How to Properly Calculate Tips for Employees

Tips represent discretionary payments from customers and form a significant portion of income for many service workers. Understanding tip definition, reporting, and distribution is important for both employees and employers to ensure adherence to tax laws and labor regulations.

Defining Tips and Tip Income

Tips are voluntary monetary payments customers make to employees, usually as a gesture of appreciation for good service. The Internal Revenue Service (IRS) defines a tip as a payment made free from compulsion, where the customer has the unrestricted right to determine the amount and recipient, and the payment is not subject to negotiation or employer policy. This discretionary nature is a distinguishing characteristic.

Tips can take various forms, including cash received directly from customers, amounts left through electronic payment methods like credit or debit cards, and the value of non-cash items such as tickets or other goods. Tips also include amounts received from other employees through tip-sharing arrangements, such as tip pools.

In contrast to tips, service charges are mandatory amounts an employer requires a customer to pay, even if labeled as a “tip” or “gratuity.” Common examples include automatic gratuities for large dining parties, banquet fees, or hotel room service charges. These mandatory service charges are generally not considered tips for tax purposes; instead, they are treated as regular wages paid to the employee and are subject to Social Security, Medicare, and federal income tax withholding. Unlike tips, service charges distributed to employees cannot be used by employers to claim certain tax credits.

Employee Tip Reporting Requirements

Employees who receive tips have specific responsibilities for reporting this income to their employer. All cash tips totaling $20 or more received in a calendar month from any single employer must be reported, including charged tips and those from tip-sharing arrangements.

To accurately track tip income, employees should maintain a daily record of all tips received. The IRS provides Form 4070A, “Employee’s Daily Record of Tips,” as a convenient tool for this purpose. This daily record should include cash tips received directly, credit and debit card tips, and any tips paid out to other employees in a sharing arrangement.

Employees must provide a written report of their total tips to their employer by the tenth day of the month following the month in which the tips were received. For instance, tips earned in January must be reported by February 10th. IRS Form 4070, “Employee’s Report of Tips to Employer,” is commonly used. This report should include the employee’s name, address, Social Security number, the employer’s name and address, the month or period covered, and the total amount of tips. Failing to report tips accurately can lead to penalties, including a 50% penalty on the Social Security and Medicare taxes due on unreported amounts.

Employer Responsibilities for Tips

Employers have significant obligations concerning employee tips. Once employees report their tips, employers are responsible for withholding federal income tax and the employee’s share of Social Security and Medicare taxes (FICA) from these reported amounts. The employer must also pay their matching share of Social Security and Medicare taxes on all reported tip income. These taxes are typically withheld from the employee’s regular wages, and if wages are insufficient, adjustments may be made to future paychecks.

A common practice in certain industries is the “tip credit,” which allows employers to pay tipped employees less than the federal minimum wage. Under federal law, employers can pay a direct cash wage as low as $2.13 per hour, provided the employee’s tips make up the difference to reach at least the federal minimum wage of $7.25 per hour. If an employee’s combined wages and tips do not meet the minimum wage, the employer must make up the shortfall. The employer must also ensure the employee retains all tips received, except for valid tip pooling arrangements.

Employers are required to report all wages and reported tips on an employee’s Form W-2, Wage and Tax Statement, at the end of the year. For large food or beverage establishments, additional reporting is necessary. An establishment is considered “large” if:
Tipping is customary.
Food or beverages are consumed on the premises.
More than ten employees are typically employed on a business day.

These establishments must file Form 8027, “Employer’s Annual Information Return of Tip Income and Allocated Tips,” annually with the IRS. This form reports total gross receipts and total reported tips. If total tips reported by employees are less than 8% of the establishment’s gross receipts, the employer may be required to “allocate” the difference among employees and report these allocated tips on their W-2s, though no taxes are withheld on allocated tips by the employer. Employers also have general recordkeeping requirements for tip reports.

Tip Pooling and Sharing

Tip pooling, or tip sharing, is a common practice where employees combine their tips into a collective pool, which is then distributed among a group of eligible workers. Federal law, specifically the Fair Labor Standards Act (FLSA), permits mandatory tip pooling arrangements.

Under FLSA regulations, employers cannot keep any portion of employees’ tips for any purpose, whether directly or through a tip pool. Managers, supervisors, and owners are generally prohibited from participating in mandatory tip pools or receiving tips from them. However, a manager or supervisor may keep tips they receive directly from a customer for services they personally and solely provide.

The rules for who can participate in a mandatory tip pool depend on whether the employer takes a tip credit. If an employer takes a tip credit, meaning they pay a cash wage lower than the full minimum wage, the tip pool must typically be limited to employees who customarily and regularly receive tips, such as servers or bartenders. If an employer pays at least the full federal minimum wage and does not take a tip credit, they may implement a mandatory tip pool that includes employees who do not customarily receive tips, such as dishwashers or cooks.

Common methods for calculating and distributing tips within a pool include dividing tips based on hours worked, a set percentage for different roles, or a point system that assigns value to various positions. For example, a server might contribute a portion of their tips to a pool that is then distributed to support staff like bussers or hosts based on a pre-determined percentage or hourly rate. Employers should establish a clear, written tip-sharing policy that outlines who is eligible, how contributions are made, and the method of distribution to ensure transparency and compliance. Pooled tips should be fully redistributed to employees no less often than when regular wages are paid.