Do You Have to Pay Tax on Gratuity?

Gratuity, or tips, represents payments customers make to service industry employees. These payments acknowledge good service and supplement an employee’s regular wages. While often perceived as extra income, gratuity is generally considered taxable income by federal tax authorities. This means that whether you receive tips in cash, through electronic payments, or even as non-cash items, these amounts are subject to taxation. Understanding how these payments are classified and taxed is important for both individuals receiving them and businesses managing payroll. This overview sets the stage for a more detailed look at the specific tax obligations related to gratuity.

Identifying Taxable Gratuity

For tax purposes, gratuity falls into distinct categories, primarily differentiated by how it is received and whether it is discretionary. “Tips” are voluntary payments from a customer to an employee, given without compulsion. These can include cash tips received directly, tips added to credit or debit card charges, or non-cash tips like tickets or other items of value. Tips also encompass amounts received through tip-sharing arrangements or tip pools among employees.

A key distinction exists between “tips” and “service charges.” Service charges are mandatory amounts an employer adds to a customer’s bill, such as an automatic gratuity for large dining parties, banquet event fees, or hotel room service charges. Even if these amounts are later distributed to employees, they are not considered tips. The crucial difference lies in the customer’s discretion; if the payment is compulsory, it is a service charge, not a tip. This distinction is important because tips and service charges are treated differently for tax and payroll purposes.

For a payment to be a tip, it must meet specific criteria:
It must be made free from compulsion.
The customer must have the unrestricted right to determine the amount.
The payment should not be subject to negotiation or employer policy.
The customer should generally have the right to determine who receives the payment.
If these factors are absent, the payment is likely a service charge.

Employee Tax Responsibilities for Gratuity

Employees who receive gratuity have specific obligations for tax compliance. All cash and non-cash tips received are considered income and are subject to federal income taxes. Cash tips are also subject to Social Security and Medicare taxes (FICA taxes).

Employees must keep a daily record of all tips received. The IRS provides Form 4070A, “Employee’s Daily Record of Tips,” for this purpose, though its use is not required.

Employees must report their tips to their employer monthly if the total tips received from any single employer in a calendar month amount to $20 or more. This report, which can be made using Form 4070, “Employee’s Report of Tips to Employer,” must be submitted by the 10th day of the month following the month the tips were received. This allows employers to accurately withhold income tax, Social Security tax, and Medicare tax from the employee’s regular wages based on the reported tip income.

If an employee’s regular wages are insufficient to cover the required tax withholdings on both wages and reported tips, the employee may need to provide additional funds to the employer. Any uncollected Social Security and Medicare taxes on tips will be shown on the employee’s Form W-2, and the employee will be responsible for paying these amounts when filing their annual income tax return. Employees should also consider making estimated tax payments throughout the year if they anticipate owing a significant amount of tax not covered by withholding. Estimated tax payments are typically due quarterly, on April 15, June 15, September 15, and January 15 of the following year, to avoid potential underpayment penalties.

Employer Tax Responsibilities for Gratuity

Employers have tax responsibilities concerning gratuity received by their employees. Upon receiving reported tip income, employers must withhold income tax, Social Security tax, and Medicare tax from the employee’s wages and tips. Employers must also pay their share of Social Security and Medicare taxes based on the total wages paid to tipped employees, including reported tip income.

All reported tips, along with regular wages, must be included on the employee’s Form W-2, Wage and Tax Statement. Key boxes on Form W-2 related to tips include:
Box 1 (Wages, tips, other compensation)
Box 5 (Medicare wages and tips)
Box 7 (Social security tips)
Box 12 (Uncollected Social Security and Medicare taxes on tips)

For large food or beverage establishments, additional reporting requirements apply. An employer operating such an establishment, where tipping is customary and more than 10 employees are typically employed, must file Form 8027, “Employer’s Annual Information Return of Tip Income and Allocated Tips.” This form reports gross receipts and total reported tips. If the total tips reported by all employees are less than 8% of the establishment’s gross receipts, the employer may be required to allocate the difference as additional tip income among employees.

Allocated tips are shown in Box 8 of Form W-2 but are not subject to income tax withholding by the employer, nor are they included in Boxes 1, 3, 5, or 7. Employees are still responsible for reporting and paying taxes on these allocated tips. Service charges are treated as regular wages for payroll and tax purposes. Employers must withhold all applicable payroll taxes from these amounts before distributing them to employees, as service charges are considered part of the employer’s revenue and not discretionary tips.