When Did Tips Officially Become Taxable?

Tipping has long been a customary practice where individuals offer voluntary payments to service providers. This tradition, widespread in the United States after the Civil War, was initially seen as a personal gesture or gift. Over time, the economic landscape and government’s need for revenue led to a re-evaluation of how these gratuities were treated for tax purposes. This shift laid the groundwork for today’s tax regulations concerning tips.

Early Interpretations of Tip Income

Before specific legislation addressed tips, they were perceived as voluntary payments or personal gifts. Service industry workers often relied on these gratuities as a primary source of income. This meant tips were often not considered traditional wages subject to taxation, creating ambiguity around their classification.

The informal nature of tipping meant there was little clarity on whether these funds represented taxable income. Their tax status remained undefined by explicit statutes, and their treatment as taxable income was not consistently enforced.

The Shift to Taxable Income

The principle that tips constituted taxable income was established early in the history of federal income tax. The Revenue Act of 1918 played a pivotal role in this classification by broadening the definition of “gross income.” This significant legislative act defined gross income to include “income derived from any source whatever,” thereby encompassing tips. This broad definition meant that tips, regardless of their voluntary nature, were recognized as compensation for services rendered and thus subject to federal income tax.

A Treasury declaration in 1919 explicitly stated that tips were considered income to the recipients. This affirmed that tips were part of an individual’s earnings. Consistent enforcement and explicit reporting mechanisms would evolve over many decades.

Establishing Reporting Requirements

While the Revenue Act of 1918 established tips as taxable income, the mechanisms for reporting and collecting these taxes evolved gradually. A major development occurred with the Social Security Act of 1935. The Act, and subsequent related legislation like the Federal Insurance Contributions Act (FICA), gradually brought tips under the umbrella of Social Security and Medicare taxes. This meant that both employees and employers would eventually have obligations for reporting and contributing taxes on tip income.

It was not until 1965 that legislation extending Social Security coverage to tips specifically required tipped employees to report their monthly tips to their employers. This mandate ensured that tips were accounted for in the calculation of retirement benefits and subject to payroll taxes. Employers became responsible for withholding the employee’s share of FICA taxes from reported tips and remitting both employee and employer contributions to the government.

Subsequent Clarifications and Enforcement

Following the initial classification and reporting requirements, the Internal Revenue Service (IRS) and Congress continued to refine and enforce tip income rules. The IRS formally addressed the taxation of tips in 1963, treating them as taxable income akin to wages. By the 1960s, there was an increased focus on ensuring compliance with tip reporting, as amounts of tip income remained unreported.

A substantial effort to improve compliance came with the Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982. TEFRA introduced mandatory tip reporting for large food and beverage establishments, requiring them to report certain tip-related information annually. If reported tips were less than 8% of gross sales, the establishment had to allocate the difference among its directly tipped employees, with this allocation appearing on an employee’s Form W-2, though employers were not required to withhold taxes from this allocated amount. Later, programs like the Tip Reporting Alternative Commitment (TRAC) agreements, implemented by the IRS in 1993, further aimed to promote tip reporting compliance through education and voluntary agreements rather than traditional audits. These ongoing efforts demonstrate a continuous progression in ensuring proper reporting and collection of tip taxes.