Whether it’s time to prepare our annual IRS form 8027, (Employers Annual Information Return of Tip Income and Allocated Tips), or not, this document is for you. The IRS 8027 form, and its proper completion (8027 instructions) have several pitfalls and misleading nuances worth investigating, or revisiting annually. Proper application of these details can potentially save the operator thousands of dollars annually, and increase declarations substantially.

As mundane as this all sounds, the underlying details required (yet often overlooked) can potentially save your establishment money, lower your chances of audit, and lower your cost of implementing one of the other tip programs. In either case, these technicalities are a valuable and worthwhile read.

Who Must File?

The IRS states that any “large” food or beverage establishment, or one that operates more than one site, must file an 8027 for each.

The IRS defines “large” establishments as those meeting all the following requirements.

Food of beverage is provided for consumption on the premises.
Tipping is a customary practice.
More than 10 employees, who work more than 80 hours, were normally employed on a “typical” business day during the preceding year.

The third test appears far more complex than it actually is. Simply take total hours worked by the entire staff for an average period (month, quarter, or year) and divide by the number of days in that period. If this average number of daily hours exceeds 80, you must file.

8027 Preparation Error #1:

Receipts with service charges of 10% or more (gratuity) included in Gross Sales.

The most frequent mistake made when completing the 8027 is in calculating “Gross Receipts”. The IRS defines these sales as all receipts (other than nonallocable receipts) from cash sales, charge receipts, charges to a hotel room, and the retail value of complimentary food or beverages. The important exclusion here is “other than nonallocable receipts”. These are elsewhere defined as sales for carryout sales and receipts with a service charge added of 10% or more. In other words, for 8027 purposes, Gross Sales should not include any sales with a gratuity added.

8027 Preparation Error #2:

Receipts containing ‘non-allocable’ receipts included in Gross Sales.

Non-allocable sales are all sales on which “tipping is not customary.” As noted above, these include not only receipts with added gratuity, but also carryout sales, employee sales, and the like. Do not however be tempted to exclude complementary items. While these items are not charged for, the typically result in a tip. Depending on your establishment’s take out food sales, this can be a substantial number. Please see “The hidden costs of Take-out sales.”

8027 Preparation Error #3:

Receipts containing a ‘gratuity’ included in charge receipts.

Calculating charged receipts is complicated when said sales with gratuities are paid for using a credit card. This payment method alone does not necessitate that they are to be included. Charged Receipts (8027 Line #2) shall not to include receipts that include a gratuity (even if paid using a credit card).

8027 Preparation Error #4:

Charged Receipts without a charged tip included in charge receipts.

Charged receipts shall not include those sales where no charged tip was added. The reason behind this is that a patron paying with a credit card who leaves no credit tip will likely leave a cash tip instead, and therefore the IRS requires that these sales be included in cash receipts.

8027 Preparation Error #5:

Charged Receipts with ‘gratuity’ but no tip included in cash receipts.

Charged receipts with no tip are to be included with cash receipts, except when a gratuity is included. Any gratuity (service charge of 10% or more) excludes the entire sale from all 8027 totals as noted in Error #1, even if paid by charge, and should not follow rule #4 simply because there is no charged tip.

8027 Preparation Error #6:

Using payroll paid date to determine calendar year totals.

The IRS makes it clear that when determining receipts and tips, one should use the transaction date and not payroll date when determining calendar year. For this reason, one should not rely on payroll reports exclusively, but adjust start and end periods using actual transaction date data.

IRS 8027 Allocation of Tips:

The allocation of tips is typically required when the overall establishment rate falls below 8%, although one may petition for specific exceptions.

There are two methods for allocating a tip shortfall to employees, both are similar in application, one based on hours worked, the other gross receipts. Employers with fewer than 25 employees may use either method. Larger employers are required to use the gross receipts method. To determine if you are a larger employer, find the average total hours worked for all staff per day. If your total average daily hours exceed 200, you are considered a large employer and must use the gross receipts method.

Gross Receipts Method:

(hours worked method: substitute hours for receipts in (3))

1. Calculate the tips to be allocated to directly tipped employees

Multiply 8% * Gross Sales

Subtract tips declared by indirectly tipped employees

2. Calculate the Tip shortfall to be allocated

Subtract from (1) the total tips declared by directly tipped employees

3. Calculate Employee portion of total receipts

Divide employee receipts by total receipts.

4. Calculate each employee’s tip shortfall

Multiply the result of (1) by each employee’s receipt ratio (3)

Subtract from this result the actual tips declared by that employee

A positive number indicates the shortfall for that employee

5. Calculate the shortfall allocation

Find the result of the employee shortfall divided by total shortfall (2)

Multiply result above by the total shortfall (2).

This is the amount of tips to be allocated to that employee.

IRS 8027 Allocation calculation notes:

Note 1: Do not include Gratuity receipts or gratuities paid in totals.

Note 2: It is worth mentioning that complete declarations of tip-outs to indirectly tipped employees do reduce the potential tip shortfall to be allocated, and in fact full declaration of tips received by indirectly tipped employees may eliminate the need to allocate entirely. Please see article entitled “A case for capturing tip-outs”.

IRS 8027 Rules of the Road:

Tips on Cash Tips:

Remember that the IRS will be focusing on the ratio of your establishments charge tip rate to the cash tip rate. With Gratuity removed, calculate declared tips less charged tips and divide this by the difference between gross sales and charged sales to find the cash tip rate. The ideal cash tip declaration rate is one that the IRS finds agreeable and does not warrant audit initiation. This magic rate appears to be one which results in an overall tip rate is 2% below that of the charged tip rate, as recently defined (7/06) in the new IRS ATIP program. Finally, if you are likely to consider the ATIP program, your required rate for declaration is tied directly to your previous year 8027 charged tip rate. It is in your best interest to ensure that these reported numbers on the 8027 are dead-on accurate – or it could end up costing you thousands.

Tip Reporting by Directly tipped employees:

Employers need also be aware that if your servers reduce cash tip declarations by the amount tipped out to other staff, they are required to record these transactions (IRS 4070A), or you both risk being held accountable for the employment taxes unpaid on these undocumented tip-outs. Please see article entitled “ A case for capturing tip-outs”.

Tip Reporting by Indirectly tipped employees:

Indirectly tipped employees traditionally report tips received from directly tipped employees at a rate far lower than what is actually received, if at all. If servers have reduced their cash tip declarations by these tip-out amounts, and recipients are not declaring these amounts, your establishment could be leaving itself vulnerable to an audit. Conversely, accurate reporting by indirectly tipped employees could significantly improve your overall establishment tip rate. Please see article entitled “ A case for capturing tip-outs”.

Mr. Marshall is the owner of Main Street Gourmet Eatery and Bakery, Main Street Fine Catering, and Main Street Euro-American Bistro and Bar. He is president of GrataSoft Solutions, developer and publisher of Grata Restrateur and Grata Persona; patent pending solutions for implementing, tracking and managing tip policy, including IRS TRAC, TRDA and EmTRAC Tip Program compliance automation for businesses and individuals. For more information, please visit GrataSoft.com.

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