If your employees receive cash tips from your customers, the tips may constitute taxable wages for payroll tax purposes. This subjects you as an employer to additional payroll tax withholding, reporting and payment requirements.
So — what constitutes a tip? Tips are defined as payments that customers make without compulsion. Customers should have the unrestricted right to determine the amount of their tips. Tips shouldn’t be subject to negotiation or dictated by the establishment’s own policy.
If this isn’t what’s going on at your business, then maybe these payments aren’t tips at all but are actually service charges. If you don’t permit direct tipping but you include a mandatory gratuity that you distribute among your employees, can you call this gratuity a tip? No. A mandatory charge is not a tip. The gratuity constitutes taxable wages once it is distributed to employees.
Managing taxes and tips
An employee’s cash tips aren’t taxable wages unless they amount to $20 or more in a calendar month and the employee reports them to you by the 10th of the month after they were received. Once the $20 threshold has been reached, however, all cash tips, including the $20, are wages.
You as the employer are responsible for withholding income taxes and FICA — Social Security and Medicare — taxes on reported tips and for paying the employer’s portion of FICA and FUTA taxes on them, even though you have no control over the amount of tips employees receive. And don’t forget the 0.9 percent FICA Medicare surtax. Tips are subject to FICA Medicare surtax withholding if, in combination with other wages paid by you, they exceed the $200,000 withholding threshold.
If your employees fail to report tips of $20 or more per calendar quarter to you, you can be held liable only for the employer’s portion of FICA, and this liability doesn’t arise until the IRS makes a written notice and demand.
If you receive a letter from the IRS concerning your payroll tax responsibilities, be sure to contact your accountant or tax advisor right away to find out your options for responding. As with any notice from the IRS, take it seriously. In most cases, you must respond within a specific time period or lose your rights to contest the IRS’s assessment.
If you are a food service employer, you can agree to take certain steps to increase tip-reporting compliance by your employees in exchange for a promise by the IRS not to demand more FICA than you determine is due.
To participate in this program, you have to enter into a Tip Rate Alternative Agreement Commitment (TRAC) with the IRS. Basically, you must agree to:
- Maintain a quarterly educational program training newly hired employees and updating existing employees about their tip-reporting obligations.
- Comply with all federal tax requirements regarding the filing of returns, paying and depositing of taxes, and maintaining records. At the same time, establish employee tip-reporting procedures to ensure accurate tip reporting by your employees.
This program is voluntary; IRS agents can’t threaten to audit you to convince you to sign a TRAC.
If the IRS considers your establishment a large food and beverage business, you are required to file some special information returns that allocate 8 percent of your gross receipts as tips to your employees if they don’t report at least that much in tips. The IRS says a large food or beverage establishment is any trade or business that meets both these criteria:
- Is a food or beverage operation where tipping is customary.
- Normally employed more than 10 people on a typical business day during the preceding calendar year.
This is reported to the IRS for informational purposes only, and although these tips must be reported on each employee’s W-2 form, you don’t actually pay or withhold taxes on allocated amounts.
