Are Tips Unearned Income for Tax Purposes?

Tips, often received by service industry workers, are payments from customers for services rendered. The tax classification of these payments frequently raises questions for individuals navigating their income tax obligations. Understanding how the Internal Revenue Service (IRS) categorizes tips is important for proper tax compliance.

Defining Earned and Unearned Income

The IRS distinguishes between earned and unearned income based on the source of funds. Earned income is compensation from personal services, labor, or active participation in a trade or business. This category includes wages, salaries, and net earnings from self-employment.

Conversely, unearned income originates from sources not requiring active participation or labor. It encompasses returns from investments or passive activities. Examples include interest, dividends, rental income, and certain government benefits like unemployment compensation or Social Security payments.

Classification of Tips

For tax purposes, tips are classified as earned income. They are considered compensation for services performed, a direct result of an individual’s work, similar to wages or salaries.

The form in which tips are received does not alter their classification as earned income. This includes cash, non-cash (such as tickets), and charged tips, even those from tip-splitting or pooling arrangements. Service charges, mandatory fees added by an employer, are treated as non-tip wages and are distinct from tips.

Reporting Tips

Employees who receive tips have specific reporting responsibilities. Maintaining a daily record of tips, using IRS Form 4070A, is advisable. Employees must report all cash tips totaling $20 or more received in a calendar month to their employer by the tenth day of the following month. This report can be made using Form 4070 or a similar written statement.

Non-cash tips are taxable income and must be reported on the individual’s income tax return. Employers include all reported tips in Boxes 1, 5, and 7 of the employee’s Form W-2. Self-employed individuals include tips in their gross income calculation, typically reported on Schedule C. In certain large food or beverage establishments, if reported tips fall below 8% of gross receipts, employers may allocate additional tips to employees, appearing in Box 8 of Form W-2.

Withholding and Tax Obligations

Tips, like other earned income, are subject to federal income tax. They are also subject to Social Security and Medicare taxes, known as FICA taxes. Employers are responsible for withholding these taxes from an employee’s regular wages and reported tip income.

For employees, the Social Security tax rate is 6.2% on earnings up to $176,100 for 2025. The Medicare tax rate is 1.45% on all covered earnings, with an additional 0.9% applying to wages exceeding certain thresholds like $200,000 for single filers. If regular wages are insufficient for tip withholding, employees may need to provide funds or make estimated tax payments. Self-employed individuals pay both employee and employer portions of FICA taxes (self-employment tax) and typically make quarterly estimated tax payments. A 2025-2028 law allows a deduction of up to $25,000 in qualified tips from federal income tax, though these tips remain subject to Social Security and Medicare taxes.