Unreported Tip Income and Additional Taxes

Preparing Form 4137

Dollar Bills and Receipt on Restaurant Table
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Employees who receive tip income are supposed to report tips of over $20 per month to their employer. If you did not report such tips, you are still required to report the tip income to the IRS using Form 4137 (PDF). You use Form 4137 to calculate the Social Security and Medicare Tax on your unreported tips.

You must also file Form 4137 if you have any amount shown on your W-2 statement, box 8, "Allocated Tips." Reporting and paying tax on allocated tips can create a significant tax bill, so I will provide some strategies for dealing with allocated tips below.

The $20 Threshold

You must report tips to your employer if you receive more than $20 in tips per month. These tips must be reported to your employer by the 10th day of the following month. If you work for more than one employer, the $20 limit is calculated for each employer separately. So, for example, one month you earned $19 in tips from one job, and $15 in tips from another job, then you do not need to report your tips to either employer. Also, you do not need to report tips totaling under $20 per month per employer on Form 4137 if that's the only unreported tips you have.

Line by Line Instructions

Names of Employers: List the company, or companies, to whom you did not report tips.

Line 1: Total up all the tips you received in 2016. This includes:

  • tips you reported to your employer,
  • tips received in cash,
  • tips received by credit card,
  • tips you did not report to your employer,
  • tips less than $20 per month that you were not required to report to your employer, and
  • any allocated tips from box 8 of your W-2.

In other words, report the total amount of all tips you received on Line 1.

Line 2: Write in the total tips reported to your employer. This is found in box 7 of your W2.

Line 3: Subtract Line 2 from Line 1. These are the additional tips you must include in your wages on Form 1040 Line 7.

These are also the additional tips on which you need to calculate your Social Security and Medicare taxes.

Line 4: Total up all the cash tips that were less than $20 per month, and so you were not required to report them to your employer.

Line 5: Subtract Line 4 from Line 3. These are the tips subject to Medicare tax. Enter this figure both on Line 5, and again on Line 2 of Schedule U, which is found at the bottom of Form 4137.

Line 6: This line is already filled in with the Social Security wage limit of $118,500. You do not need to do anything here.

Line 7: Add up all your wages reported on your W-2 statements in boxes 3 and 7, and your tier 1 railroad retirement benefits. These are the wages subject to Social Security tax. Put the total figure on Line 7.

Line 8: Subtract Line 7 from Line 6. If the result is a negative number, that means the amount on Line 7 is over $118,500. If that is the case, put "-0-" (zero) on Line 8 and on Line 9.

Line 9: Compare the figures on Line 5 and Line 8. Take the smaller of the two figures, and report it on Line 9. These are the additional tips subject to Social Security tax. Put the same figure again on Line 1 of Schedule U.

Line 10: Multiply Line 9 by 0.062.

This is the Social Security tax of 6.2%.

Line 11: Multiply Line 5 by 0.0145. This is the Medicare tax of 1.45%.

Line 12: Add Lines 10 and 11 together. This is your additional Social Security and Medicare tax. Also enter this figure on Form 1040, Line 59.

Strategies for Allocated Tips

Having allocated tips reported on your W-2 box 8 is generally not in your best interest. Here's how to protect yourself.

Take a look at your record of daily tips. If you don't have a record of daily tips, you need to get in the habit of doing this. Your system doesn't need to be fancy, just keep track of your daily tips on a calendar, day planner, or little notebook. Why do you need to do this?

If you ever get audited on your tip income, you will need evidence of what you actually received in tips.

If you do have a daily tip record, what is the total amount of tips you received for the year? Did you report this amount to your employer? Look on your W-2. Does box 7 (Social Security tips) and box 8 (Allocated tips) add up to the same amount in your daily record? Are your allocated tips (box 8) more than, the same as, or less the total tips you recorded in your daily log?

If your allocated tips are more than what's recorded in your daily log, then you may use your daily log instead of the amount reported as allocated tips. If there are any additional unreported tips, use the amounts from your daily records to fill out Form 4137. Be prepared for lots of mail from the IRS and a tip audit. Keep your daily record of tips with your tax return, so that you are ready when the IRS auditor asks to see your records.

If your allocated tips are the same as what's recorded in your daily log, and you reported your tips to your employer, then it is likely that your employer reported this amount in the wrong place. Ask your employer if this amount should have been reported on box 7 (Social Security tips) instead of box 8 (Allocated tips).

If they don't correct your W-2, then just go ahead and fill out Form 4137 using the figure in box 8.

If your allocated tips are less than what's recorded in your daily log, and you reported your tips to your employer, then it is likely that something is wrong with your employer's recordkeeping system. You can ask your employer to correct your W-2. You should report the allocated tips on Form 4137, plus any additional tips you show in your daily records.

What if you have no records of your tip income? First, read page 5 of Publication 531 Reporting Tip Income (PDF). This explains, in a general way, how your employer calculates the amount of allocated tip income. Second, you should ask your employer specifically how they calculated your allocated tips amount. Ask to see computer records, daily or weekly sales reports, or other information that would show your sales and your tip income. If your employer refuses to share this information with you, then you need to proceed very carefully, and start keeping your own daily records to protect yourself.

What to Expect from the IRS

The IRS loves to conduct tip audits. If you have allocated tips, and choose not to report the full amount of allocated tips on Form 4137, you will be getting a letter from the IRS.

Be prepared to explain how you calculated your tip income, and show your daily tip record as evidence. If your unreported tips are pretty substantial, the IRS may impose a penalty of 50% of the Social Security and Medicare tax (Line 12).