While tips are discretionary and reflect a happy customer, taxes on tips are not optional and, if overlooked, can cause unhappy headaches for both taxpayers and their employers.
All cash and non-cash tips are considered income and are subject to Federal income taxes. Tips include cash left by a customer, tips added to debit or credit card charges, and tips received from other employees or employer through tip sharing, tip pooling or other arrangements.
Employees who receive tips regularly are responsible for keeping a daily tip record and reporting all tips on their individual income tax return. They must report tips that total $20 or more in any month by the 10th of the following month regardless of total wages and tips for the year.
If an employee doesn’t have or isn’t assigned a tip-tracking and reporting tool, the IRS provides a Daily Record of Tips (Form 4070) that an employee may use to document tips in the manner which is considered sufficient proof of tips received. Reliable proof of tip income would include copies of restaurant bills and credit card charges that show the amounts customers added as tips.
Automatic service charges that are often added onto bills are not considered tips, but rather are treated as regular wages so any taxes owed would be withheld by an employer on an employee’s next paycheck. Examples of service charges include things like bottle service charges, gratuity that is automatically added to a bill for large parties, delivery charges, and room service charges.
Employers must withhold income, social security and Medicare taxes on tips just as they would on other income earned by their employee. If tips are not reported to an employer as required, an employee may face a penalty of 50% of the unpaid social security and Medicare taxes due.
If there are any unreported tips, a taxpayer must file a report of the income through another Form 4137 "Social Security and Medicare Tax on Unreported Tip Income" which helps the employee figure the amount that is subject to tax and how much is owed.
It can be a tedious process especially for workers who make money through a predetermined hourly wage with unpredictable tip income added to the total. Workers who receive their tips at the end of each shift must make certain they record the tip amounts on their monthly tip report to their employers. The taxes owed would then be deducted from their next paycheck. It’s possible that hourly wages may not cover the taxes owed. When this happens, any remaining taxes owed can paid out of the next paycheck through an employer agreement. This is the area where most problems occur as tax obligations on tips for one month may impact several paychecks. It’s up to the employee to keep track of required tax payments so that there are no outstanding payroll taxes owed at year’s end.
If you need more help understanding how to record and report tip income, please contact one of our tax preparation experts at McRuer CPAs.