• Tip income: Why proper recordkeeping is important

Tip Income: Why Proper Recordkeeping is Important

In a recent court case, Sabolic v. Commissioner, a bartender’s daily tip log was found to be more persuasive than the IRS’ estimation of his unreported tip income. If your restaurant has tipped employees, it’s important that you educate your staff on proper tip reporting. This case demonstrates how accurate recordkeeping can be vital during an IRS examination.

In this case, the IRS alleged that the taxpayer, a bartender at a casino, misstated his tip income. The IRS determined tip rates for both credit card sales and cash transactions and estimated the bartender had underreported his tips by about 50 percent.

The bartender had opted out of the IRS’ automatic tip rate formula for the gaming industry as he believed that the automatic tip rate was too high given economic conditions. Therefore, to fulfill his self-reporting requirement, he kept a daily log of his cash tips, as well as employer-generated receipts from his charged tips.

While the IRS found issues with the log (i.e., tips were recorded as whole numbers, tip outs to barbacks were not well-documented, some days appeared to be missing altogether, and the log did not match the taxpayer’s W-2s by small amounts), the bartender was able to explain the apparent discrepancies to the court’s satisfaction. The court determined that the bartender’s log was a “substantially accurate account of his tip income.” By keeping a daily diary, the taxpayer had fulfilled the recordkeeping requirement, and his approach reflected a reasonable methodology based on the facts and circumstances.

Overall, the court ruled that the taxpayer’s method of recording daily tips superseded the IRS’ method of reconstructing tip income. Although the court ruled in favor of the taxpayer in this case, it could have easily gone in the other direction due to the lack of precision in his recordkeeping. The burden of proof falls on the taxpayer to keep good records.

Be sure your tipped employees understand their tip reporting obligations, including how keeping accurate records may prevent costly tax penalties. You can direct employees to IRS Form 4070A, Employee’s Daily Record of Tips, to help them track tips.