Are Your Tips Taxable in California?

Tips received for services are an important part of income for many individuals. Regardless of the form they take, such as cash or electronic payments, tips are generally considered income by tax authorities.

Federal Tax Treatment of Tips

Tips are fully taxable income for federal income tax purposes. In addition to income tax, tips are also subject to Social Security and Medicare taxes, collectively known as FICA taxes. Both the employee’s share and the employer’s matching share of these taxes apply to reported tip income.

A payment qualifies as a tip if it is made free from compulsion, the customer has the unrestricted right to determine the amount, the payment is not negotiated or dictated by employer policy, and the customer generally has the right to decide who receives the payment. This includes cash tips received directly from customers, tips received through electronic payment methods like credit or debit cards, and amounts received from tip pools or sharing arrangements. However, service charges added to a bill by an employer are generally considered non-tip wages, not tips, and are subject to regular payroll taxes.

Employees are required to report all cash tips received that amount to $20 or more in a calendar month to their employer. Non-cash tips, such as tickets or other items of value, are also taxable income but do not need to be reported to the employer; they must be reported on the employee’s individual income tax return.

California State Income Tax on Tips

California generally aligns with federal rules regarding what constitutes taxable income. Therefore, tips that are considered taxable income for federal purposes are also subject to California state income tax. The state applies its own income tax rates to this income, which are separate from federal income tax rates. California has no specific nuances for tip income taxation; its taxability largely follows federal guidelines.

Reporting Tips as an Employee

Maintaining a daily record of all tips received is an important practice for employees. This record should include the date, the amount of tips received, and the type of tips, such as cash or charged tips. The Internal Revenue Service (IRS) provides Form 4070A, “Employee’s Daily Record of Tips,” which can be used for this purpose, although a personal log or electronic system is also acceptable.

Employees must formally report their total monthly tips to their employer if the amount is $20 or more. This report is due by the 10th day of the month following the month the tips were received. For instance, tips earned in January must be reported to the employer by February 10th. This can be done using IRS Form 4070, “Employee’s Report of Tips to Employer,” or another similar written statement provided by the employer.

Tips properly reported to an employer are included in an employee’s Form W-2, Wage and Tax Statement. Specifically, reported tips appear in Box 1 (Wages, tips, other compensation), Box 5 (Medicare wages and tips), and Box 7 (Social Security tips). All tips, including those not reported to an employer, must be included when filing a personal federal income tax return on Form 1040. If tips were not reported to the employer, or if allocated tips appear in Box 8 of Form W-2, employees may need to use Form 4137, “Social Security and Medicare Tax on Unreported Tip Income,” to calculate the additional Social Security and Medicare taxes owed. Underreporting tips can lead to penalties, including a penalty equal to 50% of the Social Security and Medicare taxes owed on the unreported amounts, in addition to the actual tax liability.

Employer Responsibilities for Tips

Employers have specific tax obligations concerning their employees’ tip income. They are responsible for withholding federal income tax, Social Security tax, and Medicare tax from the wages and reported tip income of their employees. This withholding applies to all tips that employees report to them.

Beyond withholding, employers must also pay their matching share of Social Security and Medicare taxes on all reported tip income. This employer contribution is a direct cost associated with employing tipped workers. Employers report the total wages, tips, and withheld taxes to the IRS on various forms, including Form 941, “Employer’s Quarterly Federal Tax Return,” filed each quarter.

At the end of the year, employers include all reported tip income on each employee’s Form W-2. This ensures that the employee’s total taxable earnings, including tips, are accurately reflected for income tax purposes. Employers in California generally follow these federal reporting and withholding guidelines for state tax purposes as well, ensuring compliance with both federal and state tax laws.