Employers and employees in service industries that involve tipping need to comply with a unique set of tax rules. Just like wages, income tax, Social Security tax and Medicare tax must be paid on tip income. You can share the following guide with your clients and prospects to educate and encourage them to stay compliant with the rules.
In general, tips are discretionary payments made by customers to employees, and can be paid in cash, credit cards, noncash (such as tickets) and through tip pools from other employees (indirect tips). To qualify, the tip must be voluntary, and the amount cannot be negotiated.
On the other hand, service charges are required to be paid by the customer, even if it’s called a tip or gratuity. Examples of service charges include an automatic gratuity for a large dining party, a banquet event fee, a hotel room service charge and a bottle service charge. In general, service charges are reported as non-tip wages paid to the employee, excluding the portion retained by the employer.
Reporting Tip Income
Employees must report all cash tips received to the employer, except total tips under $20 for a given month. Employees need to report tips to the employer by the 10th of the month after the month the tips were received. Noncash tips received from customers are not reported to the employer.
All cash and noncash tips are required to be included in the employee’s gross income and are subject to tax. Direct tips and indirect tips must be reported to the employer; however, you can reduce the amount of reportable tips shared with other employees. For example, if you receive a $150 tip and give the bartender $25, you would only report $125.
- Retain employee tip reports.
- Withhold income taxes and the employee’s share of FICA taxes.
- Pay employer’s share of FICA taxes.
- File Form 941, Employer’s Quarterly Federal Tax Return, along with federal deposits.
- Include tip income on Form W-2, Box 1 (wages, tips and other compensation), Box 5 (Medicare wages and tips) and Box 7 (Social Security tips).
Reporting Service Charges
Service charges distributed to an employee by an employer are treated the same as regular wages. Service charges are not included in the employee’s daily tip record, included on Form W-2, Boxes 1, 3 and 5, and subject to FICA taxes and income tax withholding.
If total tips reported by all employees at a large food or beverage establishment (see below) are less than 8 percent of gross receipts, the employer is required to allocate the difference between 8 percent of gross receipts and the actual tip income among all employees who received tips.
If the employer allocates tips, the following rules apply:
- They are shown separately on Form W-2, Box 8 (Allocated tips).
- They are not included in Boxes, 1, 5 or 7; income tax and FICA are not withheld since the employee didn’t report the amount to the employer.
- The employee includes the allocated tips in income and files Form 4137, Social Security and Medicare Tax on Unreported Tip income.
Large Food or Beverage Establishments
An employer that operates a large food or beverage establishment must file Form 8027, Employer’s Annual Information Return of Tip Income and Allocated Tips. The report includes receipts from food and beverages, tips reported by employees and allocated tips.
An establishment is considered a large food or beverage establishment if all of the following requirements are met:
- The operation is located in the 50 states or Washington, D.C.
- Food or beverages are provided for consumption on the premises, excluding fast food operations.
- Tipping employees for food or beverages by customers is customary.
- The employer normally employed more than 10 employees on a typical business day during the preceding calendar year.
Employer’s Share of Social Security and Medicare taxes on Unreported Tips
If an employee fails to report their tips to the employer, the employer is not liable for the employer’s share of Social Security and Medicare taxes (FICA) on the unreported tips until the IRS notifies and demands the taxes. The employer is not liable to withhold and pay the employee’s share of Social Security and Medicare taxes on any unreported tip income.
Voluntary Tip Compliance Agreements
The IRS has established voluntary tip compliance agreements for industries where tipping is customary, such as restaurants and bars. Among the benefits, the agreements help the employer and employee understand and meet their tax obligations through education, instead of through enforcement and examination actions by the IRS.
As discussed, the rules surrounding the proper reporting of tip income offer a few twists to reporting typical wages. The bottom line is that tip income is taxed just like wages. Be sure your clients in service industries remain compliant with these filing requirements.
For more information, here are two IRS resources:
- Publication 1244, Employee’s Daily Record of Tips and Report to Employer
- Publication 531, Reporting Tip Income