An Employer's Guide to Employee Tips

Employers in service industries have a unique pay and tax situation because their employees often receive tips. The customer doing the tipping and the person being tipped are both involved in the transaction, so you have to know how to handle the taxes and payment on that money properly if you own a business in which your employees receive tips.  

How Do I Report and Pay Taxes on Employee Tips?

You must first collect employee tip income reports from employees, from card transactions, and from other sources. Include all tip income on the employee's wage payments for each payroll.

You must withhold income taxes and FICA taxes on tip income in your calculation of wage payments. You must also pay your employer share of FICA taxes on tip income. Tip income is also subject to both the maximum Social Security limit and the additional Medicare tax. 

You must include employee tip income and withholding in all your payroll tax reports: Form 941, the quarterly tax report, and Form 940, the annual unemployment tax report. Make payroll tax deposits as required on tip withholding and FICA taxes.

How Do I Take a Tip Credit?

The Fair Labor Standards Act allows you as an employer to take a credit for the difference between the amount you pay the employee (a minimum of $2.13 an hour) and the minimum wage amount ($7.25 an hour as of August 2022). The maximum tip credit would therefore be $5.12 an hour. This credit basically allows you to pay the employee less than minimum wage, taking their tips into account as wages.

You must provide the following information to employees before you use the tip credit:

• The amount of cash wage you're paying the tipped employee (at least $2.13 per hour)
• The extra you're claiming as a tip credit (not more than $5.12 an hour)
• That the tip credit claimed by your business cannot exceed the amount of tips actually received by the tipped employee
• That the employee keeps all tips except for those in a valid tip pooling arrangement that's limited to employees who customarily and regularly receive tips, and
• That the tip credit won't apply to any tipped employee unless that employee has been informed of these tip credit provisions

You must pay your tipped employees at least the $7.25 minimum wage and allow them to keep all tips received if you don't give them this information.

What If the Employee Doesn't Report Tip Income to Me? 

It's the employee's responsibility to report their tip income to you and to the IRS. You're not liable for the employer's share of FICA taxes until notice and demand for the taxes is made to you by the IRS.

How Do I Credit Tips on Cards?

You must give the tip amount to the employee when tips are included in credit or debit card payments. Unless prohibited by state law, you can reduce the tip by the transaction fee amount that's charged by a credit card company. For example, you can give the employee $4.85 (the tip less the transaction charge) if the credit card transaction fee is 3% and an employee's tip is $5.

But the Department of Labor says this reduction can't bring the employee's pay down to less than the minimum wage, and you must reimburse the employee on the next payday. You can't wait until you receive the reimbursement from the credit card company. 

How Does Tip Income Affect an Employee's Total Wages? 

All employees must be paid at least the minimum wage, including tip income. You're not permitted to use employee tips except as a credit against the minimum wage. But you can use the tip amount to offset what the Department of Labor calls the "required cash wage," which is $2.13. The difference between the required cash wage and the 2022 minimum wage of $7.25 is assumed to be made up by tips. 

How the Required Cash Wage Works

You must first pay a tipped employee at least $2.13 an hour before tips are counted. Then the employee tips are reported to you by the employee. The $2.13 plus the tips reported by the employee should equal at least the minimum wage. You must make up the difference if the two amounts don't equal the minimum wage.   

Some states have different minimum wage rates for tipped employees. Some require that employees be paid the full minimum wage before tips, while other states have a higher minimum required cash wage than the federal amount. You must use the state's minimum wage rate amount if the state minimum wage law requires a higher amount than the federal rate.

How Are Tips and Service Charges Different?

Tips are discretionary amounts given to someone for service. Tipping is a custom in the U.S., but it varies in use around the world. Service employees are paid a wage large enough that tips aren't used commonly in most European countries.

A payment is considered a "tip" if four conditions are met: 

• The payment must be made with the giver's free will. It's not mandated or coerced.
• The customer must have the right to determine the amount.
• The payment shouldn't be negotiated or dictated by the employer.
• The customer has the right to determine who receives the payment.

It's not a tip if a restaurant adds a gratuity amount to a meal price as it might for large parties. This is a service charge. A service charge is a required amount. It doesn't matter what the business calls it.

Some examples of a service charge include:

• A fee for a banquet event
• Hotel room service charges
• Bottle service charges in nightclubs or restaurants

In What Ways Do Employees Get Tipped?

Workers often receive cash tips, such as extra cash in a payment to a taxi driver who's told to "keep the change," or an amount that's left on a restaurant table. A tip is more commonly included on a debit or credit card transaction, such as at a restaurant.

Tips can be split or pooled by various employees. You may have seen a tip jar at a car wash. You probably have a policy about how these tips are split if you have such a situation in your business. Service charges may also be considered to be pooled tips. 

Your business's tip pool can't include employees who don't usually receive tips, like dishwashers, cooks, chefs, and janitors.

How Do I Know What Tips an Employee Receives?

Employees are required to keep a daily tip record and report these tips to you on a regular basis if they're $20 or more a month. The IRS requires reporting by the tenth day of the following month.

Of course, the employee must report tip income on their individual tax return. They must also report tips for Social Security and Medicare tax calculation purposes using IRS Form 4137.

Is Tip Income Taxable? 

All tips totaling $20 or more in a month are subject to federal income tax and FICA tax (Social security and Medicare). You must receive information about those tips so you can include them on the employee's W-2 form. 

Don't forget that tip income is also subject to the additional Medicare tax for higher-income employees. You must start withholding the additional 0.9% Medicare tax when employee compensation reaches $200,000.

Service charges that are given to employees are also taxable as regular wages for federal income tax and FICA purposes.

How Are Tips Collected and Reported? 

The employee keeps all of their tips. You must reimburse the employee for these amounts if you collect the tips on a credit or debit card charge.

Pooled tips are common in some restaurants and other services. The employees divide the pooled amount according to their own arrangements and each individual reports their portion of the pooled amount to you. States have different tip pooling laws and arrangements.