Article Highlights:
- Tips are taxable and must be included on your tax return
- Tip splitting and cover charges
- Tip reporting to employer
- Employer tip allocation
- Daily log for tip record keeping
If you work in an occupation where tips are part of your total compensation, you need to be aware of several facts relating to your federal income taxes:
- Tips are taxable – Tips are subject to federal income, social security, and Medicare taxes. The value of non-cash tips, such as tickets, passes, or other items of value, is also income and subject to taxation.
- Include tips on your tax return – You must include all cash tips received directly from customers, tips added to credit cards, and your share of any tips received under a tip-splitting arrangement with fellow employees in gross income.
- Tip-splitting and cover charges – Tips given to others under the tip-splitting arrangement are not subject to the reporting requirement by the employee who initially receives them. That employee should only report the net tips received to the employer. Service (cover) charges, which are arbitrarily added by the business establishment, are excluded from the tip reporting requirements. The employer should add each employee’s share of service charges to each employee’s wages.
- Report tips to your employer – If you receive $20 or more in tips in any month, you should report all of your tips to your employer. Your employer is required to withhold federal income, social security, and Medicare taxes. If the tips received are less than $20 in any month, they do not need to be reported to the employer. However, these tips are still taxable and must be reported on your tax return as they are subject to income and social security taxes.
- Employer allocation of tips – Tip allocation is applicable to “large food and beverage establishments” (i.e., food service businesses where tipping is customary and that have 10 or more employees). These establishments must allocate a portion of their gross receipts as tip income to those employees who “underreport.” Underreporting occurs if an employee reports tips that are less than 8% of the employee’s applicable share of the employer’s gross sales. The employer must allocate the difference between what the employee reported and the 8% to those underreported employees. The allocation amount is noted on the employee’s W-2, but it does not have to be reported as additional income if the employee has adequate records to show that the amount is incorrect. Note that these allocated tips are not included in the total wages shown on the employee’s W-2. The IRS frequently issues inquiries where the taxpayer’s W-2 shows an allocation of tips and a lesser amount is reported on the tax return.
- Keep a running daily log of tip income – Tips are a frequently audited item and it is a good practice to keep a daily log of your tips. The IRS provides a log in Publication 1244 that includes an Employee’s Daily Record of Tips and a Report to Employer for recording your tip income.
If you are receiving tips and have any questions about their tax treatment, please give this office a call.