How Do Taxes on Tips Work?
Those in the service industry know that working for tips can be hard work before even thinking about taxes. But when your employer doesn’t control this portion of your pay like they do your wage or salary, understanding how tips are taxed can get confusing quickly.
While tips are different from your hourly wage, they aren’t much different for tax purposes.
Are tips taxable? Yes. And we’ll discuss the details below.
What counts as a tip?
Tips can take many forms. The most common types are credit card, debit card or cash tips left when a customer pays their check. But non-cash gratuities like tickets to sporting events or gift cards are also considered tips.
Anything received that has a value that is:
- Not compulsory
- Not mandatory based upon company policy, or
- Determined by the customer who receives the payment
is considered a tip. Basically, if a customer has a choice to leave money and a choice to decide who to leave the money to, it’s a tip.
Also, any money shared with other employees is a tip. For example, if you are a server who shares some tips with the bartender or the busser, the amount that you share with others is considered a tip to the other person.
And if your employer uses a tip pool, that money distributed indirectly to tipped employees is considered a tip.
Service charges aren't tips
It’s important to point out the difference between a tip and a service charge.
Service charges are mandatory charges set by company policy. This includes things like bottle service charges, room service charges, delivery fees, and large party surcharges. In these cases, the charges are mandated and collected by the business and distributed to the appropriate employees.
Although service charges are considered taxable wages, you won’t have to keep track of it as you do your tips, because your employer will. Your portion of the service charge is included with your hourly wage in Box 1 when your employer provides your IRS Form W-2.
How are tips taxed?
Tips are taxable income to you just like an hourly wage or annual salary would be. They are subject to federal income tax, Social Security tax, and Medicare tax. If you live in a state with an income tax, your tips will also be taxed by your state.
Don’t forget that you’ll need to report all of your tip income on your income tax return. That includes any tips not reported to your employer, including non-cash tips.
If you have unreported tip income, you’ll need to complete Form 4137, Social Security and Medicare Tax on Unreported Tip Income, and attach it to your tax return.
When and how to report tip income
Unlike an hourly wage or salary which is tracked by your employer, you’re responsible for reporting your total tip income to your employer.
You’ll only need to report your tips to your employer if they exceed $20 in a month. But these tips are still taxable income to you and you’ll need to include them on your tax return.
By the 10th of the month, you’ll need to supply the total amount of tips for the previous month. This needs to be submitted in writing and needs to include:
- Employee’s name, address, and Social Security number,
- Employer’s name and address,
- Month or period the report covers, and
- Total amount of tips received during the month or period.
If your employer doesn’t have their own tip reporting form, you can use Form 4070, Employee’s Report of Tips to Employer.
Your employer may require you to report tips more than once a month to line up with their pay period.
If you share your tips with other employees, you can deduct the shared amount from the tips you report because the other employees should report the tips received from you on their tip report. These indirectly tipped employees must report tip income to their employer.
For example, if you earned $200 in tips and give $40 to the bartender and $25 to the busser, the net amount you’ll need to report to your employer is $135 ($200 - $40 - $25). The bartender must include the $40 in his tip report and the busser must include the $25 in his tip report.
Once you report your monthly tips to your employer, they will calculate and withhold income and payroll taxes from your paycheck.
For example, for June you reported tips of $2,500 to your employer and your total hourly wages for June were $500. Your employer will calculate payroll taxes on $3,000 in total earnings and deduct them from the paycheck you’ll receive.
However, if the taxes you owe exceed your paycheck amount, you may need to make estimated payments to the Internal Revenue Service to avoid an underpayment penalty. Use our quarterly tax payments calculator to accurately figure out how much money to send.
What about allocated tips?
If you work at a large food or beverage establishment, you may have tips allocated to you. That’s because the IRS requires that large establishments allocate 8% of their total gross receipts as tip income to employees.
The company will do this calculation at the end of the year and if the amount of tips reported to them from all employees is less than 8% of the company’s gross receipts, the difference must be allocated to employees.
You won’t receive any money or payment from your employer for this allocated tip amount. However, it will show up in Box 8 of your Form W-2 and you must include this amount on your tax return as wages.
Just like with any expenses or tax deductions, the key to tips and taxes is great record keeping during the calendar year. Track how much you receive in tips and how much you share. The IRS has a Form 4070A, Employee's Daily Record of Tips that might help. These records are essential for your tax return preparation and will be a life-saver if you’re ever audited.
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At Keeper Tax, we’re on a mission to help freelancers overcome the complexity of their taxes. That sometimes leads us to generalize tax advice. Please email email@example.com if you have questions.