Section 3121(q) Notice and Demand Procedures

When an employee fails to report tips to the employee’s employer, the employer is not liable for its share of the social security and Medicare taxes on the unreported tips until the IRS makes notice and demand to the employer. See IRC 3121(q).

The employer is liable for the employer’s share of social security and Medicare taxes for tips even though the employees failed to provide the employer with written statements. The additional tax liability may be based upon the employer’s records for the tax year and/or on Form 4137 filed by employees. The additional tax liability is not due until the IRS issues a Section 3121(q) Notice and Demand (even though the tips were paid to employees in prior years).

No specific form is required for a Section 3121(q) Notice and Demand, but the IRS has developed correspondence. The first letter to be issued is Letter 3264 which is sometimes referred to as a "pre-notice letter."

Generally, the IRS will send the taxpayer the pre-notice Letter 3264 at least thirty days prior to issuing the Section 3121(q) Notice and Demand to allow the taxpayer sufficient time to gather the necessary funds for making a timely tax deposit. Examiners must use Letter 3264, to notify the taxpayer of the IRC 3121(q) FICA tax liability.

At the time the pre-notice is issued, the examiner should emphasize to the taxpayer that if a payroll service is used, the taxpayer should immediately notify the payroll service of the IRC 3121(q), FICA tax liability. This is to provide the payroll service provider sufficient time to make the necessary payroll deposit and to help reduce or eliminate any interest or deposit penalties.

It is recommended that examiners issue the Section 3121(q) Notice and Demand within the first 60 days of the quarter to give the taxpayer sufficient time to gather the necessary funds to make the tax deposit and to have sufficient time to notify its payroll service, if there is one, to ensure a timely tax deposit. If the employer reports the IRC 3121(q) FICA tax liability on the line titled "Section 3121(q) Notice and Demand - Tax due on unreported tips" on the Form 941 for the quarter corresponding to the date of the Section 3121(q) Notice and Demand and makes a timely deposit based on the date of the Section 3121(q) Notice and Demand, the tax due on this liability is interest and penalty free.

Generally, at least thirty days after the Pre-Notice letter is sent to the taxpayer, the IRS will send the Letter 3263, Section 3121(q) Notice and Demand. This letter will explain how the employer should report and pay the IRC 3121(q) FICA tax liability to avoid penalties and interest.

The employer must report the IRC 3121(q) FICA tax liability on the Form 941 for the quarter corresponding to the date of the Section 3121(q) Notice and Demand. This Form 941 is referred to as the "reporting Form 941."

If the employer fails to report the IRC 3121(q) FICA tax liability on the reporting Form 941, the examiner will initiate an examination of the reporting Form 941 in order to assess the IRC 3121(q) FICA tax liability. This, in essence, constitutes an unagreed report and the examiner then adheres to normal unagreed procedures and reports. Rev. Rul. 2012-18, provides guidelines for IRC 3121 Notice and Demand procedures.

The examiner must post-date the Section 3121(q) Notice and Demand to account for mailing delays and to provide sufficient time following receipt to allow employers to adjust their deposit amounts accordingly. A Section 3121(q) Notice and Demand should not be issued or dated on a Saturday, Sunday, or federal holiday. Therefore, the date on the Section 3121(q) Notice and Demand should be post dated with the last day of the quarter.