How Tips Affect Taxes

Tip Tax Image

Many businesses like restaurants, hotels and salons employ workers who earn tips as part of their pay. Here are the responsibilities of both the employee and the employer if you have tipped workers.

Cash vs. Noncash Tips

Customers who receive services from staff may choose to leave tips. They could be cash or noncash. Cash tips include those given by clients directly, electronic payments made by employers to employees for tips, and tips given by other employees as part of tip-sharing agreements. In general, employees are required to inform their employers about cash tips.

Items of value other than cash, like tickets, passes and other gifts, are considered noncash tips. Employees are not required to inform employers of non-cash tips.

What Qualifies as a Tip?

Four factors affect whether a payment qualifies as a tip for tax purposes:

  1. The payment is made voluntarily by the customer;
  2. The customer has unrestricted control over the amount;
  3. The payment is not negotiated with or determined by employer policy; and
  4. The customer has the right to choose who will receive the payment

Tips might be given directly or indirectly. A tip is considered “direct” if it is given to an employee directly by a customer, even if it is part of a tip pool. Waiters, bartenders, and hair stylists are examples of employees who receive tips directly. When an employee who ordinarily doesn’t accept tips does, it constitutes an indirect tip. Bussers, service bartenders, cooks, and salon shampooers are among the staff members who receive tips indirectly.

Keeping Track of Tips

Employees who are tipped are required to keep daily records of their monetary tips. They can utilize Form 4070A, Employee’s Daily Record of Tips, to keep track of them. This form is found in IRS Publication 1244.

Additionally, employees should document the dates and sum of any non-cash gratuities. While the IRS does not mandate that employees report non-cash gratuities to their employers, they are still required to do so on their tax returns.

Employees: Reporting Tips to Employers

Employees must report tips to employers by the 10th of the month following the month they were received. The IRS doesn’t mandate that employees use a certain form to report tips. However, a worker’s tip report often has to have the following information:

  • The month or period covered;
  • The total tips collected during the period;
  • The employee’s name, address, Social Security number, and signature;
  • The employer’s name and address.

Less than $20 in tips per month are not required to be reported to employers, but they must be included as income on tax returns for those employees.

Employer requirements

Every employee should receive a Form W-2 from their employer that contains reported tips. Employers must also:

  • Maintain tip reports from their staff.
  • Withhold taxes from employees’ salary and reported tip revenue, including income taxes as well as the employee’s portion of Social Security and Medicare taxes.
  • 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.
  • File Form 941, Employer’s Quarterly Federal Tax Return, with the IRS to report this information;
  • Deposit withheld taxes in compliance with federal tax deposit rules.

“Major” food and beverage companies are required to submit Form 8027, Employer’s Annual Information Return of Tip Income and Allocated Tips, each year that discloses receipts and tips.

Tip Tax Credit

Employers who use tipped personnel to prepare meals and serve beverages may be eligible for a federal tax credit for the Social Security and Medicare taxes they pay on tip income. You might find the tip tax credit to be beneficial. Please don’t hesitate to get in touch with us if you have any questions about how tips affect your taxes.

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