What’s the ‘Invisible Income’ Problem?

New W-2 reporting requirements and increased scrutiny on tip income are creating a data crisis for restaurants. While operators are aware tips and overtime are subject to FICA and often local/state taxes, many legacy payroll systems can’t handle this more complex tax logic in real time. Elizabeth Oviedo, CEO of Symmetry, highlights the “invisible income” problem, and what best practices operators should put in place.

What are the new W-2 requirements restaurant operators need to be aware of that they might not already know?

Restaurant operators must be vigilant about new W-2 requirements for tip income, as the IRS is scrutinizing proper reporting of all compensation, including cash and non-cash tips, and distinguishing service charges from tips.. With the rise of digital payment methods, operators need to ensure their payroll systems can accurately capture and report tips received through credit card and app-based transactions, as well as distributed tips among employees. The IRS is also pushing for greater transparency in reporting fringe benefits, which, while not always directly related to tips, can sometimes be intertwined with employee compensation in the restaurant industry.

Please define the “invisible income” problem as it relates to restaurant operators?

The “invisible income” problem in restaurants refers to unreported cash tips, which differ from credit card tips tracked by POS systems. This underreporting creates significant issues for restaurant operators. Firstly, it poses a tax compliance risk, as the IRS may audit businesses if reported tip income doesn’t align with gross receipts, potentially leading to penalties. Secondly, it causes payroll discrepancies, impacting FICA tax calculations for both employer and employee. Lastly, underreported tips can obscure minimum wage shortfalls for tipped employees, for which the employer is responsible.

Beyond the operator, underreported tips also negatively impact employees. Their future Social Security benefits and Medicare eligibility can be affected as their true income isn’t accurately reflected. Furthermore, securing loans, such as mortgages, becomes more challenging when their actual earnings are not fully documented.

What are the consequences of misclassifying tip income?

Failure to accurately report tip income and pay associated FICA taxes can lead to severe consequences for operators. These include significant fines and penalties from the IRS for unpaid employer’s FICA taxes, failure to deposit taxes, and inaccurate information returns. Operators will also be liable for back taxes and interest, potentially including both employer and employee portions of FICA taxes which may be unrecoverable. Such misclassification can trigger broader IRS audits, increasing administrative burdens and stress, and can also damage the business’s reputation, affecting talent acquisition and customer loyalty.

Beyond financial and administrative burdens, operators face potential legal challenges from employees whose benefits or Social Security contributions were negatively impacted by underreported income. Furthermore, operators who utilize a tip credit against the minimum wage risk losing this credit due to misclassification or non-compliance, leading to higher wage costs.

Can you give an example of how this could play out for a chain, particularly in retaining key talent?

For example, a 10-location regional restaurant chain, has an informal cash tip reporting system where employees often underreported tips. An IRS audit can reveal widespread underreporting, leading to potential penalties for unpaid FICA taxes, interest, and failure-to-file penalties. This financial strain can impact employee benefits and potential wage increases.

Employee morale can suffer as their true income wasn’t reflected on W-2s, affecting Social Security contributions and loan applications. Resentment can grow among those who reported tips diligently. There is potential for negative word-of-mouth spreading, leading to a talent exodus and recruitment challenges. The misclassification and underreporting of tip income can result in financial penalties but also damage employee trust, the employer brand, and the chain’s ability to attract and retain talent.

Can you give an example of how this could play out for a chain, particularly in retaining key talent?

Flavor Fusion, a 20-location regional restaurant chain, had an informal cash tip reporting system where employees often underreported tips. An IRS audit revealed widespread underreporting, leading to significant penalties for unpaid FICA taxes, interest, and failure-to-file penalties. This financial strain impacted employee benefits and potential wage increases.

Employee morale suffered as their true income wasn’t reflected on W-2s, affecting Social Security contributions and loan applications. Resentment grew among those who reported tips diligently. Negative word-of-mouth spread, leading to a talent exodus and recruitment challenges. The misclassification and underreporting of tip income not only resulted in financial penalties but also damaged employee trust, the employer brand, and the chain’s ability to attract and retain talent.

What best practices should be put in place by payroll providers to address the problem? What should operators be asking their providers?

Payroll providers should offer robust, integrated tip reporting solutions that simplify and automate the process for both credit card and cash tips, encouraging accurate employee reporting. Crucially, they should provide clear educational resources on regulations and tax implications, along with compliance monitoring tools to identify discrepancies and alert operators to potential risks. Additionally, features for grossing up wages to cover FICA taxes on tips and expert support for complex questions (e.g., tip pooling, tip credits) are essential.

Operators should inquire about a provider’s system for tracking both cash and non-cash tips, tools for monitoring underreported tips, and how the system clarifies W-2 reporting for tip pooling arrangements. They should also ask about available guidance for educating employees, how the provider stays updated on IRS regulations, and the support offered during an IRS audit related to tip reporting.