If your employees receive tips, it is important to remember that tip income is taxable. Employees must report all tips they receive, and you must withhold payroll taxes on tips.
Taxes on reported tips
Employees can receive tips directly from customers, from tips charged to credit cards, or from tip pooling agreements.
If an employee receives $20 or more in tips during a month, they must report all their tips to you, including the initial $20. To report their tips, employees can use Form 4070, Employee’s Report of Tips to Employer (found in Publication 1244). Employees must report their monthly tips to you by the tenth day of the next month. They can simply do this by handing you their Form 4070.
Reported tips are subject to taxes. As the employer, you must withhold taxes on tips and regular wages. Use an employee’s reported tips and regular wages to figure out how much to withhold.
Tips are subject to FITW tax (federal income tax withholding), Social Security and Medicare taxes (see FICA tax rates). Reported tips might be subject to state and local income tax withholding.
You must also pay the employer portion of the FICA taxes.
You can withhold taxes (including payroll taxes on tips) from an employee’s regular wages. Because of the tip credit, employees might not have enough wages to cover the taxes. If there are not sufficient wages to withhold all taxes, withhold taxes in the following order:
- Social Security and Medicare taxes on wages
- Federal income taxes on wages
- State and local taxes imposed on wages
- Social Security and Medicare taxes on tips
- Federal income taxes on tips
- State and local income taxes on tips.
In the next pay period, withhold the remaining taxes. Employees can also give you money to cover the taxes they owe on their wages and tips.
You will withhold any unpaid income taxes from employees’ paychecks, up to the end of the year. However, if there are unpaid Social Security or Medicare taxes on tips by the 10th of the month after the month employees reported the tips, you do not have to collect the taxes. Mark the uncollected amount as an adjustment on your Form 941. If you cannot collect all taxes by the end of the year, employees might need to make estimated tax payments. If employees do not pay enough taxes, they might owe penalties.
On the W-2 Form for employees, include employee wages and reported tips in box 1. Also, show any uncollected taxes.
Taxes on allocated tips
If you run a large food or beverage establishment, you must provide allocated tips to employees if the total amount of tips during a payroll period are less than 8% of your business’s gross receipts for that same period.
You run a large food or beverage establishment if:
- Your business is located in the 50 states or the District of Columbia.
- Tipping by customers is customary.
- You employed more than 10 employees on a typical business day during the previous year.
Allocated tips are not subject to tax withholding. You will not withhold taxes nor make tax contributions on allocated tips. You must report allocated tips in box 8 on each employee’s Form W-2.
Employees should use Form 4137 to calculate the Social Security and Medicare taxes owed on their allocated tips.
Taxes on service charges
Service charges added to a customer’s bill are considered non-tip wages. Service charges can include bottle service charges, large party charges, and delivery charges. These non-tip wages are not reported with tip wages; however, they are still subject to income taxes and FICA.
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This article has been updated from its original publication date of September 17, 2015.This is not intended as legal advice; for more information, please click here.