Are Tips Taxable? All You Need to Know About Filing Cash Tips
July 23, 2024
The “Are tips taxable?” question is often raised by taxpayers who work in industries where receiving tips from customers is considered normal. To answer that query bluntly, yes, tips are taxable because they are considered a form of taxable income by the IRS.
In that regard, workers who receive tips are not exempt from paying federal income taxes, as well as Medicare and Social Security taxes, on their tip income.
In this article, we’ll explain more about how tip income works and how the IRS imposes taxes on tips. We’ll also discuss the possible consequences of not reporting the tips you receive on your tax returns, as well as countermeasures you can take in case you fail to report some of your monthly tips to your employer.
Key Takeaways
- The answer to the “Are tips taxable?” question is yes. Taxpayers or workers who receive tip income must pay federal income taxes and FICA taxes on the tips they receive.
- Service workers use the IRS Form 4137 when reporting tips worth less than $20. The said form is also used when paying Medicare and Social Security taxes on unallocated and unreported tips.
- Other essential IRS forms used when reporting taxable tips to employers and the IRS include Form 4070A, Form 4070, Form 1040, and Form W-2.
- Employees who fail to report their taxable tips may face an audit from the IRS or pay penalties worth 50% of the Medicare and Social Security taxes they owe from their undeclared tip income.
How Does Tip Income Work?
Tip income works in a very simple way: customers give money to service business employees as a bonus for the excellent service. It is common in restaurants, salons, hotels, and other businesses where employers serve or assist customers.
Most of the time, these businesses or industries pay their staff low hourly rates and rely on tip payments from customers to increase their employees’ take-home pay. Customers can pay tips in cash or noncash form.
The amount of tips paid to service workers depends on the customer’s satisfaction level with their services and products. In the US, the standard tip percentage ranges from 20% to 25%.
However, 10% or 15% is still acceptable since tip payments are also subject to the customer’s individual experience with the establishment or business.
Some establishments have a designated tip jar where customers can drop extra change or cash as a tip. Alternatively, some customers include tips upon payment of the total amount for the service or product they consumed, which is a typical setup in restaurants and salons.
Self-employed individuals can also earn tips, particularly if they own a startup or small business in the cosmetology, food service, or hospitality industries. In this case, the business owner typically has loyal patrons who directly pay them additional cash and noncash income tips.
Are Tips and Service Charges the Same?
Tips differ from service charges; the latter refers to additional fees or payments required from customers in exchange for certain services and products provided to them.
Some examples of service charges include delivery fees, room service, and bottle service charges. Employers also include service charges in their employees’ non-tip income or wages.
Do You Have to Report Cash Tips to the IRS?
Yes, you have to report cash tips (and even noncash tips) to the IRS to avoid discrepancies on your tax returns.
The tips you report are used as a basis for assessing your and your family’s eligibility for Social Security and Medicare benefits by the time you retire or in case you become disabled, get diagnosed with a serious illness or pass away.
Reporting all your regular wages and tip income also helps the IRS verify the accuracy of the information on your tax returns.
Tax evaders tend to manipulate their income and tax information by withholding key details about the salary or income they generate in an attempt to lower their tax bill.
In some instances, certain taxpayers withhold income information to make it seem as though they belong to a low-income household and hope to gain eligibility for certain tax deductions.
As such, the IRS needs a complete and updated reference when assessing and comparing a taxpayer’s annual wages with the amount of taxes they have paid.
6 Main Types of Tips
There are different types of taxable tips, and they vary depending on the industry or the type of service that a business offers. A customer’s loyalty and level of satisfaction with an establishment’s services can also prompt them to give cash tips, noncash tips, or both.
Below are some of the most common types of tips that service workers receive and report on their returns:
Cash
Cash tips refer to additional payments that customers give to employees on top of the total cost of the services or goods they purchase.
Most employees in the service industry prefer cash-based tips because of the instant gratification and solid proof of income that come with them.
Noncash Tips
Noncash tips include sporting event tickets, goods or freebies, merchandise, and gift cards. Employees need not report noncash tips to their employers, but they must use a separate tax form to report the said income to the IRS.
Electronic Tips
Electronic tips are tip income that employees receive via online payment gateways or mobile payment applications. Some employers enable electronic tip payments to help employees secure their income and ensure transparency in compensating their staff.
The use of electronic tips is also common in ridesharing and delivery services, where customers can use the ridesharing or delivery app to pay tips.
Customers can choose from the fixed tip percentages listed in the app or provide a more specific amount based on their experience and judgment.
Credit Card Tips
Customers may give tips through credit card payments if they want to pay a higher tip amount but do not have sufficient cash with them.
When paying credit card tips, customers indicate the amount they wish to pay on the receipt and sign their name to authorize and validate the tip amount. Customers must also write the new bill to be charged from their card, which includes the total amount and the tip payment.
Pooled Tips
Pooled tips are collected tip payments from all servers. The collected tips are combined into one lump sum and then distributed among the workers. The basis for distributing the collected tips depends on the standards or conditions agreed upon by the group.
For instance, they may allocate a larger portion of the combined tips to a coworker who worked extra shifts during the week.
Allocated Tips
Allocated tips refer to any additional payments made by employers to their staff on top of the latter’s reported tip earnings. This type of tip is typical in large food businesses and establishments.
How Are Tips Taxed?
To levy taxes on tips, the IRS requires employers to withhold a sufficient percentage of your combined regular wages and earned tips to pay your FICA and income taxes.
When it comes to calculating taxes on tips, the first thing you must do is check whether your tips are taxable for Social Security or Medicare taxes or not. Typically, you need to report and pay taxes on tips that meet the following conditions:
- Monthly cash tips worth $20 or more in total
- Tips received through tip-sharing or tip-pooling arrangements with fellow employees
- Electronic tips in the form of gift cards, credit, and debit payments
Since tips are taxable income or wages, it is crucial to ensure you calculate your tips correctly. You can do this by using Form 4070-A, Employee’s Daily Record of Tips, to keep regular and updated documentation of all your tips.
Meanwhile, employers and employees share payments for the combined FICA tax rates. As such, both employers and their staff each pay 6.2% tax rates for Social Security and 1.45% for Medicare.
It is important to note that tips are taxable for the 0.9% additional Medicare tax if an employee’s Medicare wages exceed the $200,000 threshold within a calendar year, regardless of their filing status.
On the other hand, self-employed tip earners must pay the additional Medicare tax if their self-employment earnings exceed the following thresholds:
- $250,000 (if married filing jointly)
- $125,000 (if married filing separately)
- $200,000 (if single, head of household, or qualified widow/widower with dependent child)
How to Report Tips to Your Employer
To report tips to your boss every month, use Form 4070—Employee’s Report of Tips to Employer. You can also use a designated form or system implemented by your employer to report your monthly tip payments, as long as you keep your report accurate and up-to-date.
If the total amount of tips you received is less than $20, you don’t have to report the amount to your employer. However, you must still include your tips in your taxable income when filing your tax return.
Your report must contain your name, address, Social Security number (SSN), and the month or pay period covered by your accumulated tips.
Employees who receive tip payments must submit their tip reports to their employers on or before the 10th of the month following the period or month when they received their tips.
How to Report Tips on Your Tax Return
To report tips on your tax return, you must use Line 1 on your Form 1040 or Form-SR. You must report all cash and noncash tips you received within the year.
If there are tip payments that you failed to report to your employer, you must check Box 1 of your Form W-2 to declare or claim the undocumented sum. Employees whose taxable tips are generated from tip-sharing with their coworkers must report the portion of the pooled tips allocated to them.
Conversely, if you are reporting tips received during the month of December, it is best to include the tips in your tax return for the following tax year.
Can You Catch Up With Reporting Tips?
You can catch up with reporting taxable tips by using Form 4137, Medicare Tax on Unreported Tip Income.
Aside from providing instructions on determining the FICA taxes owed by taxpayers on unreported tips, Form 4137 also lets you report the tip amounts that you failed to report to your employer.
There are other online tools that you can use aside from the recommended IRS forms to keep track of your daily wages and tips.
For instance, you can use Paystub.org’s online paystub generator to document your earnings. Our generator comes with ready-made templates and a built-in calculator that lets you record and calculate all of your wages and tips for a specific pay period or month.
Later on, you can compare the amount declared on the pay stub provided by your employer with the total earnings you’ve recorded using our generator.
What Happens If I Don’t Report My Tips?
If you don’t report cash tips, that can either prompt an IRS audit or incur penalties. The penalties for not reporting tax deductible tips can be worth up to 50% of your unpaid Medicare and Social Security taxes.
You will also be required to fill out Form 4137, as explained in the previous section.
Take note that the longer it takes for you to address your unreported tips or income, the more tax penalties you will likely accumulate.
Final Thoughts
Now that we’ve clarified the most pressing questions that workers have, such as “Are tips taxable?” or “Are tips taxable according to the IRS?” there is no excuse for neglecting your tax-paying duties.
Make it a habit to document all tips you receive from your customers, whether they are in cash or noncash form. If your workplace does not yet have a tip-recording mechanism in place, perhaps this is your sign to suggest the importance of having one to your employer.
When in doubt, you can always use this article as your reference or read IRS Publication 531, Reporting Tip Income, for a more in-depth guide.
Better yet, check out our blog to boost your payroll and tax filing knowledge!
Are Tips Taxable FAQs
#1. Are tips taxed differently than wages?
No, tips are not taxed differently than wages. Employers combine their employees’ wages and earned tips to calculate the amount of payroll and income taxes they must withhold.
#2. When did tips become taxable?
Tips became taxable in the US in 1982, following the enactment of the Tax Equity and Fiscal Responsibility Act (TEFRA). TEFRA's main objective was to help generate more revenue and resolve the declining federal budget at the time.
#3. Are credit card tips taxed on a paycheck?
Yes, credit card tips are taxed on paychecks because all wages, cash, and noncash tips are usually reflected on an employee’s paycheck or pay stub. Also, credit card tips leave paper trails that make it easier for employees and employers to record the said payment for tax filing purposes.
#4. Are tips taxable to the employer?
Yes, tips are taxable to the employer because tips are considered a part of an employee’s taxable income. That said, employers must pay their half of the FICA tax rates levied on their workers’ tip income.
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