How to Report Tip Income for Tax Purposes

Any compensation received in the form of tips is considered taxable income by the Internal Revenue Service (IRS). Both employees who receive these gratuities and the employers who pay their regular wages have specific obligations for tracking and reporting this income. Understanding these distinct responsibilities is an important part of tax compliance. Failing to properly account for tip income can lead to penalties and incorrect tax payments for employees, while employers face their own set of requirements for withholding and reporting.

Defining Tip Income

The IRS defines a tip as a discretionary payment from a customer to an employee. For a payment to be classified as a tip, it must meet four conditions:

• The payment is made without compulsion.
• The customer has the unrestricted right to determine the amount.
• The amount is not subject to negotiation or dictated by employer policy.
• The customer generally has the right to decide who receives the payment.

Tips can be received in several forms, all of which are taxable income. This includes cash, tips added to a credit or debit card transaction, and tips from a tip-sharing arrangement. Non-cash tips, such as tickets to an event, are also taxable income. However, they are not reported to an employer and must be reported directly on an employee’s annual tax return.

Service charges are not considered tips because they are not discretionary. Examples include automatic gratuities for large parties, banquet event fees, hotel room service charges, or bottle service fees. These amounts are treated as regular wages paid by the employer, not as tips given by the customer.

Employee Reporting Responsibilities to an Employer

The IRS requires employees to maintain a daily record of the tips they receive. The IRS provides Form 4070A, Employee’s Daily Record of Tips, as a tool for this purpose. This daily log should document cash tips, electronic tips, and the employee’s share of any pooled tips. It should also track any tips paid out to other employees in a tip-sharing arrangement.

If an employee receives $20 or more in cash and charge tips in any given month from a single employer, they are required to report the total amount of those tips to that employer. This report is due by the 10th day of the month following the month the tips were received.

To make this formal report, employees can use Form 4070, Employee’s Report of Tips to Employer. The report must contain the employee’s name, address, and Social Security number, the employer’s name and address, the month or period the report covers, and the total amount of tips. Failure to report tips to an employer can result in a penalty equal to 50% of the Social Security and Medicare taxes owed on the unreported tips.

How Employers Handle Reported Tips

Once an employee reports their monthly tip income, the employer is responsible for withholding the necessary federal taxes. The reported tips are added to the employee’s regular wages to determine the total taxable income for that pay period. Based on this combined amount, the employer must withhold federal income tax as well as the employee’s share of Social Security and Medicare taxes, commonly known as FICA taxes.

At the end of the year, the employer summarizes this information on the employee’s Form W-2, Wage and Tax Statement. The total taxable income, which includes both regular wages and all reported tips, will appear in Box 1. The amount of tips specifically subject to Social Security tax is shown in Box 7, and the portion subject to Medicare tax is included in the Box 5 total.

In certain situations, an employee’s W-2 may also show an amount in Box 8, labeled “Allocated tips.” This occurs in large food and beverage establishments if the total tips reported by all employees fall below 8% of the establishment’s gross receipts. The employer must then “allocate” the difference among the tipped employees. No taxes are withheld on allocated tips, as this amount signals to the employee and the IRS that there may be unreported tip income.

Reporting Tips on Your Federal Tax Return

The starting point for reporting tip income is Form W-2. The total wages and reported tips found in Box 1 of the W-2 are transferred to the corresponding line for wages on Form 1040, U.S. Individual Income Tax Return. All tips an employee receives are taxable, and any tips not included in Box 1 must be added to the income reported on Form 1040. This includes all non-cash tips and any cash tips not reported to the employer, such as those totaling less than $20 in a month.

If an employee has unreported cash and charge tips, or allocated tips from Box 8 of their W-2 that they cannot dispute, they must pay their share of Social Security and Medicare taxes on this income. This is done by completing and attaching Form 4137, Social Security and Medicare Tax on Unreported Tip Income, to the tax return.

Using Form 4137, the taxpayer calculates the FICA taxes owed on the unreported tips. The additional tax calculated on Form 4137 is then carried over to Schedule 2, “Additional Taxes,” and added to the final tax liability. Filing Form 4137 ensures that these earnings are credited to the employee’s Social Security record for future benefits.