The Official Definition of Tip Income

Tip income represents compensation for many individuals in service industries. This income, defined as optional payments from customers to employees, is subject to federal income taxes. Both employees who receive these gratuities and the employers who manage their payroll must understand the specific regulations governing them. The tax implications affect how income is reported and how taxes are withheld and paid throughout the year.

The Four Factors of Tip Income

For a payment to be classified as a tip, it must satisfy four conditions set by the IRS. The payment must be made free from compulsion, meaning the customer voluntarily decides whether to give it. The customer must also have the unrestricted right to determine the amount of the payment. If a business imposes a mandatory charge, that payment fails this test.

The third factor is that the payment cannot be subject to negotiation or dictated by employer policy. A business cannot set the amount a customer leaves for an employee. Fourth, the customer generally has the right to determine who receives the payment.

This framework distinguishes tips from service charges. Service charges, such as automatic gratuities for large parties, banquet event fees, or bottle service fees, are not considered tips because they are compulsory. The customer is required to pay them, and the amount is set by the establishment. These payments are treated as regular wages and are subject to the same tax withholding as other wages.

For example, if a restaurant automatically adds an 18% charge to the bill for a party of eight, that amount is a service charge. Even if the menu refers to it as a “gratuity,” it does not meet the IRS definition of a tip because it is not voluntary and the amount is dictated by employer policy. The funds belong to the restaurant and are distributed to employees as wages. A voluntary amount left by a customer on top of the bill, however, would qualify as a tip.

Common Forms of Tip Income

Employees receive tips through various channels, and each form is treated as taxable income. The most common form is direct tips, which are payments received straight from a customer. These can be in cash or electronic, such as gratuities added to a credit card, debit card, or mobile payment transaction.

Indirect tips are received through a tip-sharing or pooling arrangement. In these systems, employees who receive tips directly, like servers or bartenders, contribute a portion to a pool. This pool is then distributed among other employees who support the service, such as bussers, cooks, or dishwashers.

Tips can also be received in a non-cash form, which are items of value given by a customer instead of money, such as event tickets or other goods. While non-cash tips are not reported to an employer, the employee must keep a record of the date and value of any items received to report their fair market value as income on a personal tax return.

Employee’s Duty to Report Tips

Employees must track and report their tip income by maintaining a daily record of all cash tips. The IRS provides Form 4070A, Employee’s Daily Record of Tips, as a tool for this purpose. This daily log helps ensure accuracy when reporting the income to the employer.

If an employee receives $20 or more in tips in a calendar month from one employer, they must report the total to that employer. This report is due by the 10th day of the following month. For example, tips received in March must be reported by April 10th.

While no specific form is mandated for this report, employees can use Form 4070, Employee’s Report of Tips to Employer, or another statement. The report must include the following information:

• The employee’s name, address, and Social Security number
• The employer’s name and address
• The employee’s signature
• The month or period the report covers
• The total amount of tips received

Employer Responsibilities for Tip Income

Once an employee reports their tip income, the employer’s responsibility is to withhold taxes from the employee’s pay. This includes withholding the employee’s share of federal income, Social Security, and Medicare tax on the reported tip income. These withheld amounts are then remitted to the government along with withholdings from regular wages.

The employer must also pay its portion of Social Security and Medicare taxes on the total wages paid, which includes the reported tip income. All of this information, including the employee’s total tips, is reported to the IRS and the employee on Form W-2, Wage and Tax Statement, at the end of the year.

If the total tips reported by all employees at a large food or beverage establishment are less than 8% of its gross receipts, the employer must allocate the difference. This amount, known as “allocated tips,” is reported in Box 8 of the employee’s Form W-2. Employers do not withhold taxes on allocated tips, so the employee must report this income and pay the taxes, often using Form 4137.