Tipping service staff in restaurants has been an age-old tradition since the 1800s in this country and even older in Europe. Once upon a time, it was a way for the wealthy to show off. Today, it is a way for an estimated 1,804 million people in the U.S. to make a living.
Tipping doesn’t come without some controversy, though. One question that often comes up is whether tips are taxable. It is essential information whether you work in the service industry, own a restaurant or bar, or just like to go out and eat occasionally.
Are Tips Taxable?
The simple answer is yes. The IRS considered tips wages that you must pay taxes on each year. It gets more complicated from there.
Tips are often done in cash, meaning they are not recorded. However, tips such as tickets or items of value can also be non-cash. So, it is up to the staff to report them. Other forms of tipping, like electronic via a credit card or tip pools, have a paper trail, so calculating taxes on them is more accessible.
What Are Tips?
The IRS defines tips as discretionary payments employees get from customers. They would include the following:
- Non-cash items with a value
- Electronic gratuities via credit, debit, or gift cards
- Monies paid as part of a tip-sharing arrangement such as tip splitting or tip pools
Tips would also include prearranged gratuities, such as what you might pay as part of an all-inclusive vacation package.
What Is Not Considered a Tip?
Tips must be voluntary, so a service charge would not fall into that category. So, for example, if you booked an event at a local restaurant and there was a set 20 percent gratuity on the check, but you had the option to change it, that would be a tip.
If there were an additional charge on the bill for service, that would not be a tip. Service charges are set by the employer and paid to the staff as wages. Therefore, they pay taxes on it the same way they would hourly wage.
Tip Reporting: How to Properly Manage Your Tips
Employees must pay taxes on their tips. That starts with a daily tip record.
Keep a Daily Tip Record
Tip employees such as servers, bartenders, and busers must keep a daily record of all their tips. The IRS provides a form to help manage tip records. Form 4070A is set up to make recording these numbers easy. In addition, it has a line for cash and charge tips. Employees can use any method, though.
Report Tips to Employers
At the end of the month, employees must report their tips to their employer. The tip statement must contain the following:
- The employee signature
- Employee’s name, address, and social security number
- A detailed list of reported tips and a total for that period, typically a month
They only report tips if they add up to more than 20 dollars. Employees must also report tip-outs they might get from other employees. For example, bartenders often get tip-outs from servers that would count toward their tips.
Reporting Tips on the Individual Tax Return
At the end of the year, employees must put both reported and non-reported tips on their individual tax returns. The employer will provide information about reported tips on the employee’s W-2 form and any withholdings from these tips.
The IRS provides form 4137 for non-reported tips. Employees fill out the form and then add the total to the designated line on their return.
Potential Penalties for Failing to Report Tips
If the IRS determines unreported tips, you are subject to additional taxes for them. There will also be a 50 percent penalty charge for the additional social security and Medicare taxes and 20 percent for the added income tax. In addition, you may also have to pay interest on the money due to the IRS.
There are other reasons reporting all your tips matters, though. Underreporting will impact financing, worker’s compensation benefits, unemployment compensation, and social security. These are all based on reported incomes. So if the employee is holding back on tips, their reported income will be lower.
Employer’s Responsibility for Tip Reporting
It is the employer’s responsibility to collect tip information from the tip staff. It is often part of the employer’s computer system. For example, they might have to report their cash tips when they clock out.
Employers then use this information when calculating taxes to withhold from hourly pay. This includes:
- Federal income taxes
- Social security
Employers report these withholdings on their quarterly tax returns. They are also listed on the employee’s W-2 at the end of the year.
If employees fail to report tips, the employer is not liable for social security and Medicare taxes on that money unless given a notice by the IRS. However, if the IRS evaluates the employee’s taxes and finds unreported tips, they will have to pay their share at that time.
Additional Medicare Tax on Tips
Since 2013, employers have been required to withhold an Additional Medicare Tax of 0.9 percent on Medicare wages to employees that make an excess of 200,000 dollars in that calendar year. This tax is only withheld from employees. Employers do not pay the Additional Medicare Tax.
Service charges are not tips. They are wages given to employees and treated as such. An employer withholds taxes from services charges the same way they would when paying an hourly wage.
It is the employer’s responsibility to maintain records that include payment information such as:
- Name of the employee
- Employee’s address
- Employee’s social security number
- Date and amount of the payment
- Taxes withheld
The IRS may ask the employer to show how they distinguish service charges from tips. For example, Point of Sale records may show reports of various transactions. The IRS may also ask for receipts and payroll records to further validate the transactions.
Voluntary Tip Compliance Agreements
The IRS provides voluntary tip compliance agreements in some industries, typically restaurants and casinos. They help enhance tip compliance among employees and employers using education instead of tip examinations.
There are three compliance programs available:
- Tip Reporting Alternative Commitment (TRAC)
- Tip Rate Determination Agreement (TRDA)
- Gaming Industry Tip Compliance Agreement (GITCA)
The TRDA requires the employee to sign a Tipped Employee Participation Agreement. The employer agrees with the IRS on a tip rate for employees. The employee must report tips at or above that rate to stay in the program. The employer must report detailed information, including sales and reported tips the IRS for anyone who doesn’t participate.
Participation in TRAC requires employers to educate their employees regarding tip-reporting responsibilities and to formalize the procedure. As part of the agreement, the IRS bases the employer’s liability for social security and Medicare taxes based only on the employee’s reported and nonreported tips.
The TRAC program makes reporting to the IRS easier. Employers do not have to give detailed information. Instead, it requires them to formalize the reporting process to encourage accurate employee participation.
GITCA is a similar agreement but applies to the casino industry. The casino must provide education and a formal structure for tip reporting to participate. The goal is to encourage accurate reporting from employees.
Filing for Large Food or Beverage Establishments
Employers with large food or beverage establishments must file an annual report with the IRS. Form 8027 covers receipts and reported tips. The IRS defines a large employer as someone who staffs more the ten employees on a typical day.
If the reported tips on the form are less than 8 percent of the gross receipts, the employer must allocate the difference among the tipped employees. In other words, if the reported tips are six percent of the gross receipts, the employer must pay the tipped employees an additional 2 percent to make up the difference. The employers show the allocated tips on the form but do not withhold taxes on those tips.
Tip reporting is a complicated process for both employees and employers. It can be made more accessible with the right restaurant HR software, such as SynergySuite. You can integrate scheduling and payroll into one comprehensive program for easier tip reporting.