Do Tips Get Taxed? How Tip Income Is Taxed

Tips received from customers are a form of income and are subject to federal taxation. The Internal Revenue Service (IRS) views these payments as compensation for services, similar to regular wages. Consequently, tips are included in an individual’s gross income and are subject to federal income tax, Social Security tax, and Medicare tax. This applies to all tips, regardless of the amount or how they are received.

Defining Taxable Tip Income

For tax purposes, a tip is a discretionary payment made by a customer to an employee. These payments can come in several forms. The most common form is cash given directly by a customer, but tips added to credit or debit card transactions are also included and are typically distributed to the employee by their employer. The definition extends to tips received through a tip pool or other sharing arrangement where gratuities are collected and then distributed among a group of employees.

Non-cash tips are also considered taxable income. If a customer provides an item of value, such as event tickets or a gift card, the employee must report the item’s fair market value as income. It is important to distinguish these voluntary gratuities from mandatory service charges, which are sometimes added to a bill for large parties or at specific venues. The IRS classifies automatic service charges as regular wages, not tips, because the payment is required and not left to the customer’s discretion.

Employee Reporting Responsibilities

Employees who receive tips are expected to keep a daily log of all tips received. This record should detail cash tips, tips from credit cards, and the value of any non-cash items. It is also useful to note any tips that are paid out to other employees through a tip-sharing arrangement. The IRS provides Form 4070A, Employee’s Daily Record of Tips, as a tool for this purpose, though any personal log with the required information is acceptable.

An employee must report their tip income to their employer if they receive $20 or more in a single calendar month from that one job. This report is due by the 10th day of the month following the one in which the tips were received. This reporting allows the employer to withhold the necessary taxes.

The standard method for this monthly reporting is IRS Form 4070, Employee’s Report of Tips to Employer. While employers often provide copies of this form, an employee can use a substitute statement as long as it contains all the required information. Failure to report this income can lead to penalties.

Employer Withholding and Reporting

Once an employee reports their monthly tips, the employer becomes responsible for withholding the appropriate taxes from the employee’s pay. The employer will calculate and deduct the employee’s share of federal income tax, Social Security tax, and Medicare tax based on the sum of their regular wages and reported tips. The employer also pays their own share of Social Security and Medicare taxes on the tip income.

In some situations, an employer may need to assign additional tip income to an employee, a process known as tip allocation. This typically occurs in large food and beverage establishments when the total tips reported by all employees amount to less than 8% of the location’s gross sales. The employer must allocate the difference between the reported tips and the 8% threshold among the employees who receive tips.

This allocated amount is not subject to immediate tax withholding. Instead, the employer reports the figure separately on the employee’s year-end tax document. The amount of allocated tips is shown in Box 8 of the employee’s Form W-2, Wage and Tax Statement. This entry serves as a notification that there may be unreported income to address on the annual tax return.

Including Tips on Your Annual Tax Return

When filing an annual tax return using Form 1040, an employee must account for all tip income received during the year. The total wages, salaries, and tips reported to an employer and subject to withholding will be included in Box 1 of the Form W-2. This amount from Box 1 is then entered on the corresponding line for wages on the Form 1040.

A separate procedure is required for any tips that were not reported to an employer, such as when the monthly total was less than $20. These unreported tips must be reported on Form 4137, Social Security and Medicare Tax on Unreported Tip Income. Allocated tips, which appear in Box 8 of the W-2, must also be reported on Form 4137 unless the employee has adequate records, like a daily tip log, to prove their actual tip income was lower. The total from Form 4137 is added to the wage line on Form 1040, and the form itself is filed with the tax return to calculate the Social Security and Medicare taxes owed.