Tips are a unique income source that employers in the service industry have to consider when setting wages and taxes. Tipping is a two-way transaction. However, you must know how to handle the taxes on tips if you own a business where your employees are regularly tipped.
What Are Employee Tips?
Employ tips are extra payments that customers give to employees who have provided satisfactory service (cleaning services, transportation services, software development services, etc.). In general, customers decide how much tips to leave. However, certain industry standards provide recommendations for how much employees should receive as tips.
A payment is considered a “tip” if it fulfills the following conditions:
- It must be voluntary (not coerced or mandated)
- Customers should have the right to choose how much they want to pay
- An employer shouldn’t dictate or negotiate the payment
- Customers can choose who receives their payments
Does tip income have to be taxed?
If you earn $20 or more in tips in a month, you are subject to Federal Income Taxes and FICA Taxes (Medicare and Social Security taxes). As an employer, you must obtain information about the tips your employee receives so that you can include them on his or her W-2 form.
Remember that higher-income employees are charged an additional Medicare tax on tip income as well. Once an employee’s compensation reaches $200,000, you must begin withholding the additional 0.9% Medicare tax. Federal income tax and FICA also apply to service charges given to employees.
What Is the Process of Collecting and Reporting Tips?
Employees keep all the tips they receive. It is your responsibility to reimburse the employee for tips that are collected on credit or debit cards.
Employers sometimes pool their tips and split the funds among many employees. Most employers usually set their own rules for how these tips are split.
For example, restaurants and other service-based businesses (car wash, stylists, taxi drivers) pool tips. You will receive a report from each employee regarding their portion of the pooled amount. Your employees usually divide the pooled amount according to their own arrangements. Different states have different laws and arrangements for tip pooling.
What is the process for crediting tips on cards to employees?
In situations where tips have been included on a debit or credit card, the tip amount must be given to the employee. If your credit card company charges a transaction fee, you may reduce your tip accordingly. For example, a tip of $5 and a 3% credit card transaction fee means that you can give the employee $4.85.
Tip Credits: How do I take them?
Employers are entitled to take a credit under FLSA (Fair Labor Standards Act) for the difference between the amount they pay employees (minimum $2.13 an hour) and the federal minimum wage (presently $7.25). Employers can take advantage of this credit to pay employees less than the minimum wage while showing their tips as wages.
Employees need the following information before using the tip credit:
- The cash wage the tipped employee is receiving (at least $2.13 an hour)
- The additional tip credit (not exceeding $5.12 an hour) you are claiming
- Your business may not claim a tip credit that exceeds the tip credit received by your tipped employees
- All tips are kept by the employee, with the exception of tips received under a valid tip pooling arrangement, which is limited to employees who receive tips on a customary and regular basis
- Unless tipped employees have been informed of these tip credit provisions, the tip credit will not apply to them.
When you do not provide this information to your employees, you are required to pay them the normal minimum wage and allow them to keep any tips that they receive.
How To Report and Pay Taxes on Employee Tips?
You must first compile employee tip income reports (from employees, card transactions, and any other sources). Also, don’t forget to add the tip income to each employee’s pay stub.
In calculating wages, you must deduct income taxes and FICA taxes from tip income. The employer must also pay their share of FICA taxes on tip income. The reason is that the Social Security and additional Medicare taxes also apply to tip income.
In all payroll tax reports, employee tip income and withholding should be included (Form 940 — the annual unemployment tax report and Form 941 — the quarterly tax report). Additionally, you must make FICA and payroll tax deposits as required. It is necessary to track all tip reports in employee files, in case of an audit.
Should My Employees Report Tip Income to Me?
To comply with the IRS’s income tax requirements, the employee is required to report their tip income to you as the employer.