If you've recently started working in the service industry, you might wonder: Are tips taxable? In short, yes, tips are taxable income according to the IRS.
If you earn tips, you'll have to pay income, Social Security, and Medicare taxes on that money.
You may have a hard enough time working for tips, but if you aren't familiar with the tax rules for tips, it becomes even more difficult.
Learn everything you need to know about tips and taxes.
Are tips taxable?
Yes, tips in the form of cash and non-cash are taxable according to the IRS. Tips are subject to federal income taxes, unless the total amount of all tips is below $20.
When you receive a tip as an employee or employer, you are mandated to pay taxes on this additional income. Tips come in different forms; as a voluntary extra payment from a customer to an employee or an employer, and as charges added to debit card or credit card payments.
Tracking the taxes owed on tips can be complicated, especially for businesses with a large workforce. However, if you are a small-business owner, and work with few employees then keeping track of tip tax gets a little simpler. No matter how large your workforce is, it's important to find efficient ways to keep track of the incoming taxes. If you are the employer, you should request your employees to submit records of their tips earned. If you are an employee who receives tips, then your employer might provide a way to keep track of your earnings. If not, then there are great resources out there for you to use. Below are ways that you can track your expenses
- You can use a Tax Expense Tracker app
- You can use a tip diary, where at the end of each night you write down your amount of tips
- The IRS provides Form 4070A for the purpose of tracking expenses
No matter how you decide to do it, make sure that you are keeping track of your tips in some way. If you earn less than $20 per month in tips, then you don't need to report this income.
What kind of tips are subject to tax?
Usually when we think of tips, we think of cash left on a table for our waiters at a restaurant. There are a lot of different ways an employee can be tipped, and the workers who get tipped are not soley within the food service industry. A customer can give cash tips physically at the point of purchase, give tips through electronic payment channels, or may even give gifts, tickets, and other valuable items. Generally speaking, you won't have to pay taxes for gifts, tickets, or other valuable items unless the gift is worth $10,000 or more.
Do you have to report cash tips to the IRS?
Tip income is taxable. Tipping can include cash left by customers, tips added to debit or credit card charges, tips distributed by your employer, or tips shared by other employees.
You might wonder, who earns tips? The following is a list of professions that commonly earn tips:
- Tattoo artists
- Taxi drivers
- Golf caddies
- Cruise stewards
- Casino dealers
How are tips taxed?
Your employer is required by the IRS to withhold from your wages enough to cover your income, Social Security, and Medicare taxes. However, you are responsible for reporting your tips to your employer.
The amount withheld from your paycheck is determined by the total of your wages and the tip income you report, even if you receive cash tips directly from the customer. Your employer needs to know the number of tips you receive every month, so you should keep an accurate daily record of them.
Tax Responsibility of Employees That Recieve Tips
If you're an employee who receives tax, then you have the same responsibility to pay taxes as everyone else.
It's important to know what you owe, so that you don't get audited for under-reporting income. The IRS is aware that mistakes happen, and you probably won't receive any penalties if you forget to report a few dollars here and there. However, if you've been receiving large amounts of tips and purposely under-report the amount, then the punishment can be severe. Under-reporting, or a total lack of reporting, income is known as Tax Evasion. This is a common type of Tax Fraud. The IRS estimates that millions of dollars don't make it back to the government each year due to tax evasion.
You might think that under-reporting your tips won't make a difference, but the reason millions of dollars go missing each year is due to enough people acting under the mindset that they don't need to report ALL their income.
If you'd like to read more about the consequences of tax fraud and tax evasion, then click the hyperlink to learn more!
Reporting Tips to an Employer
When you have received more than $20 tip in a month, your employer needs to be informed. Ideally, employees are to report tips on the 10th day of each month. Tips received in the month of May should be reported to the employer on the 10th of June.
For reasons best known to the employer, however, employees may be required to report more than once a month or every other month. Despite the pattern an employee chooses, the report must always cover just one month. For extended months, the report must be prepared for each month singly.
Do service charges count as taxable tips?
As we analyze more details regarding the responsibility of employees to record tips, we now look at charges added to customer bills. Charges added to a customer's bill and shared with employees are not recorded as daily tips. Such additional payments are specified by the employer and as such no longer considered tips because the customer is compelled to pay an amount dictated.
As an example, if a business mandates 12% of the total amount spent by a customer as a charge, the extra is not a tip but rather a service charge. If the 12% is however a voluntary addition not specified by the business, then it's a tip that must be recorded.
In reality, service charges, which are automatically added to a customer's bill, are not tips; the IRS considers this as part of their regular wages. Therefore, you're more likely to see them on payday than at the end of each shift. Here are some examples of service charges:
- Bottle service charges.
- Room service charges.
- Delivery charges.
- A gratuity is automatically added for large parties.
What if an employer distributes service charges to employees?
If an employer decides to share service fees among employees it must be regarded as wages. The employer must take note of the details( name, social security and Medicare taxes, amount of payment, and date of payment) of the employee in relation to the amount paid as a service fee. If paid more than $200,000 for a year, additional Medicare tax should be imposed on the employee.
Tax Responsibilities of Employers
An employer has multiple responsibilities which include keeping records and paying taxes on tips employees receive. Remember that employees are to submit reports of tips collected in a month. Employers have the responsibility of keeping this record. More to that is the responsibility of withholding taxes on such tips.
If an employee fails to give an accurate report of tips collected the employer is not required to pay the employee's social security and Medicare taxes on it.
What does an employer get to keep?
Service charges are customary to restaurants, casinos, and a few other establishments. Service charges are not voluntary tips but imposed by the employer, hence an employer can choose to keep it all or distribute it to employees. However, the fees are counted as gross income to the employer either the amount is kept or a part is shared with employees.
How do I report tips to the IRS?
By the 10th of the following month, your employer must report your total monthly tips to the IRS. Any employee who has received tips can use Form 4070 to report them to their employers if their employer does not have a process for reporting tip income. However, you do not need to use that form if the report you submit includes all of the following:
- Your name, address, and Social Security number
- Your signature
- Your employer's name and address
- The month or period the report covers
- The total amount of tips you received during that period
To cover tip withholding, your employer will pass along your figures to the IRS.
How to catch up on unreported tips
If you fail to report your tips during the year and decide to come clean on your tax return, Form 4137 can help. You can report overlooked tips and pay your fair share when you file your taxes. The penalty, however, could be hefty: 50% of the Social Security and Medicare taxes you owe, on top of those taxes.
Form 4137 has a tip for you if that's the case: "You can avoid this penalty if you can show (in a statement attached to your tax return) that your failure to report tips to your employer resulted from reasonable cause and not from willful neglect."
What are the potential penalties for failing to report tips accurately?
A penalty equal to 50% of the Social Security and Medicare taxes you fail to pay can be imposed by the IRS if you fail to report your tips to your employer.
In addition, if you didn't earn enough in wages and tips that your employer paid directly to you to cover your tax withholding, your W-2 will show how much tax you still owe. After you file your tax return, you will have to pay estimated tax penalties if the amount you underpaid is significant.
For help filling out all the right tax forms, you should work with a tax accountant. Whether you have simple or complex tax returns, a professional can handle them all.
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