Do You Claim Tips on Taxes? Here’s How and Why

Tips represent a significant portion of income for many individuals in service industries. These payments, whether received directly from customers or through other arrangements, are considered taxable income by the Internal Revenue Service (IRS). Proper reporting of tips is essential to meet legal obligations and ensure accurate tax reporting.

Identifying Taxable Tips

For tax purposes, a “tip” is a discretionary payment made by a customer to an employee. Tips can come in various forms, including cash, electronic payments (credit cards, debit cards, gift cards), or amounts from tip-sharing or pooling arrangements.

The value of non-cash tips, such as tickets or passes, is taxable income. Employees do not report non-cash tips to their employer; instead, their value must be reported directly on the individual’s tax return.

It is important to distinguish between a voluntary tip and a mandatory service charge. Service charges, sometimes called auto-gratuities, are amounts an employer requires a customer to pay, often added for large parties or specific services like banquet events or room service. Unlike tips, service charges are mandatory payments treated as regular wages by the IRS and are subject to standard payroll taxes.

Employee Tip Reporting Obligations

All cash tips received in a calendar month that total $20 or more from a single employer must be reported to that employer. This $20 threshold applies to cash tips, which include direct cash tips, credit/debit card tips distributed by the employer, and tips received through tip-sharing arrangements. Even if an employee receives less than $20 in tips from one employer in a month, all tips received are still considered taxable income and must eventually be reported to the IRS.

Tips must be reported to the employer by the 10th day of the month following the month in which they were received. If the 10th falls on a Saturday, Sunday, or legal holiday, the deadline is extended to the next business day. Employees can use IRS Form 4070, “Employee’s Report of Tips to Employer,” or a similar written statement to provide this information.

When reporting tips to an employer, the statement should include:
The employee’s name, address, and Social Security number.
The employer’s name and address.
The month or period the tips were received.
The total amount of tips.

Employees are encouraged to keep a daily record of all tips received, using Form 4070A, “Employee’s Daily Record of Tips,” to ensure accurate reporting. This daily record helps employees track both cash and non-cash tips.

Tax Treatment and Forms for Tips

Once tips are reported to the employer, they are treated as part of the employee’s regular wages for tax withholding. The employer withholds federal income tax, Social Security tax, and Medicare tax from these reported tips, in addition to regular wages. If an employee’s regular wages are insufficient to cover the required tax withholding on both wages and reported tips, the employee may need to provide additional funds to the employer to cover the tax liability.

Reported tips are included on an employee’s Form W-2, “Wage and Tax Statement,” at the end of the year. The total amount of wages, tips, and other compensation appears in Box 1. Reported tips are also detailed in Box 5, “Medicare wages and tips,” and Box 7, “Social security tips.” This ensures the employee’s earnings record accurately reflects their total income, including tips, which is important for future Social Security benefits.

If an employee does not report all cash and charge tips of $20 or more received in a calendar month to their employer, they are still legally required to report these tips directly to the IRS. This is done using Form 4137, “Social Security and Medicare Tax on Unreported Tip Income.” These unreported tips are subject to both income tax and the employee’s share of Social Security and Medicare taxes.

When Form 4137 is filed, the employee includes these previously unreported tips in their gross income on their federal income tax return, such as Form 1040. This ensures the Social Security and Medicare taxes on these tips are paid and the employee’s Social Security earnings record is credited. Accurate reporting of all tips, whether through the employer or directly to the IRS via Form 4137, contributes to an individual’s Social Security earnings record, which directly impacts their eligibility and future Social Security benefits. Failure to report tips as required can result in penalties, potentially equal to 50% of the Social Security and Medicare tax due on those unreported amounts.