When it comes to restaurant accounting and calculating taxes, tipped income requires special considerations. Any business that employs tipped workers is subject to additional payroll reporting and withholding requirements. Employees are also responsible for keeping track of their tipped income, but underreporting tips is a common issue among tipped workers. We’ll explain the basics of tip reporting so you can prepare your taxes correctly and avoid any potential consequences from the IRS.
What Is a Tip?
First of all, what is considered a tip? A tip is an optional payment given by a customer to an employee. Tips are discretionary, which means that the customer must choose to give a tip. They have the right to choose the amount of the gratuity and the recipient. Any employee who receives more than $20 a month in tipped income must report their earnings.
Are Tips Taxed?
Yes, tips are considered taxable income. Just like hourly wages, tips are subject to Federal income tax. But how do you pay taxes on cash tips? That's where tip reporting comes in. Employees are responsible for reporting all cash tips they have earned so the appropriate taxes can be withheld from their paycheck. Because the amount of taxes paid is based on tips plus wages, paychecks for tipped employees tend to be much smaller than non-tipped employees.
What About Shared Tips?
Tipped employees are only responsible for paying taxes on the tips they take home. If tips have been shared with another employee, those tips become their responsibility to report. In the case of tip pooling, each worker is only responsible for the portion of tips they receive.
Do Employers Have to Pay Taxes on Tips?
Yes, employers must pay a portion of taxes on tipped income, just like they do on regular wages. The Federal Insurance Contributions Act, or FICA, is a tax that employees and employers both pay. This tax funds the Social Security and Medicare programs.
Tip reporting, also called claiming tips or declaring tips, is the method used to make sure taxes are being withheld from tipped employees. Modern POS systems can be set up to perform many of these steps automatically, which makes reporting tips much easier. Keep reading to find out what employers and employees need to know about tip reporting.
As an employee, you are responsible for reporting all tipped income by the 10th day of the month after you receive the tips. Despite the 10th day rule, your employer might require you to report your tips daily to line up with their payroll. The whole process of claiming tips is much easier if you keep a daily record of the gratuity you’ve received. At the end of your shift, you may be able to report your tips directly through the POS system when you cash out. If your employer doesn’t have this software in place, you have to do your reporting the old fashioned way:
- Form 4070A and 4070 - These voluntary forms are issued by the IRS and offer a way to report your tipped income to your employer. If your employer doesn’t provide these forms, they can be found on the IRS website listed under Publication 1244.
- Form 1040 - This form is the individual income tax return that each employee files every year. If you haven’t reported your tips by other means throughout the year, you must report them here.
- Form 4137 - Use this form in conjunction with a 1040 form to report tips and calculate the taxes you owe on your tipped income.
You can also report your tips just using a pen and paper (make a copy for your records). Make sure to include the following information:
- Name, address, social security number, signature
- Date range and total tips earned for that period
- Your employer’s name and address
Even though tipped workers are responsible for reporting their tips, it falls to the employer to use this information for withholding taxes correctly. If the IRS determines that tips have been underreported, you could end up paying FICA taxes (Social Security and Medicare contributions) on that income. It’s in your best interest to encourage your tipped employees to report their tipped income accurately. The best way to do that is to use your POS system to collect tip reports before each employee clocks out for their shift.
These are your responsibilities as an employer when it comes to tip reporting:
- Collect a tip report from each employee for every payroll period, either by using Form 4070A or through POS system reports.
- Make sure Federal income and FICA taxes are withheld from each paycheck.
- File a quarterly report (Form 941) that contains reported tips, employee hours, and hourly rates.
- File an annual report (Form 8027) that summarizes your annual sales and total reported tips.
The purpose of filing an annual report is to determine if all reported tips meet the 8% rule. According to the IRS, the total amount of reported tips from your employees should equal at least 8% of your restaurant's total sales. If you fall below this percentage, it's a sign to the IRS that tips are being underreported. You must then allocate a percentage of tips to your employees on their W2 forms.
What Are Allocated Tips?
If tips have been underreported for the year, allocated tips are supposed to make up the difference. Tips should make up 8% of your total sales. When they fall below 8%, the difference is divided between all your tipped employees and added to their W2 forms as allocated tips. As the employer, you do not pay taxes on this amount. The employee must add this amount to their wages and tips when they file their tax return.
Not Reporting Cash Tips
Underreporting tips occurs when employees fail to declare the total amount of tips they have earned. Cash tips may go underreported because if they aren’t documented, the employee doesn’t get taxed for that income. It’s very tempting to underreport tips to receive a bigger paycheck, but this can become an issue for both employers and employees. There are several great reasons to be honest about tipped wages. Share this information with your tipped employees so they understand the consequences of underreporting.
When an employee underreports their tips, it appears as though their annual income is much lower than it actually is. This can cause several issues that workers may not be aware of:
- Applying for loans - If you’re applying for a mortgage loan or car loan, your total income plays a big part in whether you’ll be approved. With a lower annual income on paper, you won’t be eligible for the same level of financing.
- Renting an apartment - To be considered for an apartment rental, you have to meet the income requirements. When your monthly income appears lower than it is, you have lowered your chances of moving into that cool, new apartment.
- Social Security benefits - Throughout your working life, you pay Social Security taxes so you can collect benefits when you retire. If you fail to report your annual income and pay fewer taxes than you should, that just means you’ll have less Social Security benefits when you retire.
- Unemployment - Unemployment might be far from your mind, but the last few years have shown us that unfortunate events can strike when you least expect them. If you've underreported your income and you need to apply for unemployment, you won't get the maximum benefits.
- Audits - The IRS has methods to detect underreporting and if you are flagged, you could end up being audited. During an audit, all your financial documents are reviewed to determine if your reported earnings are correct.
In the short term, underreporting your cash tips is tempting because it results in a higher paycheck. But misreported earnings affect your life in many other ways, including your ability to buy a car, buy a house, and even retire comfortably.
Handling tipped income can be tricky to get right. Your payroll service or accountant will handle most of these details for you, but it helps to have an understanding of how it all works. It's especially important to educate your tipped employees about reporting tips and why it's necessary.