Arguably the best part about working in the service industry is the tips. Something about tucking away cash—whether earned in the food, hospitality, or a similar industry—is so much more satisfying than the traditional paycheck. When you store cash away on the spot after earning it, the government has no record of the payment amount.
But the IRS still considers income in the form of tips taxable. People who earn tips are obligated to report their income and remit the government’s share to Uncle Sam. Unlike traditional wages, which are subject to automatic withholdings, those who earn tips must calculate and withhold their own taxes. Read on to learn more about the tax process when it comes to tips.
Are Tips Taxable?
The short answer is yes. Tips are subject to Social Security and Medicare taxes, just like base wages. In most cases, if you receive tips from your job, you must report your tip income to your employer in a written statement. Tip income includes:
- Cash or charge received directly from the customer
- The value of any noncash tips, like tickets, for example
- Tips distributed to an employee by an employer, typically through a tip-sharing or tip-pooling arrangement
If the total amount of tips received by an employee in one month is less than $20, they are not required to report it to their employer, and taxes do not need to be withheld.
If you receive tips, you are required to report the amount received each month to your employer. Your employer will then use this information to calculate the amount of Social Security, Medicare, and income taxes to withhold for the pay period, both on tips and wages.
How To Report Tips
The IRS requires tip-receiving employees to inform their employer of all tips made. You must keep a daily record of tips, inform your employer of the tip income in writing, and report all your tips on your income tax return.
Consider using IRS Publication 1244, which contains Forms 4070A and 4070, to keep track of the tips you receive. This way, you will have a record of your tip income to provide to your employer, as well as to the IRS, come tax season.
Reporting to Your Employer
Tips must be reported to your employer in writing by the 10th day of the following month for which you received the funds. So, if you were to receive $500 in tips in October, you would need to report that amount on or before November 10. If the 10th falls on a holiday, Saturday, or Sunday, the employee is required to turn in their tip report by the next applicable day.
While there is no set format for reporting tips, the report must include basic information like your name, Social Security number, address, signature, employer, and, of course, the total amount of tips received.
An employer may require you to report tips more than once a month so long as the statement does not cover a period of more than one month.
Your employer is responsible for calculating and paying the employer’s portion of Social Security and Medicare taxes on your tip income. Employers determine the tax burden based on your tip records, which is another reason why you should take special care to keep an accurate log of your tip earnings.
Reporting to the IRS
When you receive a W-2 statement from an employer, the total amount of tips received for the year should be in box 1. When you file taxes as a tip-receiving employee, you must report all of your tips for the entire year on your Form 1040. To do so, you would add up the amount in box 1, as well as any other tips that you did not report to your employer over the course of the year. If you don't report your tip income to your employer for one month because it was under $20, for example, you are required to report your income to the IRS.
Other unreported tip income includes allocated tips, which are funds an employer assigned to you in addition to the tips you reported. You can report this income using IRS Form 4137. File Form 4137 with your tax return if there is an amount included in box 8, "Allocated Tips," of your W-2 statement.
Your employer is required to allocate tips only in certain cases. These include if you work in a food or beverage business, such as a restaurant; if you regularly receive tips; and if you reported receiving tips to your employer that were less than 8% of the business’s food and drink shares.
The Dangers of Not Reporting Tips
If you do not properly report your tips to the IRS and to your employer, you are at risk of various penalties and fines as a result of a possible IRS audit. The IRS has been known to investigate both individuals and establishments when performing an audit. In the case of the food or hospitality industries, the IRS holds these entities accountable for accurately and honestly calculating and reporting tip income.
If the IRS finds that you have not correctly reported your tip income, they may charge you a penalty equal to 50% of the Social Security, Medicare, and federal income taxes due on those tips.
Failure to accurately report your earnings can also affect your Social Security benefits upon retirement. The Social Security Administration must receive an accurate record of your earnings in order to properly access your benefits. If you have failed to report your taxable income accurately, contact the Social Security Administration to set the record straight.
Advice for Reporting Tips
With the advent of digital payment systems, tracking tip funds is more straightforward than it used to be.
“Nowadays, most of an employee's tips from debit and credit card payments tend to be recorded automatically in a restaurant's point-of-sale system,” Brian Cohen, CPA and tax manager at Zeifmans, told The Balance via email.
When reporting taxes to your employer from pooled tips, you are only required to account for the amount you received. You can disregard the total amount split among employees.
The Bottom Line
Tip earners operate under a form of an honor system, but as tempting as it may be to maximize your take-home pay, it is unwise and illegal to underreport tip income. An audit can open you to an IRS action, including hefty penalties on unreported wages. Further, by not keeping the Social Security Administration informed, you may jeopardize your retirement earnings.
Keep careful records of your tip earnings and be sure to regularly keep your employer informed of this information. This will enable you to properly report your income on your tax return at year-end and will protect you in case of an audit.