Tips are discretionary (optional or extra) payments determined by a customer that employees receive from customers.
- Cash tips received directly from customers.
- Tips from customers who leave a tip through electronic settlement or payment. This includes a credit card, debit card, gift card, or any other electronic payment method.
- The value of any noncash tips, such as tickets, or other items of value.
- Tip amounts received from other employees paid out through tip pools or tip splitting, or other formal or informal tip sharing arrangement.
All cash and non-cash tips an employee receives are income and are subject to Federal income taxes. All cash tips received by an employee in any calendar month are subject to social security and Medicare taxes and must be reported to the employer, unless the tips received by the employee during a single calendar month while working for the employer total less than $20. Cash tips include tips received from customers, charged tips (e.g., credit and debit card charges) distributed to the employee by his or her employer, and tips received from other employees under any tip-sharing arrangement.
As an employee who receives tips, you must do three things:
- Keep a daily tip record.
- Report tips to the employer, unless less than $20.
- Report all tips on an individual income tax return.
Keep a daily tip record
Employees must keep a daily record of tips received. You can use Form 4070A, Employee's Daily Record of Tips, included in Publication 1244. In addition to the information asked for on Form 4070A, you also need to keep a record of the date and value of any noncash tips you get, such as tickets, passes, or other items of value. Although you do not report these tips to your employer, you must report them on your tax return.
Report tips to the employer, unless less than $20
The Internal Revenue Code requires employees to report to their employer in a written statement, all cash tips received except for the tips from any month that do not total at least $20. Cash tips include tips received from customers, charged tips (e.g., credit and debit card charges) distributed to the employee by his or her employer, and tips received from other employees under any tip-sharing arrangement. No particular form must be used. The statement must be signed by the employee and must include:
- Employee's name, address, and social security number,
- Employer's name and address (establishment name if different),
- Month or period the report covers, and
- Total of tips received during the month or period.
The employee may use Form 4070, Employee's Report of Tips to Employer, (available only in Pub. 1244, Employee's Daily Record of Tips and Report to Employer), unless some other form is provided by the employer. You can use an electronic system provided by your employer to report your tips.
Both directly and indirectly tipped employees must report tips to the employer.
Report all tips on an individual income tax return
An employee must use Form 4137, Social Security and Medicare Tax on Unreported Tip Income, to report the amount of any unreported tip income to include as additional wages on their Form 1040, U.S. Individual Income Tax Return, and the employee share of social security and Medicare tax owed on those tips.
When to Report Tips to Your Employer
Employees must report tips to the employer by the 10th of the month after the month the tips are received. For example, tips received by an employee in August 2014 are required to be reported by the employee to the employer on or before September 10, 2014. If the 10th falls on a Saturday, Sunday, or legal holiday, an employee may give the report to the employer by the next day that is not a Saturday, Sunday, or legal holiday. An employer may require employees to report tips more than once a month. However, the statement cannot cover a period of more than 1 calendar month.
Do Not Include Service Charges in Your Daily Tip Record
Charges added to a customer's check, such as for large parties, by your employer and distributed to you should not be added to your daily tip record. These additional charges your employer adds to a customer's bill do not constitute tips; they are service charges. These distributed payments are non-tip wages, and are subject to social security tax, Medicare tax, and federal income tax withholding.
An employer's or employee's characterization of a payment as a "tip" is not determinative. Distributed service charges (often referred to as "auto-gratuities" by service industries) should be characterized as non-tip wages. Revenue Ruling 2012-18 reaffirms the factors which are used to determine whether payments constitute tips or service charges. Q&A 1 of Revenue Ruling 2012-18 provides that the absence of any of the following factors creates a doubt as to whether a payment is a tip and indicates that the payment may be a service charge:
- The payment must be made free from compulsion;
- The customer must have the unrestricted right to determine the amount;
- The payment should not be the subject of negotiation or dictated by employer policy; and,
- Generally, the customer has the right to determine who receives the payment.
See example below.
Example: Restaurant's menu specifies that an 18% charge will be added to all bills for parties of 6 or more customers. Dana's bill for food and beverages for her party of 8 includes an amount on the "tip line" equal to 18% of the price for food and beverages and the total includes this amount. Restaurant distributes this amount to the waitresses and bussers. Under these circumstances, Dana did not have the unrestricted right to determine the amount of the payment because it was dictated by employer policy. Dana did not make the payment free from compulsion. The 18% charge is not a tip. Instead, the amount included on the tip line is a service charge dictated by Restaurant.
Reporting Tips Allocated by Your Employer
If the total tips reported by all employees at a large food or beverage establishment are less than 8 percent of the gross receipts (or a lower rate approved by the IRS), the employer must allocate the difference among the employees who receive tips. If your employer allocated tips to you, they are shown separately in Box 8 of your Form W-2. They are not included in Box 1 (Wages, tips, other compensation), Box 5 (Medicare wages and tips), or Box 7 (Social security tips) of your Form W-2, Wage and Tax Statement. Generally, you must report the tips allocated to you by your employer on your income tax return. Attach Form 4137, Social Security and Medicare Tax on Unreported Tip Income, to Form 1040, U.S. Individual Income Tax Return, to report tips allocated by your employer (in Box 8 of Form W-2). Other tips not reported to the employer must also be reported on Form 4137. However, you do not need to report tips allocated to you by your employer on your federal income tax return if you have adequate records to show that you received less tips in the year than the allocated amount.
The employer has multiple obligations with regard to employee tip income, including recordkeeping and reporting responsibilities, collecting taxes on tips, filing certain forms, and paying or depositing taxes.
Employers are required to retain employee tip reports, withhold employee income taxes and the employee share of social security and Medicare taxes based upon wages and tip income received, and then report this information to the IRS. In addition, employers are required to pay the employer share of social security and Medicare taxes based on the total wages paid to tipped employees as well as the reported tip income.
Tips reported to the employer by the employee must be included in Box 1 (Wages, tips, other compensation), Box 5 (Medicare wages and tips), and Box 7 (Social security tips) of the employee's Form W-2, Wage and Tax Statement. Enter the amount of any uncollected social security tax and Medicare tax in Box 12 of Form W-2. For more information, see the General Instructions for Forms W-2 and W-3.
Employers must report income tax and social security and Medicare taxes withheld from their employees' wages and the employer share of social security and Medicare taxes on Form 941, Employer's QUARTERLY Federal Tax Return, and deposit these taxes pursuant to federal tax deposit requirements.
Most employers are also responsible for filing Form 940, Employer's Annual Federal Unemployment (FUTA) Tax Return, and depositing those taxes. Only the employer pays FUTA tax; it is not withheld from the employee's wages.
Employer Share of Social Security and Medicare Taxes on Unreported Tips
If an employee fails to report tips to his or her employer, the employer is not liable for the employer share of social security and Medicare taxes on the unreported tips until notice and demand for the taxes is made to the employer by the IRS. The employer is not liable to withhold and pay the employee share of social security and Medicare taxes on the unreported tips.
For more information on the Section 3121(q) Notice and Demand, see Revenue Ruling 2012-18, which sets forth guidance on social security and Medicare taxes on tips.
Additional Medicare Tax on Tips
Beginning in 2013, a 0.9% Additional Medicare Tax applies to Medicare wages, Railroad Retirement Tax Act (RRTA) compensation, and self-employment income that are more than:
- $125,000 if married filing separately,
- $250,000 if married filing jointly, or
- $200,000 for any other filing status.
An employer is required to withhold Additional Medicare Tax on any Medicare wages or RRTA compensation it pays to an employee in excess of $200,000 in a calendar year without regard to the employee's filing status. An employer is required to begin withholding Additional Medicare Tax in the pay period in which it pays wages or compensation in excess of $200,000 to an employee and continue to withhold it until the end of the calendar year. Additional Medicare Tax is only imposed on the employee. There is no employer share of Additional Medicare Tax. All wages and compensation that are subject to Medicare tax are subject to Additional Medicare Tax withholding if paid in excess of the $200,000 withholding threshold. Tips are subject to Additional Medicare Tax withholding, if, in combination with other wages paid by the employer, they exceed the $200,000 withholding threshold. Similarly, tips are subject to Additional Medicare Tax withholding, if, in combination with other RRTA compensation paid by the employer, they exceed the $200,000 withholding threshold.
For more information, see Topic 560 - Additional Medicare Tax.
Distributed Service Charges
Service charges distributed to employees must be treated as wages to those employees. The employer must keep a record of the name, address, and social security number of the employee, the amount and date of each payment and the amount of income, social security, and Medicare taxes collected with respect to the payment.
In an examination, the IRS may ask the employer to demonstrate how sales subject to service charges are distinguished from sales subject to tipping. Examiners may ask for Point of Sale (POS) records, such as their summary reports regarding their sales transactions. To further validate the employer's procedures, examiners may sample daily receipts and ask the employer to walk through a complete transaction, from the customer's bill, to the POS transaction or sales journal, and trace it to payroll to validate how the distributed service charges were paid out to the employee.
Service Charges Retained by Employer Are Income to the Employer
Service charges are fees imposed upon customers by the employer. Thus, service charges are always income to the employer regardless of whether the employer distributes all or a portion of the service charges to employees. This is distinguished from "tips" which are voluntarily paid by customers to employees. Tips are not gross income to the employer.
An employer may distribute service charges (sometimes referred to as "autogratuities") collected from customers as it chooses and to any employee it chooses. The employer also has the option of retaining all or part of the service charges. Regardless of whether the service charges are distributed to employees, these amounts are gross income to the employer.
Note that the employer may be entitled to a business deduction with regard to the service charges distributed to employees provided all the usual criteria for a business deduction under section 162 of the Internal Revenue Code are met.
Tip Calculations on Customer’s Check are Not Service Charges
Sample tip calculations provided by the business are allowed on the customer’s bill as indicated by Q&A 1 of Revenue Ruling 2012-18. See example below:
Example: Restaurant includes sample calculations of tip amounts beneath the signature line on its charge receipts for food and beverages provided to customers. The actual tip line is left blank. Jackie's charge receipt shows sample tip calculations of 15%, 18% and 20% of the price of food and beverages. Jackie inserts the amount calculated at 15% on the tip line and adds this amount to the price of food and beverages to compute the total. Under these circumstances, Jackie was free to enter any amount on the tip line or leave it blank; thus, Jackie entered the 15% amount free from compulsion. Jackie and Restaurant did not negotiate the amount nor did Restaurant dictate the amount. Jackie generally determined who would get the amount. The amount Jackie entered on the tip line is a tip and not a service charge.
Voluntary Tip Compliance Agreements
Voluntary tip compliance agreements have been established by the IRS for industries where tipping is customary, such as the restaurant industry and casinos. These agreements are designed to enhance tax compliance among tipped employees and their employers through taxpayer education instead of through traditional enforcement actions, such as tip examinations. In addition to helping taxpayers understand and meet their tip reporting responsibilities, these agreements offer many benefits for the employer and the employee.
The Service currently offers employers the opportunity of entering into one of several types of voluntary tip compliance agreements:
TRAC – Tip Reporting Alternative Commitment
TRDA – Tip Rate Determination Agreement
GITCA – Gaming Industry Tip Compliance Agreement
The Market Segment Understandings program has voluntary tip compliance agreements available for industries where tipping is customary.
Treatment of Amounts as Service Charges
Revenue Ruling 2012-18 was effective immediately upon publication and was applicable retroactively. However, under limited facts and circumstances with regard to amounts paid before January 1, 2014 which were improperly characterized as tips when they properly should have been characterized as service charges, Q&A 1 of Revenue Ruling 2012-18 may be applied prospectively under Announcement 2012-50. To the extent that Q&A 1 is applied without retroactive effect, an employer will not be required to pay any additional taxes.
In limited circumstances, some employers that have either a Gaming Industry Tip Compliance Agreement (GITCA) or a Tip Rate Determination Agreement (TRDA) may receive an extension beyond January 1, 2014. The IRS determined that employers participating in the GITCA Program or participating in a TRDA related to gaming may request one additional GITCA or TRDA contract term before the IRS applies Q&A 1 of Revenue Ruling 2012-18. The IRS requires the employers to agree that postponing the treatment of service charges consistent with Revenue Ruling 2012-18 does not make any service charge eligible for the section 45B credit under the Internal Revenue Code or inclusion on Form 8846, Credit for Employer Social Security and Medicare Taxes Paid on Certain Employee Tips.
Employers Who Operate Large Food or Beverage Establishments
File Form 8027
An employer who operates a "large food or beverage establishment" must file Form 8027, Employer’s Annual Information Return of Tip Income and Allocated Tips, to make an annual report to the IRS for their receipts from food and beverages and tips employees reported to the employer. In addition, employers use Form 8027 to determine allocated tips for tipped employees. As an employer, you must file a Form 8027 for each large food or beverage establishment. Thus, many employers are required to file multiple Forms 8027.
A food or beverage operation is a large food or beverage establishment if all of the following apply:
- Food or beverage operation is located in the 50 states or in the District of Columbia.
- Food or beverages are provided for consumption on the premises (other than fast food operations).
- Tipping of food or beverage employees by customers is a customary practice.
- Employer normally employed more than 10 employees on a typical business day during the preceding calendar year. See the Instructions for Form 8027, to determine if you had more than 10 employees on a typical business day.
If the total tips reported by all employees at a large food or beverage establishment are less than 8 percent of the gross receipts (or a lower rate approved by the IRS), the employer must allocate the difference among the employees who receive tips. These "allocated tips" are computed and reported on Form 8027, Employer’s Annual Information Return of Tip Income and Allocated Tips. Employers show allocated tips on the employee's Form W-2, Wage and Tax Statement, in the box titled "Allocated tips." No income tax, social security or Medicare taxes are withheld on allocated tips.