If Gifts Are Not Income, Why Tax Gratuities?

I don’t often slap a warning label on my own columns, but note the following: If you are a waitress, valet, doorman, barista or otherwise receive gratuities in the course of your work, don’t omit tips from your income tax return just because I think maybe you should.

What I think does not matter nearly as much as what the Internal Revenue Service thinks, and the IRS position is crystal clear: Tips are taxable income.

Let’s ask why.

The basic rule comes from Section 61 of the Internal Revenue Code, which announces that “gross income” (which is the starting point for calculating income taxes) means “income from whatever source derived,” specifically including compensation for services. To the IRS, it couldn’t get much clearer than that. Since we tip the people who serve us, those tips must be compensation for services and therefore taxable.

On the other hand, if I buy my daughter a motorcycle as a graduation present, she does not have to report the motorcycle’s value on an income tax return. This is a gift, and gifts are not subject to income tax. (There is a gift tax, but that’s something entirely different; when it is applicable, the person making the gift, rather than the one receiving it, pays the tax.)

Section 102 of the tax code instructs us that “Gross income does not include the value of property acquired by gift, bequest, devise or inheritance.” It helpfully clarifies that this exception to the income tax does not apply to “any amount transferred by or for an employer to, or for the benefit of, an employee.” So the annual bonus I pay an employee is taxable to that employee, regardless of whether he truly earned it or if I am just feeling generous.

Now let’s apply these general rules to a typical situation involving a gratuity. I go to a diner, sit down and ask the waitress to bring me a cup of coffee and a big slice of chocolate cream pie. (This is my example, so I see no reason why I can’t enjoy it. It won’t hurt my diet.) She does. If the check is for $6 and I leave a couple of bucks on the table, the IRS says the waitress has to pay tax. Clearly, I am not her employer, so this money is not being paid “by” the employer. So am I paying it “for” the employer?

The employer probably pays the waitress a very small wage, which is allowed under many minimum wage laws because she has a job that typically generates tips. The IRS might therefore argue that my tip is paid “for” the employer. But I am under no compulsion to leave the waitress anything. The employer, on the other hand, is obliged to pay for the services his workers render. So I don’t think the exception under Section 102 applies. If the tip is taxable income to the waitress, it is only under the general principle of Section 61.

Now suppose that, instead of leaving the typical couple of bucks, I choose to hand the waitress a $100 bill. Maybe I just scored a big business success and want to share it. Maybe I know from conversation that she is a single mother, and I figure the money means a lot more to her than it does to me. Maybe I just want to impress her with what a big shot I am. Should my motivation, noble or otherwise, be a factor in the waitress’ obligations to the U.S. Treasury? Clearly, the amount I am paying bears no rational relationship to the service that she rendered. In fairness, many would contend that the amount some CEOs are paid bears no rational relationship to the value of their services, either. CEO compensation is always taxable (Section 102 again), regardless of its merits.

But is my $100 tip to the waitress really payment for services, or is it a gift? If a $100 gratuity is a tax-free gift, why is a $2, or $5, or $10 gratuity taxable?

Let’s change one more fact in our example: I give a $100 tip to the waitress, and the waitress happens to be my daughter. If I give her the $100 bill at home, it’s clearly a nontaxable gift. Yet if I give her the $100 at her place of employment, the IRS says she owes income tax on it. Why does the venue make a difference?

Defenders of the IRS position would say it comes back to Section 61. The waitress provided a service for me, and I paid for it. Compensation for services is taxable. End of story.

So, if I don’t tip the waitress, does she take back my pie? It’s too late for that. Does she refuse to serve me next time I come to the diner? That’s not likely, either. Maybe I won’t get her friendliest smile, but I’m not paying for someone to smile at me.

In fact, this column was inspired by a New York Times article that ran last week, arguing that generous tipping “is a technique that is guaranteed to have no effect on your service.” Then why does the person being tipped pay tax?

It could seem unfair to let workers who receive tips legally avoid tax on a significant part of their income, while other workers must pay tax on everything they take home. By similar logic, a daughter lucky enough to have a father who hands her a $100 bill is unfairly advantaged over one who has to earn that $100 at a job.

Perhaps more persuasively, I can point out that from the government’s point of view, there is a big difference between money the diner owner pays the waitress and money customers pay her. Wages the diner owner pays are deductible business expenses (“ordinary and necessary,” to use the tax code’s language), while tips customers leave are, in most cases, non-deductible. So if I pay the diner $6 for my pie and coffee, and the diner owner pays the waitress $2 for serving me, the government collects tax on the owner’s profit of $4 (less the cost of the food) and on the waitress’s $2. If I leave another $2 on the table, the diner owner does not deduct it. Neither do I; I am not the waitress’ employer.

The IRS would observe that I am not allowed to deduct any of my diner expense if this is a personal, non-business meal. The fact that I don’t deduct a tip to the waitress does not mean it isn’t income to her. I don’t deduct the amount I pay my lawn guy for cutting my grass, either. This is a fair point. But if I don’t pay my lawn guy, he doesn’t cut my grass. If I don’t tip the waitress, she still brings me my coffee.

I would have expected someone, at some point, to have tested this question in litigation with the IRS. Maybe somebody has, but I did not readily find any such cases. What I did find, however, is that the Treasury has specified any argument that “Wages, tips and other compensation received for the performance of personal services” are not taxable as being among “frivolous” positions that carry a $5,000 penalty under the tax code’s Section 6702.

An argument that tips, in some or all cases, are not “compensation received for the performance of personal services” still might work. But if it did not, I would expect the IRS to assert this penalty. This is why I put a warning label at the top of this column. I don’t want some unsuspecting server to get drawn into a fight he or she can’t afford to lose.

But there might be something telling in the lack of case law on this subject. The question of why someone leaves a tip, and whether it really represents payment for services rendered, might be one that the IRS would prefer not to test too thoroughly. The Treasury might stand to lose a lot more than just one big tip.

About Larry M. Elkin 553 Articles

Affiliation: Palisades Hudson Financial Group

Larry M. Elkin, CPA, CFP®, has provided personal financial and tax counseling to a sophisticated client base since 1986. After six years with Arthur Andersen, where he was a senior manager for personal financial planning and family wealth planning, he founded his own firm in Hastings on Hudson, New York in 1992. That firm grew steadily and became the Palisades Hudson organization, which moved to Scarsdale, New York in 2002. The firm expanded to Fort Lauderdale, Florida, in 2005, and to Atlanta, Georgia, in 2008.

Larry received his B.A. in journalism from the University of Montana in 1978, and his M.B.A. in accounting from New York University in 1986. Larry was a reporter and editor for The Associated Press from 1978 to 1986. He covered government, business and legal affairs for the wire service, with assignments in Helena, Montana; Albany, New York; Washington, D.C.; and New York City’s federal courts in Brooklyn and Manhattan.

Larry established the organization’s investment advisory business, which now manages more than $800 million, in 1997. As president of Palisades Hudson, Larry maintains individual professional relationships with many of the firm’s clients, who reside in more than 25 states from Maine to California as well as in several foreign countries. He is the author of Financial Self-Defense for Unmarried Couples (Currency Doubleday, 1995), which was the first comprehensive financial planning guide for unmarried couples. He also is the editor and publisher of Sentinel, a quarterly newsletter on personal financial planning.

Larry has written many Sentinel articles, including several that anticipated future events. In “The Economic Case Against Tobacco Stocks” (February 1995), he forecast that litigation losses would eventually undermine cigarette manufacturers’ financial position. He concluded in “Is This the Beginning Of The End?” (May 1998) that there was a better-than-even chance that estate taxes would be repealed by 2010, three years before Congress enacted legislation to repeal the tax in 2010. In “IRS Takes A Shot At Split-Dollar Life” (June 1996), Larry predicted that the IRS would be able to treat split dollar arrangements as below-market loans, which came to pass with new rules issued by the Service in 2001 and 2002.

More recently, Larry has addressed the causes and consequences of the “Panic of 2008″ in his Sentinel articles. In “Have We Learned Our Lending Lesson At Last” (October 2007) and “Mortgage Lending Lessons Remain Unlearned” (October 2008), Larry questioned whether or not America has learned any lessons from the savings and loan crisis of the 1980s. In addition, he offered some practical changes that should have been made to amend the situation. In “Take Advantage Of The Panic Of 2008” (January 2009), Larry offered ways to capitalize on the wealth of opportunity that the panic presented.

Larry served as president of the Estate Planning Council of New York City, Inc., in 2005-2006. In 2009 the Council presented Larry with its first-ever Lifetime Achievement Award, citing his service to the organization and “his tireless efforts in promoting our industry by word and by personal example as a consummate estate planning professional.” He is regularly interviewed by national and regional publications, and has made nearly 100 radio and television appearances.

Visit: Palisades Hudson

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