Understanding How Tips Are Taxed For Employees and Employers

In the United States, tips received by employees are considered taxable income, whether they are in cash, non-cash form, or received electronically. Both cash tips and non-cash tips must be reported as part of an employee's earnings to ensure compliance with IRS regulations and to safeguard benefits like Social Security in the future.

This article outlines how tips are taxed, reporting requirements, and important compliance details for both employees and employers.

How Are Tips Taxed?

Tips are treated as taxable income, meaning they must be included in an employee's total earnings, whether received in cash, via credit card payments, or through other electronic transactions.

According to the IRS, all tips—cash or non-cash—that an employee receives must be reported to their employer if they total more than $20 in a calendar month. Once reported, these tips are subject to tax withholding just like regular wages.

Key Taxation Points for Tips:

• Federal Income Tax: All reported tips are subject to federal income tax and must be included in your gross income.
• Social Security and Medicare Taxes: Tips are also subject to Social Security and Medicare taxes, which are a combined total of 7.65%.
• Threshold for Reporting: If the total tips from a single employer are less than $20 in a given month, employees are not required to report or pay taxes on them.

Employee Responsibilities for Reporting Tips

Employees are legally obligated to report all tips they receive, whether in cash or through electronic payments. Failing to report tips can result in penalties for both the employee and the employer. Here are the key steps employees must follow to ensure compliance:

• Keep Daily Records: Employees should track all tips received on a daily basis, using IRS Form 4070A, "Employee’s Daily Record of Tips." This includes cash tips and non-cash tips like tickets or other items of value.
• Report Tips to Employers: By the 10th day of each month, employees must report their total tips for the previous month to their employer using IRS Form 4070, "Employee’s Report of Tips to Employer." This helps ensure that the employer withholds the correct taxes from the employee's paycheck.

Failure to comply with these reporting requirements could result in penalties, so it’s crucial for employees to maintain accurate records and report tips promptly.

Employer Responsibilities for Tip Reporting

Employers also have specific responsibilities when it comes to tip reporting. They are required to:

• Withhold Taxes: Employers must withhold federal income tax, Social Security, and Medicare taxes from reported tips.
• Report Tips on Form 941: Employers must include the reported tips on their quarterly tax filings (Form 941) and accurately reflect them in the employee’s earnings.

It’s important for employers to stay updated on the IRS rules regarding tips and make sure that all tips received by their employees are properly recorded and taxed.

Why Tip Reporting Matters

Proper tip reporting is essential for both employees and employers. For employees, accurate reporting ensures they receive the appropriate credit toward Social Security benefits and other future retirement benefits. For employers, it helps avoid penalties for non-compliance with IRS regulations.

In conclusion, both employees and employers must understand the tax obligations and reporting procedures related to tips. By following IRS guidelines, employees can protect their future benefits, and employers can ensure they comply with federal tax laws.