Are Gratuities Taxable in California?

Gratuities, commonly known as tips, are a customary part of transactions in many service industries. Understanding the tax implications of these payments is important for individuals who earn tips. Gratuities are considered income and are subject to taxation, just like regular wages.

Taxability of Gratuities

Gratuities, regardless of their form or how they are received, are considered taxable income by both the Internal Revenue Service (IRS) for federal and the Franchise Tax Board (FTB) for California state income tax purposes. This applies to all amounts received, whether directly from customers or through distribution arrangements.

Cash tips, given directly by customers, are fully taxable. Similarly, charged tips, which are amounts added to credit or debit card payments, are also taxable income. Employers typically process and distribute these electronic tips to employees.

Tips received through pooling or sharing arrangements are taxable income. The final amount an individual takes home, even after redistribution, is subject to taxes. Non-cash tips, such as tickets or other items of value, are also taxable income, though they are not reported to the employer.

There is a difference between voluntary tips and mandatory service charges. Tips are discretionary payments determined by the customer, who has the unrestricted right to determine the amount and recipient. In contrast, service charges are amounts added to a customer’s bill by the establishment, often for large dining parties or specific services. These mandatory charges are considered regular wages, not tips, and are subject to standard payroll withholding rules.

Reporting Gratuities

Employees must report all tips received to their employer. This includes cash tips, charged tips, and any amounts received from tip pooling or sharing arrangements. Reporting is required if total tips from a single employer in a calendar month are $20 or more.

Reporting must be done by the 10th day of the month following the month in which the tips were received. For example, tips earned in January must be reported by February 10th. Employees can use IRS Form 4070, “Employee’s Report of Tips to Employer,” or a similar document provided by their employer.

The report submitted to the employer should include the employee’s name, address, Social Security number, the employer’s name and address, the month or period covered, and the total amount of tips received. Employees should keep a daily record of their tips, using IRS Form 4070A, “Employee’s Daily Record of Tips,” to help ensure accuracy. While non-cash tips are not reported to the employer, their value must be included as income on the employee’s personal tax return. All reported tips are included in the employee’s gross income on their Form W-2, Wage and Tax Statement, and must be accounted for when filing federal and state income tax returns.

Employer Responsibilities Regarding Gratuities

Employers have several obligations concerning the gratuities reported by their employees. Upon receiving an employee’s tip report, the employer must withhold federal income tax, Social Security and Medicare taxes (FICA), and California state income tax from these earnings. These taxes are typically withheld from the employee’s regular wages or other available funds.

Employers must also pay their share of Social Security and Medicare taxes on total reported tip income. This employer portion of FICA tax is part of payroll compliance for businesses with tipped employees. Additionally, employers must ensure employees’ wages, including tips, meet the applicable minimum wage requirements. In California, employers cannot use tips to offset their minimum wage obligation; employees must receive the full minimum wage in addition to any tips they earn.

Accurate record-keeping is a further employer responsibility. Employers must maintain employee tip reports and other relevant payroll records, typically for four years for employment tax records. Large food or beverage establishments, defined by factors such as having more than 10 employees and customary tipping, must file Form 8027, Employer’s Annual Information Return of Tip Income and Allocated Tips. If total tips reported by employees at such an establishment fall below 8% of gross receipts, the employer may be required to allocate the difference among employees.