Reporting Tips To The IRS

Tip-earning employees do not have to include service charges when they report tips in their tax refund as these are considered non-tip wages and will be subject to regular Social Security and Medicare taxes.

Compared to the regular wages or salaries that employers use to pay their employees, tips are discretionary or optional payments that employees earn directly from customers. The processes for filing a tax return and reporting federal income tax are different for taxpayers across varying industries, and the nuances can be especially confusing for workers who earn income through tips.

There are certain industries, especially in the United States, where employees of a business earn money through both hourly wages and tip income. For example, in the restaurant industry, food and drink sales are often paired with tipping. Additionally, businesses such as beauty salons, coffee shops, delivery services, taxi services, and valet services often involve tipped employees.

Although it is exciting to leave a work shift with a pile of cash in your pocket, it is important that you keep track of this additional income and report your tips for tax purposes. Because this tip income will not show up on their regular paycheck, these tip workers may find that they need tax help when it is time to file taxes.

Key Takeaways:

Tips are discretionary or optional earnings that tip employees receive directly from customers.
Tips include cash tips earned directly from customers, non-cash tips earned through an electronic payment platform like credit cards, debit cards, or gift cards, non-cash items of value like tickets, or tips provided by other employees due to a tip-sharing arrangement.
Employees who earn tip income are responsible for keeping a daily tip record, reporting tips to their employer, and reporting tip income to the IRS.
Employers who operate large food or beverage establishments must file IRS Form 8027, Employer’s Annual Information Return of Tip Income, and Allocated Tips.
If the total tips reported by all employees in a food or beverage establishment add up to less than 8% of the gross receipts, the employer must allocate the difference to all tipped employees.

What is considered tip income?

Items that are considered tips include:

Cash tips that are given to you directly from customers
Tips provided from customers using an electronic payment platform. This could include credit cards, debit cards, or gift cards.
Non-cash items of value, including event tickets.
Tips received from other employees due to tip sharing arrangements such as tip splitting or a tip pool.

What are Social Security and Medicare Taxes?

Social security and medicare taxes are included in what is known as the Federal Insurance Contributions Act (FICA) and are a type of payroll tax that is withheld from an employee’s paycheck to contribute toward medicare programs and pay social security. When a taxpayer works in an establishment in which they earn an hourly wage as well as tips, they are required to report social security tips to their employer and on their tax return and contribute toward Social Security and Medicare taxes.

Responsibilities of workers who earn tips

If you are an employee who also earns tip income, there are three tasks that you are required to complete in order to be considered within good standing with the IRS:

Keep a daily tip record of all of the tips you earn.

A daily tip record highlights all of the tips you earn across all payment methods. This could include cash tips received from customers, credit card or debit card receipt tips, and tips gathered from other tip-sharing methods that may be utilized in your place of employment.

Do Not Include Service Charges When You Report Tips

When you keep a daily record of your tip income during a typical business day, you do not need to include service charges that are added to a customer’s bill in your reported tip income. Service charges include an automatic gratuity fee for large parties, such as when a group is larger than 6 people. In this example, since the automatic gratuity was not made by the customer free from compulsion, it is not considered a tip, and the employee responsibilities would not require reporting these service charges on their daily tip record. The service charges are considered non-tip wages and will be subject to regular Social Security and Medicare taxes.

All of the following circumstances must be in place for a payment to be considered a tip:
The tip payment was made voluntarily or free from compulsion
The customer was offered the unrestricted right to select the tip rate
The tip rate was not up for negotiation or dictated by the business’s policies
Usually, the customer has the right to determine to who the tips are awarded.

Report all of your tips to your employer, unless your total tip earnings account for less than $20 a month.

According to the Internal Revenue Code, all employees must provide their employer with a written statement of all tip income earned during that shift. Both cash and cashless tips must be reported in this written statement.

There is no particular form that must be used when reporting tip income to your employer, however, the written statement must include the employee’s signature, the employee name, address, and Social Security number, the employer’s name, and address, the month or time block represented by the report, and the total tips reported during this period. The IRS Form 4070 can be used for this written statement.

You may be asking yourself: how frequently do I need to report tips to my employer? All allocated tips must be reported to your employer by the 10th of the month after the tip income is received. For example, if tipped employees earn tips in February, they must report tip income to their employer by March 10th of that same tax year. In the case that the 10th of the month falls on a weekend or legal holiday, employees must provide a statement of their reported tips for the month by the next working day.

It is beneficial for tip employees to acknowledge how frequently their employer requires them to report tips. The employer can require reported tips more than once a month, but the report cannot display reported tip income for a period longer than one calendar month.

Report all of your tips on your individual income tax return.

There are multiple forms that the IRS requires for tip-earning employees when filing their tax returns. Form 4137, Social Security and Medicare Tax on Unreported Tip Income is used to report unreported tip income to the IRS. Form 4137 must be utilized in addition to either their Form 1040, U.S. Individual Income Tax Return, or their 1040-SR, U.S. Tax Return for Seniors.

Employer Filing Responsibilities

Employers who manage “large food or beverage establishments” and oversee employees who earn tip income must submit an annual report to the Internal Revenue Service highlighting the receipts from food and beverage sales as well as the tips reported by the employees. The reporting responsibilities of employers involve filing Form 8027, Employer’s Annual Information Return of Tip Income and Allocated Tips, and this form must be completed for each large food or beverage establishment that the employer operates.

A business is considered a large food or beverage establishment when:

The food or beverage establishment must exist in one of the 50 states or in the District of Columbia
Aside from fast food operations, the food or beverages served are consumed on the premises
It is customary practice for customers to tip employees at this operation
Normally, the employer will have employed at least 10 people on a typical business day

If a large food or beverage establishment contains all of the preceding qualifications, the employer is responsible for filing Form 8027 to report income, reported tips, and allocated tips.

Allocated Tips From An Employer

If you work at a restaurant and the total tips reported by all employees in the establishment from food and drink sales add up to less than 8% of the gross receipts, one of the employer’s responsibilities is to allocate the difference across all of the tip-earning employees. If you receive allocated tips from your employer during this circumstance, you will not report allocated tips in the same way as you would report regular tips on your federal tax return.

When you receive your Form W-2 form from your employer, allocated tips will be shown separately in Box 8 instead of combined in Box 1 with wages, tips, and other compensation, Box 5 with medicare wages and tax, or Box 7 with Social Security tips.

To report allocated tips directly on your income tax return, you can attach IRS Form 4137, Social Security and Medicare Tax on Unreported Tip Income, to Form 1040, U.S. Individual Income Tax Return, or if you are above the age of 65, to Form 1040-SR, U.S. Tax Return for Seniors. However, if you have adequate records that can prove you earned less in tips during that year than you have reported in allocated tips, you do not need to report allocated tips on your federal income tax return.

Understanding how to file taxes can be confusing for employees, especially when they earn income through both hourly wages and tip income. When the season arises and it is time to report your tips, you may feel more comfortable with the process if you receive help from a licensed tax professional. Tax experts at Ideal Tax are experienced in navigating the Internal Revenue Code and tax laws to help taxpayers manage their tax debt, so contact a representative today to get started. Interested in our fresh start program or tax relief services? Contact us today!