How to Claim Tip Out on Your Taxes: A Clear Breakdown

Accurately reporting all income, including tips, is fundamental for tax compliance. For service industry workers, tips often form a significant portion of earnings. Understanding how to account for these amounts, especially when sharing them, is important for tax obligations. The process of “tip out,” or tip sharing, introduces a specific nuance to reporting, affecting the net tip income subject to taxation. This guide clarifies the steps for navigating tip income and tip out on tax returns.

Understanding Tip Income and Tip Sharing

Tip income encompasses various forms of payments employees receive from customers, including direct cash tips and amounts received through electronic methods like credit or debit cards. Tips can also be distributed by an employer, such as service charges that are subsequently paid out to staff.

Employees may also receive tips from other co-workers as part of a sharing arrangement or through a tip pool. Even the value of non-cash tips, like tickets or other items of value, is considered taxable income.

“Tip out” refers to the practice where employees who directly receive tips, such as servers, share a portion of those tips with other employees who contribute to the customer’s service experience. This often includes bussers, hosts, or kitchen staff.

Common methods for tip sharing include a fixed percentage of sales, a percentage of tips received, or a pooled system where all tips are collected and then distributed among eligible employees. When a mandatory tip-sharing arrangement requires an employee to pay out a portion of their tips to co-workers, the amounts paid out are generally not considered income to the employee who initially received them.

Employee Responsibilities for Reporting Tips to Employers

Employees bear the responsibility of reporting all cash tips received to their employer. This reporting is required by the 10th day of the month following the month in which the tips were received, but only if the total cash tips received amount to $20 or more in a given month. If the 10th falls on a weekend or holiday, the deadline shifts to the next business day.

A crucial aspect of this reporting is that the amount submitted to the employer should reflect the net cash tips received. This means employees should deduct any amounts they paid out to other employees as part of a mandatory tip-sharing arrangement before reporting their tips to the employer. This adjustment at the source is the primary way the “tip out” is accounted for in the tax process.

Many employers use Form 4070, Employee’s Report of Tips to Employer, or provide their own system. Form 4070, or an equivalent report, requires specific information:
The employee’s name, address, and Social Security number.
The employer’s name and address.
The month or period the report covers.
The total amount of tips received during that period.

Employers are then responsible for withholding income tax, Social Security tax, and Medicare tax from the reported tip income. Accurate and timely reporting by the employee is important to ensure correct tax withholding and to avoid potential penalties.

Recordkeeping for Tip Income and Tip Out

Maintaining detailed daily records of all tip income received is an important practice for accurate reporting and tax compliance. These records serve as a crucial reference for both reporting tips to the employer and for substantiating income in the event of an inquiry from the tax authorities. Employees can utilize methods such as a personal tip diary, a spreadsheet, or a dedicated application to keep track of their daily earnings.

The daily record should specifically capture:
The date.
The name of the employer.
Gross tips received (distinguishing between cash and credit card tips).
The amount of tips paid out to other employees through tip sharing or pooling arrangements.

It is also beneficial to note to whom these tips were paid out and the reason for the payout, leading to a clear calculation of the net tips retained. These meticulous records are valuable for several reasons. They allow employees to accurately report their tips to their employer and to verify the amounts reported on their annual Form W-2, Wage and Tax Statement. Detailed records also provide support for any necessary adjustments or deductions on the final tax return, particularly if allocated tips are received or if not all tips were initially reported to the employer. It is advisable to retain these records for a minimum of three years from the date the tax return was filed or the tax was due, whichever is later.

Reporting Tip Income on Your Tax Return

Tips properly reported to an employer are included in Box 1 (“Wages, tips, other compensation”) and Box 7 (“Social Security tips”) of an employee’s Form W-2, Wage and Tax Statement. The Form W-2 reflects tips for which the employer has already accounted and from which taxes have been withheld.

Additional reporting of tip income is necessary in specific situations. If an employee received $20 or more in cash tips in a month but did not report all of them to their employer, or if the employer did not withhold enough Social Security and Medicare tax on reported tips, Form 4137, Social Security and Medicare Tax on Unreported Tip Income, must be used. On Form 4137, if gross tips are reported, amounts paid out to other employees as part of a mandatory tip-sharing arrangement can be deducted.

Allocated tips, which may appear in Box 8 of Form W-2, represent the difference between an employer’s total receipts and the tips reported by employees, if the reported amount is less than a certain percentage of gross receipts. If allocated tips are shown, the employee must include these in their income unless detailed records demonstrate their actual tips were less. If Form 4137 is used to report allocated tips, the same principle of deducting amounts paid out in tip sharing applies. For individuals who are not employees, such as independent contractors, tips received directly from customers are reported on Schedule C and are subject to self-employment tax.