Tip income

OK proposing on a plan where tip income is a large chunk of their pay.  What do I need to know? I "always" use the w-2 definition of wages, so I should be able to easily identify the comp number at year-end.

I think the biggest question I have is, if someone wants to contribute 4% of pay, how does that work?  Does anyone have an article about tip income and a 401k plan?

In the 1990s, another lawyer and I worked on a plan for a company with several national restaurant chains.  The IRS reviewer would not approve anything that would allow an employee to make a cash-or-deferred election on the portion of her wages from cash tips.

But an employee might consider a wage reduction that’s a big percentage (perhaps up to 100%) of her net wages, after tax withholding, paid by the employer rather than collected as cash tips.  But sometimes that net wage after tax withholding is $0.00.

The practical challenges vary with the restaurant.  If many customers use only payment cards and no currency, the employer might control those payments.  But if many pay tips in currency, more is beyond the employer’s control.

I don’t know whether the tax law, or the IRS’s views, have changed since I worked on this issue.

And here’s a BenefitsLink discussion: 

I've never had to deal with this issue so would like someone to confirm my guesses as to the legal issue, or set me right if I'm missing it. On the one hand, the tips (both deemed and any actual in excess of deemed) are W-2 wages, therefore comp, therefore subject to deferral. On the other hand, I guess the IRS would have a hard time agreeing that the employee can take cash that is initially in his/her possession (because left on the table or handed to him or her by customer), and give it back to the employer for purposes of making a contribution, although I could argue they should allow that. But I believe most tipped employees also receive non-tip amounts, and the credit card tips are not subject to the employee's dominion and control until paid to him/her by the employer. So isn't the right theoretical (i.e., putting aside how you accomplish this in plan administration/payroll) answer that the employee should be able to defer whatever stated percentage he or she elects of Box 1 W-2, subject to reduction if that amount is less than the amount actually paid to him or her physically by the employer? 

You are seeing the tax-law issue.  The IRS’s view was that a cash-or-deferred election can apply only regarding compensation not yet “currently available” to the employee.  And the IRS viewed the cash tips as, if not actually or constructively received, at least available.

So a waiter gets a paycheck for wages of $800 plus two crisp $100 bills.  Total taxable income = $1,000.  They elect 10%.  You're saying that their 401k can only be $80, and not $100?

But if on the other hand, the waiter gets $800 and an allocation of tips for $200, and their gross paycheck is $1,000, their 10% contribution would be $100.  Is that right?

And where would one read about all of this stuff?  I could not anything specifically on point.  But as I drive through, well, everywhere, there are a lot of restaurants out there (hence this must come up literally all the time).

Consider that a tipped employee’s compensation might comprise three elements:

(1)   a base wage, which might be as little as $2.13 per hour;

(2)   credit-card tips, which might be adjusted by a portion of credit-card processing fees; and

(3)   tips paid in currency.

Recognizing practical difficulties, a plan’s administrator might design its communications and forms to explain exactly which portion of compensation a 401(k) election operates on.

It won’t be total compensation because that amount will be an unknown when the 401(k) election must be made (and might remain an unknown until W-2 wages is reported).  Further, with some employers and pay practices (and with some deemed currency tips), it might be impractical for a 401(k) election to operate as a percentage of credit-card tips.

Considering the variability in a tipped employee’s compensation, some employers prefer that the 401(k) elections specify a dollar amount, rather than a percentage of any measure of compensation.

I’m unaware of a publication on this point.

7 hours ago, austin3515 said:

So a waiter gets a paycheck for wages of $800 plus two crisp $100 bills.  Total taxable income = $1,000.  They elect 10%.  You're saying that their 401k can only be $80, and not $100?

But if on the other hand, the waiter gets $800 and an allocation of tips for $200, and their gross paycheck is $1,000, their 10% contribution would be $100.  Is that right?

austin3515, personally I think the answer should be the same in both cases. The employer just couldn't fund the contribution by asking the server to pay over one of the $100 bills.

7 hours ago, austin3515 said:

And where would one read about all of this stuff?  I could not anything specifically on point.  But as I drive through, well, everywhere, there are a lot of restaurants out there (hence this must come up literally all the time).

Yeah. Sort of surprising there's no guidance. Might even require leglislation.

Some (most?) IRS pre-approved documents have a kind of "catch-all" paragraph where certain compensation, including tips, may be excluded from salary deferral elections if the employer adopts a uniform policy and does not or may not have the ability to withhold elective deferrals in cash for purposes of transmitting them to the plan. So I think cash tips would fall nicely into this category.

Have you checked your document to see if it contains such a provision? You use FIS docs, right? They have it - or at least their basic DC Cycle 3 doc does. That may solve your problem. The employer can ignore cash tips, and the salary deferral election the employee signs could be a higher amount than they would otherwise elect, to make up for cash tips (whether declared or undeclared, but we won't go there...)

Mine does indieed include that catch-all language, and the question I have submitted to Corbel concerns wheter or not, if I use that exclusion, i have any issues with 414(s).  So that's another question related to this topic!  My plan is going to be a safe harbor match plan.

What do you think about that?  I had said to FIS, so lets suppose somoene contributes 10% from their $1,000 weekly wage, and based on this exclusoin contribute nothing form their $1,000 of tips.  So they are contributing 5% of eligbile pay and getting the full 4% match on $2000 of pay,.  So would that mean I'm OK with 414(s)??

Someoe has to write something about this topic!

Certainly the technicalities can be debated.  But I don't understand - how are they getting a match on the $1,000 of cash tips? How would the employer even know that they had $1,000 in cash tips? Are you assuming that all participants actually report 100% of their cash tips to their employer? That would seem to fly in the face of common practice, at least as far as I understand it...

Assuming for the moment that they do report 100% of cash tips - and cash tips are excluded, there is no dispensation that I'm aware of for 414(s) testing for such an exclusion, so yes, if you EXCLUDED the tips for deferral (and match, for that matter) purposes and the tip amount is known, then it would have to pass 414(s) - IMHO. I'd be very surprised if FIS opines otherwise.

Assuming the employer doesn't know how much the cash tips are, then I don't see how 414(s) testing is even possible.

Be careful what you wish for - any IRS guidance on this could lead to far worse problems...

So this is great new client new 401k and they want to know how to operate this thing and the upshot is no one knows :(.  I'd rather have guidance!

On 4/15/2021 at 2:44 PM, Luke Bailey said:

On 4/15/2021 at 7:04 AM, austin3515 said:

So a waiter gets a paycheck for wages of $800 plus two crisp $100 bills.  Total taxable income = $1,000.  They elect 10%.  You're saying that their 401k can only be $80, and not $100?

But if on the other hand, the waiter gets $800 and an allocation of tips for $200, and their gross paycheck is $1,000, their 10% contribution would be $100.  Is that right?

austin3515, personally I think the answer should be the same in both cases. The employer just couldn't fund the contribution by asking the server to pay over one of the $100 bills.

I agree with you that the answer should be the same for both scenarios.  

Id like to throw in another twist though.  Suppose that the wages portion is closer to a 50/50 split or maybe even less than the tip income.  Also, suppose that the employee pays for health insurance and other optional benefits from the wages portion of the paycheck.  When there are not enough wages to cover benefit premiums and elective deferrals its an even more complicated issue than the math of $80 vs $100.

20 hours ago, RatherBeGolfing said:

Id like to throw in another twist though.  Suppose that the wages portion is closer to a 50/50 split or maybe even less than the tip income.  Also, suppose that the employee pays for health insurance and other optional benefits from the wages portion of the paycheck.  When there are not enough wages to cover benefit premiums and elective deferrals its an even more complicated issue than the math of $80 vs $100.

Good points, RatherBeGolfing. I think bottom line, if there are a lot of tipped employees who (a) want to report all their income, and (b) want to save in their company's 401(k), there needs to be some attention and helpful guidance to this from IRS. The existing does not seem adequate and IRS's preapproved plans group and field agents are perhaps not applying the current law in a completely consistent manner, albeit that what they are doing may be practical.

21 hours ago, RatherBeGolfing said:

I agree with you that the answer should be the same for both scenarios.

Well I would think this would be the most correct answer as well, but someone indicated that you can't contribute 401k from money you already have.  They're processing the funds thorugh payroll on Friday, but they put the money in their pocket last week.  I guess I see the point but if one takes that position, then that waitress working to support her 2 kids is seriously hampered.  I think I'll advocate for her to my client and recommend applying 401k against all taxable income including tips.  Come to think of it my pre-approved document gives me the OPTION of excluding it.  It is not a requirement to exclude it.  I think this solves my problem!!

Regardless of the definition of Compensation selected in the Adoption Agreement, the Administrator may adopt a uniform policy for purposes of determining the amount of a Participant's Elective Deferrals by excluding "non-cash Compensation." For purposes of this Section, "non-cash Compensation" means tips

These situations are so dependent upon facts and circumstances that I think it is difficult for anyone to provide a meaningful opinion that fits across the board.

In the situation you describe, I'm guessing that most waiters/waitresses who are working to support their two kids will not wish to report any more of their cash tips than they have to.  Some exceptions, of course. (A friend of our daughter's took a substantial pay cut when she switched from waitressing to a full-time high school English teaching job.)

Unless your clients and their payroll systems are a heck of a lot better than many of ours, I can forsee administrative angst in trying to properly administer this for all employees. But maybe it'll work out ok with a motivated client who is willing to put in the time and oversight to accurately and consistently handle 401(k) deferrals from cash tips. However you decide to handle it, can you let us know in a year or so how it is working out, and give us any tips (pun intended) on things that work well, and things that don't? Hopefully everything will all work well!

If a) I win the business and b) I remember, you bet 🤣

Sorry, late to this conversation.  You might want to ask the future client or when you win the business the client how they handle and report tip income.   They are required to measure it and report it on their W-2.  So they might be able to measure the tips and take deferral from the wages on a check. 

The following is based on my memory (for what it is worth) of my daughter who put herself through nursing school as a waitress.  She saved some money in the restaurant's 401(k) plan. 

She was required to report tips daily as part of her checkout process.    This included cash paid to her and via credit card tips at the end of the night.   She was actually allowed to defer on her tips at that restaurant.   They took it from her check however not her tips.   I remember this clearly because one time she got a zero check.   Between the 401(k) deferral, and all the tax withholding it took up 100% of her wages.  In fact as we looked at it my daughter and I became convinced they had to cut back the deferral becasue the taxes came first and then the deferral came out.

That would be the other practical issue that would come up if you allow deferring on tips and they are cashed out daily.    What do you do if the deferrals plus withholding exceed the cash wage paid for the week or two week period?  

Not sure if that helps or hurts but I am rather sure their is a restaurant company in the St. Louis area that allows deferrals on tips.  

5 minutes ago, ESOP Guy said:

That would be the other practical issue that would come up if you allow deferring on tips and they are cashed out daily.    What do you do if the deferrals plus withholding exceed the cash wage paid for the week or two week period?  

It would just be a zero check? And that sounds ok since the waiter/waitress is walking out of there with a wad of cash in her pocket, right?  It's not exactly as though they didnt get paid.

32 minutes ago, austin3515 said:

It would just be a zero check?

It happens more than you would think.  It does create an issue when you have benefits like 125/401 and you come up short.  You cant just ignore a health insurance premium.

39 minutes ago, ESOP Guy said:

Not sure if that helps or hurts but I am rather sure their is a restaurant company in the St. Louis area that allows deferrals on tips.  

Here is a workaround I have heard before:

• wages and tips are comp for plan purposes
• deferrals are calculated on wages and tips
• the actual contribution can only come from the wages portion
• if the deferral exceeds available wages in any payperiod, the difference is contributed with the following payroll

55 minutes ago, austin3515 said:

It would just be a zero check? And that sounds ok since the waiter/waitress is walking out of there with a wad of cash in her pocket, right?  It's not exactly as though they didnt get paid.

 Yes, she just got a zero check.   She had gotten her tips every time she closed out her shift she worked.   So she got the tip cash.  As a practical matter for the typical waitress the tips is the game.   My daughter pretty much paid cash for nursing school via her tips.

A § 401(k) deferral measured on the reported wages is feasible if the portion paid by the employer is enough.

Imagine a tipped employee’s workweek is five shifts of six hours each.

Imagine tips in the week is $400 on payment cards and $600 in currency.

Imagine the employer allocates none of the credit or payment processing fees to the server.

The employer-paid wage is ($2.13 x 30) + $400 = $463.90

Imagine the tipped employee reports to the employer $300 from the $600 in currency tips.

Following this, assume the wages the employer will report to tax authorities is $763.90.

Employer-paid wages                         $463.90

FICA taxes                                          -   58.44           7.65%

Federal income tax                              -   88.13           15% (for illustration) of $587.51

State and local income taxes               -   29.38             5% (for illustration) of $587.51

Unemployment taxes                          -   53.47             7% (for illustration)

Health insurance                                 -   75.00           to show RBG’s point

401(k) elective deferral                     -   76.39           10% of reported wages

Net pay                                                $   83.09

While someone who knows hospitality businesses can explain how these overly simplified assumptions depart from reality, the key is that withholding for taxes is based on a wage more than (if there are tips beyond payment-card tips) the employer-paid wages.

The mix of payment-card and currency tips changes over time and by particular work settings.

have I been mistaken all these years in assuming that there is a hierarchy of deductions as follows:

• payroll taxes
• health insurance
• voluntary deductions, like 401(k)

And if the net is insufficent the 401k is just less because you have to the CASH to defer in the arrangement.  Maybe I'm mistaken but I really thought that's how it worked.

10 minutes ago, austin3515 said:

have I been mistaken all these years in assuming that there is a hierarchy of deductions as follows:

• payroll taxes
• health insurance
• voluntary deductions, like 401(k)

That is my understanding as well. 

11 minutes ago, austin3515 said:

And if the net is insufficent the 401k is just less because you have to the CASH to defer in the arrangement.  Maybe I'm mistaken but I really thought that's how it worked.

The reasoning behind making up the difference in a subsequent payroll is that the election and calculation is still valid based on the eligible comp.  In theory ,contributing the remainder of the 1/1/XX 401k contribution on 1/15/XX is ok because 1/15/XX is when the cash is first available to be deferred (for the remainder). It isn't a late deferral issue since it was separated from employer assets as soon as reasonably possible.  It was also contributed before it was received by the participant.

Again, this is how it was described to me, I think at a seminar or session of some sort.  The only restaurant plans I have either collect tips and pay them out with the wages or the establishment does not allow cash tips at all  (members only club where everything is billed to the member at month end).

OK but someone elects 75% of pay and makes $500 a week.  Their health care is $250 a week.  My opinion is a zero check and all is done and all is well.

I mean at some point I think you just have to be practical, and collecting from a next paycheck is maybe just a wee bit impractical. Maybe a better word is imposslbe?

Here an old BL thread ont he subject:

austin3515, what you describe is mainstream:  an employer puts withholding taxes before any other wage reduction or deduction; and within employee benefits, many employers put health before retirement.

My example showed enough employer-paid wages to allow, after withholding taxes, health and retirement reductions.

But a mix with less in payment-card tips and more in currency tips could make a wage reduction for a 401(k) elective deferral impossible (at least from that paycheck), and perhaps impractical (even if an employer would accrue a wage reduction until a paycheck supports it, if that ever happens).  (I suspect you’re right about what seems practical.)

If (whether to pursue your prospective client, or sate your curiosity) you want to learn the real-world practicalities, ask someone who manages payroll for a big restaurant group or for an employer similar to your prospective client.