendation 4: The Commissioner should develop a risk-based case selection methodology using historical statistics and data analysis to identify the highest risk tip examination cases on an annual basis. For example, the IRS could focus on taxpayers with projected unreported tips in a high-dollar value. The cases could then be classified based on the updated prioritization of 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 the related outcome measure, stating that it does not account for revenues that would be lost from diverting resources from other examination programs.

• Recommendation 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. The CETO function already performs this work for the Form 4137 tip compliance work stream so it would not be a new process for them.

• Management's Response: IRS management will review the current process for working 3121(q) Notice and Demands for closed tip examinations to determine whether CETO resources can be used to supplement field resources.

• Recommendation 6: Update the Tip Examination Interim Guidance Memorandum (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 to prior/subsequent years.

• Management's Response: IRS management will issue an IRM 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 to prior/subsequent years.

• Recommendation 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 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 the Form 8027 analysis of unreported tips. Provide employee training on the changes to the IRM.

• Management's Response: IRS management will issue an 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 the Form 8027 analysis of unreported tips. Training workshops will be delivered to ensure that employees understand and implement the IRM.

• Recommendation 9: The Commissioner should ensure that Form 4137 compliance cases are addressed in the CETO function's annual work plans, including the tax year 2013 through 2015 cases, which involved more than $1.5 million in potential increased FICA tax revenue.

• 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 Indian Tribal Government Form 4137 compliance cases. Indian Tribal Government higher risk cases will be included in the CETO work plan as resources permit. However, IRS management disagreed with the related outcome measure, stating it does not account for revenues that would be lost from diverting resources from other Examination programs.

Ernst & Young insights

The TIGTA's recent audit findings and recommendations could well spark changes in the manner in which the IRS is currently managing 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.

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