Do you run a small business in a service industry? Do your employees earn tips? The way you handle tip income is different than how you handle regular wages. There are unique ways to report and withhold taxes on tips. Here is a brief summary of things you should know about tip income.
Ideally, employees will earn enough in tips that their wages will be equal to or more than the minimum wage. If employees do not earn enough in tips to make minimum wage, you must make up the difference.
Be sure to check your state laws as minimum wages and tip credits vary.
Your employees can earn tips directly from customers, from customer credit card charges, or from a tip pooling arrangement. When an employee earns $20 or more in tips during a month, the employee must report the tips to you.
Employees should report their tips on their annual income tax return. Also, you should list reported tips on Form 8027, Employer’s Annual Information Return of Tip Income and Allocated Tips.
Allocated tips are tip amounts you give to your employees in addition to reported tips. You must allocate tips to your employees if, during a payroll period, the total reported tips for all employees are less than 8% of your business’s gross sales.
You can request a rate lower than 8% to calculate allocated tips. You must send a petition to the IRS that includes specific information about your business to explain why you should have a lower rate.
You must report allocated tips on your annual Form 8027. You will also report allocated tips for each employee that received them on their IRS Form W-2.
With a tip pooling arrangement, tipped employees combine part or all of their tips. Then, you evenly divide the pooled tips among the tipped employees. Only employees who regularly receive tips can be in the tip pool.
Even when pooling tips, employees should still earn at least minimum wage when their tips are added to their regular wages.
Tip pooling is different than tipping out. With tipping out, employees give part of their tips to employees who were involved in a customer’s experience. Employees can tip out to employees who do not regularly receive tips.
Taxes on tips
Tip income is subject to taxes. Taxes includes federal, state, and local income taxes; Social Security tax; and Medicare tax.
Use an employee’s reported tips to calculate taxes on tips. If an employee’s wages are not sufficient to withhold all the taxes, withhold the remaining taxes from the next payroll. Employees can also give you money to cover the taxes on tips.
You must report payroll tax withholdings on each employee’s Form W-2. You should also report the withholdings on your quarterly Form 941.
You do not need to withhold payroll taxes from allocated tips.
With Patriot’s online payroll software, you can enter employees’ reported tips. We will calculate the taxes for you. Try it for free.