Are Credit Card Tips Taxed? Reporting Rules Explained

Tips, whether received in cash or through electronic methods like credit cards, are a common form of compensation in many service industries. The Internal Revenue Service (IRS) considers all tips as taxable income, meaning they are subject to various federal taxes. This guide explains the reporting requirements and tax obligations associated with credit card tips.

Taxability of Credit Card Tips

Credit card tips are considered taxable income by the IRS, just like cash tips. This means they are subject to federal income tax, Social Security tax, and Medicare tax. Tips are a form of compensation received for services rendered.

There is no distinction in taxability between tips received in cash and those received via credit card. Both forms of tips are treated as income that must be reported. Employees are responsible for paying their share of Social Security and Medicare taxes on these tips.

Employers are generally required to withhold these taxes from an employee’s regular wages or from the tips themselves if sufficient wages are available. This withholding covers the employee’s portion of federal income, Social Security, and Medicare taxes. Reporting all tips accurately is important for employees to ensure proper tax withholding and avoid underpayment.

Employee Reporting Requirements

Employees who receive tips have specific obligations for reporting their income to their employer and the IRS. A central requirement is maintaining a daily record of all tips received, including those from credit cards. IRS Form 4070A, “Employee’s Daily Record of Tips,” can be used for this purpose, allowing employees to track cash tips, credit card tips, and tips paid out to others.

Employees must report their total tips to their employer monthly. This report is due by the 10th day of the month following the month in which the tips were received. For instance, tips earned in August must be reported by September 10th. This reporting threshold applies if an employee receives $20 or more in tips in a calendar month from a single employer.

Employees can use IRS Form 4070, “Employee’s Report of Tips to Employer,” or a similar employer-provided form, provided it includes essential information such as the employee’s name, address, Social Security number, employer’s name, the period covered, and the total tips received. If an employee fails to report all tips to their employer, they may need to use IRS Form 4137, “Social Security and Medicare Tax on Unreported Tip Income,” when filing their annual tax return. This form calculates the Social Security and Medicare taxes owed on any tips not reported to the employer, including certain allocated tips shown on Form W-2.

Failure to report tips can lead to penalties, potentially including a 50% penalty on the Social Security and Medicare tax due on the unreported amounts. Accurate and timely reporting is important for tax compliance and for ensuring that an employee’s Social Security earnings record accurately reflects their total income, which can impact future benefits. Even tips less than $20 in a month, while not required to be reported to the employer, must still be included as income on the employee’s individual tax return.

Employer Responsibilities

Employers have responsibilities concerning credit card tips reported by their employees. Upon receiving tip reports, employers must withhold federal income tax, Social Security tax, and Medicare tax from these reported tips. These withholdings are typically taken from the employee’s regular wages; however, if wages are insufficient, the employee may need to provide funds to cover the tax liability.

Employers are also responsible for paying their own share of Social Security and Medicare taxes on the reported tip income, in addition to their share on regular wages. These employer and employee payroll taxes are reported quarterly using IRS Form 941, “Employer’s Quarterly Federal Tax Return.” Form 941 summarizes total wages, tips, and other compensation, along with the federal income tax, Social Security, and Medicare taxes withheld.

At the end of the year, employers must include all reported tip income on the employee’s Form W-2, Wage and Tax Statement. This ensures that the employee’s total taxable income, including tips, is accurately reflected for their individual tax filing. For large food and beverage establishments, if the total tips reported by employees are less than 8% of the establishment’s gross receipts, the employer may be required to “allocate” the difference among employees. These allocated tips are shown in Box 8 of an employee’s Form W-2, but no income tax, Social Security, or Medicare taxes are withheld on them by the employer.

Distinctions in Tip Handling

While all tips are taxable, the mechanics of handling credit card tips differ from cash tips, and both are distinct from mandatory service charges. Credit card tips are processed through the employer’s payment system, creating an inherent digital record. This makes tracking and reporting these tips generally more straightforward for both employees and employers compared to cash tips, where the burden of meticulous record-keeping falls entirely on the employee.

A distinction exists between voluntary tips and mandatory service charges. Tips are discretionary payments determined by the customer, where the customer has the unrestricted right to decide the amount, or even whether to leave one. Conversely, a service charge is a compulsory fee added to a customer’s bill by the business, such as an automatic gratuity for a large dining party or a banquet event fee.

For tax purposes, mandatory service charges are generally considered wages, not tips. This means they are subject to withholding and payroll taxes in the same manner as regular wages, and the business owns this income before distributing it. Unlike tips, service charges are not reported by employees to the employer as tip income; instead, they are processed directly through the payroll system as non-tip wages.