Is Gratuity Taxed Before or After You Receive It?
Uncover how gratuity is taxed: before or after you receive it? Get clear insights into IRS rules for tip reporting, withholding, and various forms of gratuity.
Understanding how gratuity is handled for tax purposes can be unclear. Gratuity, often received for services rendered, is a common form of income. Navigating its tax implications requires understanding specific rules set forth by tax authorities. This article explores how gratuity is treated under tax law, including when and how it is subject to taxation.
Defining Gratuity for Tax Purposes
The Internal Revenue Service (IRS) considers all forms of gratuity as taxable income. This means money or value received for providing a service is subject to federal income tax. These amounts are also subject to Social Security and Medicare taxes, known as Federal Insurance Contributions Act (FICA) taxes.
Gratuity is recognized as income because it represents compensation for services performed, whether paid directly by a customer or distributed through an employer. The IRS distinguishes between “tips” and “service charges.” Tips are discretionary payments made by customers, given freely without compulsion.
Service charges, for example, include automatic gratuities added to a bill for a large party or a specific service fee. These are not considered tips by the IRS, but rather wages. This distinction affects how the income is reported and how taxes are withheld.
Tax Withholding and Reporting for Gratuity
Gratuity is subject to tax withholding before an employee receives their net pay. For tax purposes, gratuity is treated similarly to regular wages and is subject to income tax withholding. Employers are responsible for withholding these taxes from an employee’s regular wages or from the tips themselves if they process them.
Employees must report all received tips to their employer, especially if tips amount to $20 or more in a month from any one job. This reporting is important for accurate tax withholding and for the employer to fulfill their tax obligations. Employees can use Form 4070, Employee’s Report of Tips to Employer, to report these amounts.
The employer includes the reported tip income on the employee’s Form W-2 at year-end. Reported tips are included in various boxes on the Form W-2, such as those for wages, Social Security, and Medicare. If an employee does not report all tips to their employer, they are still responsible for paying Social Security and Medicare taxes on those unreported tips. This obligation is met by filing Form 4137, Social Security and Medicare Tax on Unreported Tip Income, with their income tax return. Taxes on gratuity are accounted for at the time of earning, either through employer withholding or the employee’s own tax obligations.
Different Forms of Gratuity and Tax Implications
The form in which gratuity is received influences the specific mechanism of tax reporting and withholding. Cash tips, received directly by an employee from a customer, must still be reported to the employer. While the employer may not physically handle the cash, the reported amount is used to calculate FICA and income tax withholding, which is then deducted from the employee’s regular wages.
Non-cash tips, such as those paid by credit card, are processed by the employer. In these scenarios, the employer has direct knowledge of the tip amount and is responsible for withholding the appropriate taxes before distributing the funds to the employee. This direct processing simplifies the withholding procedure for both the employer and employee.
Pooled tips, or tip-sharing arrangements, involve employees combining their tips and redistributing them based on a pre-determined formula. While the distribution method changes, the underlying taxability of each employee’s share remains the same. Each employee is responsible for reporting their allocated share of the pooled tips as income.
Mandatory service charges, distinct from voluntary tips, are considered wages by the IRS, not tips. These charges, such as an automatic 18% gratuity added to a large dining party’s bill, are subject to standard payroll withholding. Since the employer controls these funds and their distribution as compensation, they are treated identically to regular hourly wages for tax purposes, with all applicable income and payroll taxes withheld before payment to the employee.