Should Tips Be Taxed? IRS Rules for Reporting Income

Under United States tax law, all tips received by an employee are considered taxable income. The Internal Revenue Service (IRS) does not distinguish between tips received directly in cash, those added to a credit card charge, or non-cash tips when determining their taxability. This means that any form of gratuity given by a customer to an employee is subject to federal income tax.

The Taxation of Tip Income

The taxability of tips extends to various arrangements common in service industries. In a tip-pooling or tip-sharing arrangement, the amount an individual employee ultimately receives and retains is their taxable income. Mandatory service charges added to a customer’s bill by the employer are not considered tips; instead, they are treated as regular wages and are subject to the same tax withholding as hourly pay.

Whether a tip is received electronically through a payment app or as cash left on a table, the IRS views it as payment for a service rendered and part of the employee’s income. The responsibility for reporting this income falls on the employee, with specific duties assigned to the employer.

While the principle of taxing tips remains, legislative proposals aim to ease the burden. In May 2025, the U.S. Senate passed the “No Tax on Tips Act.” If enacted, this bill would allow workers earning up to $160,000 annually to claim a deduction for up to $25,000 in reported cash tips. This change would not exempt tips from Social Security and Medicare taxes, and the bill must still pass the House of Representatives and be signed by the President to become law.

Employee Reporting Obligations

An employee’s primary responsibility is to maintain a detailed and accurate record of all tips received. The IRS requires employees to keep a daily log of their tips, using a personal log or a system provided by their employer to track income from cash, credit card, and pooled tips. While the IRS once provided forms like Form 4070A, they are now considered historical.

A significant regulation for employees is the “$20 rule.” If an employee receives $20 or more in tips during any single calendar month from one employer, they are required to report the total amount of tips for that month to that employer. This threshold applies separately to each job. If an employee works for two different employers and earns $15 in tips from one and $25 from the other in the same month, they only need to report the $25 to the second employer.

To report this income, an employee must provide their employer with a written statement by the 10th day of the month following the month the tips were received. The IRS no longer provides an official form, but 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
• The total amount of tips

Failure to report tips can result in a penalty equal to 50% of the Social Security and Medicare taxes owed on the unreported tips.

Employer Withholding and Tax Responsibilities

Once an employee reports their tip income, the employer must include this income with the employee’s regular wages to calculate the necessary tax withholdings. These withholdings include federal income tax, the employee’s share of Social Security and Medicare taxes (FICA), and any applicable state taxes.

The employer is also responsible for paying their own share of FICA taxes on the employee’s reported tip income. This information is reported to the IRS on the employer’s quarterly federal tax return, Form 941.

To help offset this cost, food and beverage establishments may be eligible for a FICA tip credit. This credit is calculated on the employer’s share of FICA taxes paid on employee tips that exceed a certain minimum wage threshold ($5.15 per hour). Employers can claim this credit by filing Form 8846, Credit for Employer Social Security and Medicare Taxes Paid on Certain Employee Tips.

Allocated Tips on Form W-2

An employee may see an amount for “allocated tips” on their Form W-2. Allocated tips are amounts an employer assigns to an employee when the total tips reported by all employees at a large food or beverage establishment are less than 8% of the establishment’s gross receipts. This 8% figure is a standard rate set by law, though an employer can petition the IRS for a lower rate, down to 2%, if they can justify it.

These allocated amounts are reported in Box 8 of the employee’s Form W-2 and are not included in the wages in Box 1. No income tax, Social Security, or Medicare taxes have been withheld on this amount because the employee did not report this income to the employer.

The appearance of allocated tips in Box 8 places a direct responsibility on the employee. The employee must calculate the Social Security and Medicare taxes owed on this income by filing Form 4137, Social Security and Medicare Tax on Unreported Tip Income, with their Form 1040. If an employee has records to prove they earned less than the allocated amount, they can report the actual amount; otherwise, they are generally required to report the allocated figure.