The IRS has issued two new Chief Counsel Advices (CCA) that discuss the proper tax treatment of payments made by adult entertainment clubs, restaurants, nightclubs, and other service establishments to taxicab drivers who bring passengers into the establishment [Chief Counsel Advice 201106009; Chief Counsel Advice 201106010].
The facts. The personnel at these establishments do not generally render payment to the driver until the passengers pay a cover charge or otherwise indicate in some manner that they are patrons—for example, by purchasing drinks. Such payments are usually made in cash, although some clubs issue vouchers that can be exchanged for cash at a later time. The amount of the cash or voucher payments sometimes, but not always, bears a relationship to factors such as the meter fare or the number of passengers delivered.
The law. Code Sec. 61(a)(1) provides that gross income includes all income from whatever source derived. Under Reg. §1.61-2(a)(1), tips must be included by recipients in their gross income.
Although tips aren't defined in the Internal Revenue Code or federal regulations, Rev Rul 59-252, 1959-2 CB 215, sets out a number of factors to be used in evaluating whether an amount received in an employment relationship is a tip, the absence of any of which would tend to indicate that the payment may be a service charge:
1. the payment must be made free from compulsion;
2. the customer must have unrestricted right to determine the amount thereof;
3. the payment should not be the subject of negotiation or dictated by employer policy; and
4. generally, the customer must have the right to determine who receives the payment.
Under Code Sec. 6041, information returns (Form 1099, Miscellaneous Income) must be filed by every payor engaged in a trade or business who makes payments aggregating $600 or more in any tax year to a payee in the course of the payor's trade or business. The information returns must be filed with the IRS, and corresponding statements must be sent to each payee.
The clubs are generally not reporting the payments on Form 1099, purportedly on the basis that the drivers should treat the payments as tips received in the course of their employment and should be reporting the payments to the taxicab companies. However, the drivers are not separately reporting the payments to the taxicab companies as tips, so the taxicab companies are not treating the payments as reportable wages on Form W-2. As a result, some drivers are not reporting the payments as income on their personal income tax returns.
The rulings. In Chief Counsel Advice 201106010, the IRS determined as an initial matter that, regardless of the payments' characterization, they are clearly income to the drivers. The IRS then concluded that, under the particular facts in the CCA, the payments are not tips received by the drivers in the course of their employment with the taxicab companies, but are rather payments for the separate and distinct services of referring and delivering patrons to clubs. Therefore, the clubs are required under Code Sec. 6041 to file a Form 1099 with the IRS for each taxicab driver to whom they paid $600 or more during the calendar year. If the clubs fail to do so, they could be subject to penalties under Code Sec. 6721.
In issuing its ruling, the IRS distinguished between the drivers' duties under their regular employment (i.e., to simply deliver a passenger to his requested location), and the transactions at issue — influencing a passenger and delivering him to a specific club in return for a payment. The IRS also found it compelling that the drivers' payments were conditioned upon the passenger becoming a patron of the club and that the drivers sometimes collaborated with hotel personnel. These activities were different than the duties that the drivers ordinarily performed for the taxicab company.
The IRS concluded in Chief Counsel Advice 201106010, that whether the payments are tips for services performed as employees (reported on Form W-2) or payments for separate and distinct services (reported on Form 1099) depends on the specific facts and circumstances. For instance, the IRS noted that if a passenger independently selected an establishment with which the driver had such an arrangement, without any encouragement or persuasion from the driver, this could support characterization of the payment as a tip because the driver merely performed the transportation service that the passenger requested.
Observation: The IRS recently issued guidance that requires its tax examiners to more closely scrutinize these payments (see IRS Memorandum SBSE-04-1210-068).