Many employees at restaurants, casinos, nail salons, and hotels depend on tips. While tips sometimes get a reputation for being under-the-table, they are taxable just like wages. Employees have to diligently self-report their tips so employers can withhold the proper amount for taxes from their paychecks or allocate more money if they were under-tipped. All that record keeping can get complicated, so we’ve put together a guide to help you figure out how tips are taxed and your responsibilities as an employer.
What Qualifies as a Tip?
According to the Internal Revenue Service (IRS), any of the following forms of payment are considered a tip:
- Electronic payment made from a credit card, debit card, or gift card
- Noncash tips, like tickets or passes
- Tips awarded from a tip pool, tip splitting, or any other tip sharing method
Further, to classify as a tip, the payments must meet the below criteria:
- The payment is not required;
- The customer is free to determine the payment amount;
- The payment is not subject to negotiation or employer policy; and
- The customer can determine who receives the payment
Automatic service charges or “auto gratuities,” such as an 18 percent service charge for large dining parties, are compulsory and not considered tips. If an employer decides to distribute some of the service charge to employees, the payment is considered a non-tip wage and is subject to withholding.
As tips are self-reported, the brunt of the work falls on employees. That said, employers should make sure its employees know exactly what to do. An employer has four main responsibilities:
- Ensure all employees accurately report their monthly tips and
- Ensure standard taxes (Federal Income, Social Security, Medicare) are withheld;
- Allocate tips to employees when tips are less than eight percent of your total receipts for the pay period
- Make sure the proper breakdown of Social Security wages and taxes is reported in Box 5b of the Form 941
All employee tips should equal eight percent of your total receipts for the pay period, although some businesses have lower requirements. Should employee tips fall short of that eight percent, you must allocate them the difference between the eight percent of gross receipts and their actual reported tip income. To calculate tip allocations, employers might have a good-faith agreement or use the hours worked or gross receipt method. Employers can request a lower rate for tip allocation by submitting a Form 8027 to the IRS.
Employees who receive tips are required to:
- Record the amount of tips they receive every day, independently or using Form 4070-A
- Report their tips to their employer
- Report total monthly tips by the 10th day of each month on a Form 4070
When tax filing season comes, they must also:
- File a Form 4137 for unreported tips *
- File a Form W-2 or Individual Income Tax Return including all earned tips
* If an employee’s monthly tip total is less than $20, they don’t have to report their earnings on a Form 4070, but rather a Form 4137. The Form 4137 records tips that were unreported by the employee or allocated by their employer. It is submitted in addition to a Form 1040 (W-2) and tells employees any additional Social Security and Medicare deductions they need to pay.
Do your employees still have questions about their paychecks? Download our guide, How to Read Employee Paystubs. From earnings to withholdings, we break down what every section of a paycheck means so you’ll have no trouble fielding employee questions on the fly.
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