Figuring out tax implications for employees who receive tips can be complicated. In 2018, there were over 2.6 million waiters and waitresses in the United States. This figure is expected to reach 2.8 million by 2028, which represents a 6 percent increase.
The number of tipped workers is much higher. For example, the above figure does not include bartenders or hairdressers.
Tipped income is what makes servers different from the vast majority of American workers. In many cases, employers give these workers a lower hourly salary because of these tips.
Read on to learn everything you need to know about tips and taxes. Explore complex tax topics such as claiming tips and pooling tips.
What Is the Definition of a Tipped Worker?
Just because an employee makes a few dollars here and there in tips does not make them a tipped worker. In fact, the government sets a monthly threshold.
To be considered a tipped employee, the worker must bring in $30 or more per month in tips. This dollar threshold needs to be met regularly and customarily.
What Are the Reporting Requirements?
Tip reporting is very important for small business owners. For starters, business owners need to prove that they are meeting minimum wage laws at the state and federal level.
Accrued tips are counted as a credit towards meeting the minimum wage. This is what employers can pay waiters or bartenders less than the minimum in hourly earnings.
The federal minimum wage is currently $7.25, with many states requiring a higher amount. The maximum tip credit allowed by the U.S. federal government is $5.12 per hour. This means that a tipped worker must earn at least $2.13 per hour to meet government wage laws.
Employees must keep a daily tip log and report it to their employer. The IRS suggests that employees use Publication 1244 to maintain this daily log.
Any tips in excess of $20 per month need to be reported to an employer. After the month in which the tips are received, this daily log is due on the 10th of the next month.
As the employer, you are responsible for using this data to populate the W-2 form. In addition, the employer is responsible for filling out Forms 940 and 941. These forms report how much of the employee’s earnings are withheld for income tax, Medicare, and Social Security.
What Is Tip Pooling?
Some restaurants shy away from individual tips and instead implement a pooling system. A tip pool is designed to redistribute tips to other important restaurant workers like busboys and hostesses. All the tips are pooled together into a common fund and then evenly distributed amongst the service staff.
Income from a tip pool still needs to be reported to the employer. It is important for employers to research state laws on how to report tip pools. For the federal government, tips earned from a pool only count as a minimum wage credit.
What about Service Charges?
Most people have gone to a restaurant that applies a service charge on top of the bill. The receipt may refer to an 18 percent service charge as gratuity for the staff.
The truth is that service charges are not considered a tip. The staff is not entitled to any proceeds from the service charge and has no legal rights to pursue it. What happens to the service charge is at the sole discretion of the employer.
The IRS is looking to discourage the use of mandatory service charges. If any portion is allocated to the employee, they can no longer use it towards the minimum wage tip credit.
Do Employees Pay Taxes on Tips?
Tips are most certainly taxable income to both the state and the federal government. The W-2 form you provide to the employee includes all tipped income. Your employee uses W-2 data to populate their 1040 individual income tax forms.
The employee also needs to make their contribution to entitlement programs and unemployment insurance. Annual contributions to these accounts are listed on the W-2 form.
These entitlement programs, Medicare and Social Security, are often referred to as FICA taxes. FICA is the Federal Insurance Contributions Act which mandates employee and employer contributions to these programs.
What Are the Employer’s Tax Responsibilities?
Now that all the paperwork is filed, it is time to start planning for taxes. For Social Security, employers need to withhold 6.2 percent of the employee’s gross earnings. This figure includes the money earned from tips. The employee needs to contribute an equal 6.2 percentage share.
The next withholding is for Medicare, sometimes referred to as a hospital insurance tax. Again, the employee and employer contribute an equal 1.45 percent each.
If an employee earns more than $200,000 per year, the employer must withhold an additional 0.9 percent for Medicare. However, this is uncommon in the service industry.
It is also important to note what happens if an employee does not properly report taxes. Without the proper income data, you as an employer cannot be expected to make the correct FICA contributions.
The IRS gives leniency to employers who fall under this situation. You are not liable for FICA contributions until the employee reports the full amount to the IRS.
How Do State Laws Affect Tipped Income?
It is imperative that small business owners consider state laws as well for tax implications. Let’s take New Jersey as a perfect example.
The state minimum wage in New Jersey is currently $11 per hour with plans to increase to $15 over the next few years. The state allows employers to claim a tip credit of $7.87 per hour.
This means the minimum hourly wage for tipped workers is $3.13 per hour. This is slightly higher than the federal wage of $2.13 per hour. To comply with state law, make sure to research all rules and regulations.
A Recap of Tips and Taxes
Dealing with tipped wages is confusing for some. The best way to handle it is to get familiar with federal and state laws on tipped income. This way, you can ensure that proper FICA contributions are being made.
If you need help with tips and taxes, do not hesitate to contact us for additional information.