How Tips are Taxed

Many times in the service industry, customers can offer a tip to the person providing the service. Even though tips are different from wages, employers still need to know how to withhold taxes and report on them.

Classifying a Tipped Employee

While the federal minimum wage is $7.25 per hour, tipped employees often fall into a different category. The Department of Labor classifies a tipped employee as someone who makes more than $30 per month in tips while performing their job. In addition to tips, an employer is required to pay $2.13 per hour in wages if the employee meets the tip classification. However, if the employee's tips plus their wages do not equal the federal minimum wage, the employer is required to make up the difference so that the employee makes the federal minimum wage rate of $7.25 per hour.

Classifying a Tip

A tip is a form of payment an employee may receive for performing a service. In the service industry, customers are often expected to tip the employee providing the service. Tips are also known as gratuity since the customer is showing their appreciation for excellent service.

In some industries, it may be necessary for a business to implement a service charge. A customer may view a service charge as a tip to the employee; however, employers and employees must manage them as wages. Service charges alter from gratuity payments because a tip is a voluntary payment from the customer to the employee. In contrast, a service charge is a mandatory payment from the customer to the business. Therefore, employers must treat service charge income as regular gross income. 

Reporting Tips

Even though tips are not viewed as revenue by an employer, employers are still required to report tips to the IRS. If tips are not tracked and reported correctly throughout the pay period, it may become difficult for an employer to accurately report the company's income to the IRS. Many establishments require employees to report tips at the end of the pay period. However, it may be more beneficial to the employer and employee if tips are reported at the end of each day.

In some industries, customers can tip an employee with a credit card, debit card, or phone application. This process makes it much easier for an employer and employee to track and report tips throughout a pay period accurately. Other businesses, like casinos, are majorly tipped in cash since customers are often using cash in the establishment rather than a credit or debit card. Depending on the industry and level of service provided by the employee, tips can quickly accumulate among employees and become cumbersome for everyone to track. Requiring employees to report their total amount of tips at the end of each shift simplifies the business's process.

Once all tips are accurately recorded for each employee, the employer can begin the reporting process. On each paycheck, employers must withhold and report income taxes, Medicare taxes, and social security from the employee's wages and tips. At the end of the year, tips must be recorded on the employees Form W-2 in Box 1, Box 5 and Box 7. Box 1 requires the employer to include all wages, tips, and other compensation paid to the employee throughout the year. Box 5 is used to report the Medicare taxes withheld from the employee's wages and tips. Box 7 requires that the employer report all tips they paid social security taxes on. The Form W-2 instructions will guide an employer through the content in these boxes.

Throughout the year, employers are required to pay the employer share of Medicare taxes and social security based on the employee's income and reported tips. Using Form 941, the Employers Quarterly Federal Tax Return, employers must report the income taxes, Medicare taxes, and social security withheld from the employee's income as well as the employer's Medicare taxes and social security.

Tax Compliance

To enhance tax compliance for businesses with tipped employees, the IRS created the Voluntary Tip Compliance Agreements. These agreements minimize the need and hassle of tip examinations by offering more taxpayer education. The agreements available include the food and beverage industry, the gaming industry, and the cosmetology and barber industry.

PaycheckCity Payroll

The IRS and the U.S. Department of Labor provide comprehensive resources for employers with tipped employees. Employers should check with the IRS for any new Form updates or reporting requirements. While the federal minimum wage for tipped employees is $2.13 per hour, employers should also check their state minimum wage requirements through the U.S. Department of Labor. PaycheckCity provides tools and resources for small businesses, including those in the service industry with tipped employees. Using PaycheckCity Payroll, employers can show paid and unpaid tips on a paystub for easier tracking and reporting. Get started now with a 7-day free trial of PaycheckCity Payroll!