Is Tip Calculated Before or After Tax?

A tip, or gratuity, represents an optional payment customers make to employees as an expression of appreciation for service provided. These payments are distinct from service charges, which are often mandatory additions to a bill. The tax treatment of tips differs for sales tax and income tax, a distinction important for customers and service industry professionals.

Sales Tax and Tips

Sales tax is generally calculated on the price of goods or services before any tip is added. Since tips are voluntary payments directly from the customer to the service provider, sales tax is usually not applied to the tip amount.

However, if a gratuity is mandatory or automatically added to a bill, it may be treated differently and become subject to sales tax. For instance, a mandatory service charge becomes part of the taxable sales price.

Tips as Taxable Income

Tips, regardless of how they are received, are considered taxable income for the employee. This includes cash tips, electronic payments such as credit or debit card tips, and amounts received through tip-sharing arrangements or tip pools. Tips are subject to federal income tax withholding, Social Security tax, and Medicare tax, similar to regular wages.

Employees are responsible for reporting all tips earned. For certain large food or beverage establishments, if reported tips are less than 8% of gross receipts, employers may allocate additional tips. While allocated tips appear on Form W-2 in Box 8, employers do not withhold taxes on these amounts. Employees must still include allocated tips as income on their tax returns and pay Social Security and Medicare taxes on them.

Reporting Tips for Tax Purposes

Employees who receive $20 or more in cash tips in a calendar month from a single employer must report these tips to their employer. This reporting should occur by the tenth day of the month following the month the tips were received, using Form 4070 (Employee’s Report of Tips to Employer) or a similar written statement. Non-cash tips, such as tickets or other goods, do not need to be reported to the employer but must still be included as income on the employee’s individual tax return.

Employers must withhold federal income tax, Social Security tax, and Medicare tax from an employee’s wages and reported tip income. They also pay their share of Social Security and Medicare taxes based on total wages, including reported tip income. This information, including reported tips, is included on the employee’s Form W-2, and employers report these amounts quarterly on Form 941.