Q&A: Tips and Taxes on Them

Businesses in service industries—such as restaurants, hotels, and salons—often employ workers who earn tips as part of their wages. Here are key tax considerations for employers and employees to help you navigate tip-related tax obligations this year.

What are Tips?

Tips are optional payments that can be either cash or noncash. Cash tips include those received directly from customers, electronically paid tips distributed by employers, and tips from tip-sharing arrangements.

Employees must generally report cash tips to their employers. Noncash tips, such as tickets, passes, or other items of value, don’t need to be reported to employers.

Tip Qualifiers

A payment qualifies as a tip for tax purposes if it meets these four criteria:

• The customer makes the payment voluntarily.

• The customer has full discretion to determine the amount.

• The payment isn’t negotiated or required by employer policy.

• The customer decides who receives the payment.

Direct vs. Indirect Tips

• Direct tips: Received directly from customers, either individually or as part of a tip pool. Directly tipped employees include waitstaff, bartenders, and hairstylists.

• Indirect tips: Received by employees who don’t normally receive tips directly. Examples include bussers, service bartenders, cooks, and salon assistants.

Are Taxes Tax-Free?

No, tips are not tax-free. Tip income is taxable and must be reported to the IRS. This includes cash tips, tips distributed through electronic payments, and tips received from tip-sharing arrangements. Tip income is subject to federal income tax, Social Security tax, and Medicare tax. Noncash tips (like tickets or passes) aren’t subject to these taxes but must still be reported as income.

However, during his campaign, President Trump promised to end taxes on tips. Although no law has been passed to address this, taxpayers should adhere to the exisiting IRS rules.

How Should Employees who Receive Tip Manage their Records?

Tipped employees must keep daily records of their cash tips, which can be done using Form 4070A, found in IRS Publication 1244. Employees should also record the dates and values of noncash tips. While noncash tips don’t need to be reported to employers, they must be reported as income on tax returns. Accurate recordkeeping is essential for tax compliance.

How Should Employees Report Tips to Employers?

Employees must submit a “worker’s tip report” employers by the 10th of the month after the month they were received, using no particular form. Monthly tips that are less than $20 do not have to be reported; however, they must be included as income on the employee’s tax return. A worker’s tip report generally should include the:

• Employee’s name, address, Social Security number and signature,

• Employer’s name and address,

• Month or period covered, and

• Total tips received during the period.

What’s the Tip Tax Credit?

The tip tax credit, officially known as the FICA Tip Credit, allows employers in the food and beverage industry to claim a tax credit for the employer portion of Social Security and Medicare taxes paid on employee tips. This credit applies to tips that exceed the federal minimum wage. It helps businesses reduce their tax liability but doesn’t affect employee wages or taxes.

Other Employer Requirements

Employers are responsible for sending each employee the Form W-2 for employees to report their tips received. In addition to, employers must:

• Keep employees’ tip reports.

• Withhold taxes, including income taxes and the employee’s share of Social Security and Medicare taxes, based on employees’ wages and reported tip income.

• Pay the employer share of Social Security and Medicare taxes based on the total wages paid to tipped employees as well as reported tip income.

• Report this information to the IRS on Form 941, Employer’s Quarterly Federal Tax Return.

• Deposit withheld taxes in accordance with federal tax deposit requirements.

What’s the Tip Tax Credit?

The tip tax credit, officially known as the FICA Tip Credit, allows employers in the food and beverage industry to claim a tax credit for the employer portion of Social Security and Medicare taxes paid on employee tips. This credit applies to tips that exceed the federal minimum wage. It helps businesses reduce their tax liability but doesn’t affect employee wages or taxes.

All in all, running a business with tipped employees goes beyond delivering great service. It demands strict compliance with wage and hour laws, diligent recordkeeping, accurate reporting, and staying informed about evolving regulations. While efforts to eliminate taxes on tips haven’t become law, it’s crucial to remain compliant with current rules. Contact us for tailored guidance for your business.