Restaurant workers typically rely on tips for a majority of their income. But they are not the only ones who rely on tips. In today's economy, service employees earn tips in many different occupations including hotel and casino employees, limo drivers, valet parking attendants, and hair and nail stylists. Although it may be difficult for the Internal Revenue Service (IRS) to figure out exactly how much you earn in cash from your satisfied customers, tip income is taxable. IRS rules require that employees who work for tips report them and pay taxes on them.
Taxation Begins With Recordkeeping
All employees who work in industries where tips make up most of their income must report their earnings to their employers monthly. If you're a bartender, waiter, waitress, bellboy, or other employee who receives tips, you're expected to keep a record of how much you earn in tips each day. This report is due on the 10th day of the month after the month the tips were received. This statement must be signed by you and include:
- your name, address, and Social Security number
- your employer’s name and address
- the month or period the report covers
- the total tips you received—including cash tips, tips paid by credit or debit card, and the value of any noncash tips you receive such as tickets or items of value, and
- the amount of any tips you paid to other employees through tip pooling or splitting, or other arrangements, and the names of the recipients.
No report is required for any month your tips totaled less than $20.
There are various ways to do this recordkeeping and reporting. Many restaurants and other service businesses use electronic tip reporting systems. Such electronic point-of-sale systems make tip recordkeeping easier because the system automatically records tips on credit cards and prompts employees to enter cash tips, tip outs, and tip ins at the end of their shift. However, if your employer uses this type of an electronic system, it must give you a paper copy of its record which you should keep with your tax records. You can also use IRS Form 4070A, Employee's Daily Record of Tips and IRS Form 4070, Employee's Report of Tips to Employer—both are contained in IRS Publication 1244, Employee’s Daily Record of Tips and Report to Employer. Or you can use any other paper or electronic log containing the required information.
Service Charges Are Wages
Some restaurants include a percentage toward tips in customers' bills, such as a mandatory 18% for parties of six or more. These are service charges, not tips, and you don't have to include these in your tip record. However, you do have to pay taxes on the income. Your employer will typically include these payments on your W-2 as wages earned and will withhold taxes on this income from your paycheck.
A payment is a tip, not a service charge, if:
- it is not compulsory
- the customer has the right to determine the amount, or
- the payment is negotiable.
Your Wages May Not Cover Tip Withholding
Tips are considered to be employee wages, thus employers are required to withhold and pay to the IRS payroll taxes on the tips employees report to them each month. This includes income tax, Social Security tax, and Medicare tax. Because, unlike regular wages, tips go directly into the employees’ pockets, employers typically do this withholding by deducting the taxes due for tips from their employees’ regular wages.
However, most tipped employees earn little in the way of regular wages, often no more than the minimum wage (in fact, there is special reduced minimum wage for tipped employees). Thus, their paychecks may not be enough to cover regular withholding plus withholding for reported tips as well. When this happens, withholding carries over to the next pay period. Employees can also elect to make cash payments to their employers to cover the amount of tax due on their tip income.
If you don’t pay enough withholding during the year, you could have a large tax bill due when you file your return and you could also be subject to a penalty for underpayment of estimated taxes. You must report on your tax return the amount of any Social Security and Medicare taxes you failed to pay on your tip income. These uncollected taxes will be shown on your Form W-2 your employer gives you showing your wage and tip income for the year.
Your Employer Can Allocate Tips
Employers who operate large food or beverage establishments must allocate tips to their employees. This requirement applies to employers who provide food or beverages for consumption on their premises, and who normally employ more than ten people who work more than 80 hours on a typical business day.
If your employer allocates tips, it means that, at a minimum, you must pay taxes on tips equaling your share of 8% of your employer's monthly sales. For example, if your employer's total sales for a month amount to $50,000, it must allocate 8% of that to employees, or $4,000 for the month. There are different ways to do such an allocation: If there are 10 employees, your employer might allocate $400 to each. If you reported at least $400 in tips to your employer that month, no additional tips would be allocated to you. However, if you reported only $300, an additional $100 would be allocated to you. If you don’t know how your employer allocates tips, ask about the exact allocation method it uses.
These allocated tips are shown in box 8 of your Form W-2. You must report the allocated tips on your tax return and pay tax on them, unless you have records proving that you earned less. Income, Social Security, and Medicare taxes are not withheld on allocated tips, so you must report these taxes as an additional tax on your return.
Reporting Tips on Your Tax Return
Generally, you must report all tips you received during the year on your tax return, including both cash tips and noncash tips. Any tips you reported to your employer as required are included in the wages shown in box 1 of your Form W-2. Add to the amount in box 1 only the tips you did not report to your employer.
Penalties for Noncompliance
If you do not report tips to your employer as required, the IRS may require you to pay a penalty equal to 50% of the Social Security and Medicare tax you owe on the unreported tips. The penalty is in addition to the taxes you owe.
A Tax Lawyer Can Help
The law requiring payment of income taxes on tips is complicated. Plus, the facts of each case are unique. This article provides a brief, general introduction to the topic. For more detailed, specific information, please contact a tax lawyer.