If you accept tips for your services, there are basic guidelines to keep in mind, whether you are an employee, sole proprietor, or business owner. As an employee, if you receive tips that total $20 or more for any month while working for one employer, you must report your tips to that employer. You must then continue reporting tips totaling $20 or more every month regardless of your total wages and tips for the year. As a sole proprietor, you must report your monthly tips over $20 to the Internal Revenue Service (IRS) as well. If you are an employer, you have multiple obligations when it comes to tip income, including recordkeeping and reporting, collecting taxes on employee tips, filing tax forms, and paying or depositing taxes. Following are tips on tips to keep you in compliance with IRS income guidelines.

What Is a Tip?

The IRS defines “tips” as payments clients make solely of their own volition. In other words, the client chooses to pay you more money than they owe you for services rendered. Tips can include:

• Cash tips received directly from customers

• Tips from customers received through electronic payment (credit, debit, or gift cards—or any other electronic payment method)

• The value of any noncash tips (such as event tickets or other items of value)

• Tip amounts received from other employees (paid out through tip pools, tip splitting, or other formal or informal tip-sharing arrangements)

Mandatory tips (added to bills) are not considered tips by the IRS, but instead are viewed as service charges (sometimes called auto-gratuities). These service charges, which are added to a bill or fixed by an employer, are considered non-tip wages and are subject to social security tax, Medicare tax, and federal income tax withholding. Employers cannot use non-tip wages when computing tax credits available to them under section 45B of the Internal Revenue Code because these amounts are not tips.

Reporting Guidelines

Generally, any income received in the form of tipping is considered taxable income. Use the following guidelines to correctly report any tip income you or your employees receive.

Employees

If you’re an employee, you must keep accurate, daily records of cash tips, including sufficient proof of your tip income for the year. A daily record of your tip income is considered sufficient proof. No particular form must be used, but your tip statement must be signed by the employee and must include:

• Your name, address, and social security number

• Your employer’s name and address (and establishment name, if different)

• Month or period your report covers

• Total amount of tips you received during the month or period

You may also use Form 4070, Employee’s Report of Tips to Employer, which is available in IRS Publication 1244, Employee’s Daily Record of Tips and Report to Employer. Additionally, you may use any other form provided by your employer, including electronic forms.

Your monthly tip reports should be submitted to your employer by the 10th of the following month. For example, tips received in January should be reported by February 10. If the 10th falls on a Saturday, Sunday, or legal holiday, an employee may give the report to the employer by the next business day.

Sole Proprietors

As you may know, self-employment income in excess of $400 must be reported to the IRS as taxable income. Tips are considered income, so it’s important to keep accurate, daily records. Similar to the requirements for employees, your records should contain sufficient proof of your tip income for the year. As with employees, a daily record of tip income is considered sufficient proof.

When you are ready to calculate your income taxes on your tips, just add your tip receipts to your other self-employment income. As a rule of thumb, make it a habit to save at least 25 percent of your tips in anticipation of these income taxes.

Employers

If you are an employer and your employees receive taxable tips, you must receive a tip report from each employee for every payroll period. While the IRS requires tipped employees to provide this report once a month, you will need a report for every payroll period; otherwise, you cannot correctly report the employee’s total wages, nor can you withhold the proper taxes.

As an employer, you are then required to withhold both income taxes and FICA (social security and Medicare) taxes on the tips. You also will have to cover the employer’s portion of FICA and FUTA (Federal Unemployment Tax Act) taxes.

Under normal circumstances, you would withhold income taxes from the employee’s regular wages. In the case of tips, though, you also have to take tip withholdings from an employee’s regular wages because you never actually have the tip money in your hands.

In order to comply with these IRS withholding requirements, you will:

• Retain employee tip reports

• File IRS Form 941, Employer’s Quarterly Federal Tax Return, each quarter. (This form is used to report wages, tips, and other compensation paid to your employees. The form also indicates whether you made tax deposits or withheld income and FICA taxes during the quarter.)

• Report tips to the IRS annually, using IRS Form W-2 (Wage and Tax Statement)

For more information on tips as taxable income, visit www.irs.gov and search “tip income.”

Please Note

As an employer, you are not liable to withhold and pay the employee share of social security and Medicare taxes on the unreported tips until notice and demand for the taxes is made to the employer by the IRS.