How to Deal with Tips & Taxes
If you own a business in the service industry (like a restaurant or hair salon), your employees probably make a good bit from tips. Waiters, especially, rely on tips for most of their income.
The IRS expects you to tax your employees’ tips like any other wages paid, so how do you deal with that?
Tips vs. Service Charges – What’s the Difference?
The first step in determining how to tax your employees’ tips is to understand the difference between them and services charges.
A payment made to your employees is a tip, if
- it’s not compulsory;
- the customer has the right to determine the amount;
- the payment is not subject to negotiations or dictates by an employer policy; and
- the customer has the right to determine who receives the payment.
If any of those four factors is missing, however, the additional payment may be a service charge. A service charge could be something like a
- mandatory gratuity on large parties,
- banquet fee,
- hotel service charge, or
- bottle service charge.
Since a service charge is not a tip, your employees won’t report it to you. Instead, you’ll include service charges on your employee’s W-2 as wages earned. You’ll also withhold taxes on them like normal.
How Should My Employees Report Tips?
Your employees must report their tips to you monthly (if they made $20 or more in tips that month). The IRS expects your employees to keep a detailed record of how much tip money they earned every day. Your employees, then, must report that information to you on or before the 10th day of the month following the month the tips were received. So, for example, if one of your employees was tipped $100 in January, they would have to report that to you by February 10.
Your employees must give you a report that includes:
- the employee’s name, address, and social security number;
- their employer’s name and address;
- the month the report covers;
- the total tips received, including cash, tips paid by credit or debit card, and the value of non-cash tips received; and
- the amount of any tips paid to other employees through tip pooling or splitting, with the names of those recipients.
There are a few ways your employees can turn in a tip report to you each month. They can
- complete Form 4070A, Employee’s Daily Record of Tips, and Form 4070, Employee’s Report of Tips to Employer; or
- complete any other paper or electronic log, if it includes the required information.
What if My Employees’ Wages Don’t Cover Tax Withholding?
Since tips are considered wages, you must withhold and pay payroll taxes on them. Because they go directly into your employees’ pockets, you’ll withhold the taxes from their regular wages.
If your employees didn’t make enough in regular wages to cover all their taxes, they can choose to make a cash payment to you to cover the taxes, or you can carry over the withholding to the next pay period. If your employee’s paycheck and cash payment don’t cover their tax withholding, withhold taxes in the following order:
- social security and Medicare taxes on wages,
- federal income tax on wages,
- state and local taxes on wages,
- social security and Medicare taxes on tips,
- federal income tax on tips, and
- state and local taxes on reported tips.
Do I Have to Allocate Tips?
If you operate a large food or beverage establishment, you must allocate tips to your employees. You’re considered a large food or beverage establishment if
- you provide food or beverages for consumption on your premises;
- you normally employ more than 10 people, who work more than 80 hours on a typical business day; and
- tipping by customers is customary.
If your employees received less than 8% of your business’s gross sales in tips for the payroll period, then you must allocate at least 8% of your monthly sales to your employees, . For example, if you had $100,000 in sales for the month, you must allocate $8,000 to your employees.
At the end of the year, you’ll report allocated tip money in Box 8 on your employees’ W-2. You don’t withhold taxes from those tips, so your employees will have to report them on their tax return and pay an additional tax. You’ll also have to report the allocated tips on Form 8027, Employer’s Annual Information Return of Tip Income and Allocated Tips. Your employees will use Form 4137, Social Security and Medicare Tax on Unreported Tip Income, to calculate how much taxes they owe on their allocated tips.