Dollars and Sense: How to Report and Withhold Tax on Tips

Have you ever noticed when you vacation abroad in places like Europe, the service at restaurants isn’t quite as attentive? It’s not that the servers are rude, but they’re also not going out of their way to impress you. The difference? The tipping culture.

In the U.S., tips are a crucial part of servers’ income, which is why their minimum wage is $2.13 an hour rather than the federal minimum of $7.25 (in many states). This wage gap explains why our servers go above and beyond to deliver exceptional customer service and highlights the importance of American tipping culture.

As tipping options continue to pop up in new places like fast-food restaurants, stadiums, and even retail stores, business owners and managers must figure out how to properly track, report, and withhold taxes for this additional income. We’ll walk you through the entire process. After all, no one likes a surprise at tax time.

What are tips? 

Tips are those extra bucks that customers voluntarily give service workers as a token of appreciation for a job well done. Any business can prompt its customers for a tip, and more and more businesses are doing so. Tips are most commonly expected in restaurants, hotels, beauty salons, taxis, and food delivery.

There are a few ways that businesses can handle and distribute tips. Typically, customers leave service providers (like servers or hairstylists) a percentage of their bill as a tip. While the percentage varies by industry, these tips are generally given directly to that employee. However, some businesses like restaurants require servers to tip out a percentage to share with those who don’t get tips. Think cooks, dishwashers, and hosts—they usually receive a portion of cash from a shared tipping pool. Pooled tips can come from individual employees, communal tips jars, POS tips (like at fast-food chains or coffee shops), and event gratuities given to catering companies. 

Managers have the flexibility to determine how tips are incorporated into their team’s compensation. Restaurants may include tips in regular paychecks, while bars might distribute cash after shifts. Collaborative settings like hotels may periodically pay out pooled tips as bonus payments. However, these methods often require labor-intensive manual calculations. That’s why tech-savvy establishments opt for automated payroll systems to simplify and streamline the entire process.

Are tips taxable?

The short answer is that yes, tips are taxable—and don’t let anyone tell you otherwise. It doesn’t matter if tips are given in cash or included on a credit card transaction, anyone who makes over $20 in tips (in a calendar month) has to report the income to their employer.

From there, it’s on the employer to report the additional income and withhold relevant taxes. Why? Well like it or not, the IRS considers tips taxable income—yes, even cash tips. And just like any other form of income, those snoopy folks at the IRS want to know about it so they can take their cut. 

If you’ve been in the service industry for a while, you’ve probably overheard people chatting about how they don’t report their tips. They assume that the IRS won’t bother auditing individuals with lower earnings. However, that’s a very real—and very dangerous—misconception. If you have a few team members operating under this assumption, they could be in for a rude awakening if or when the IRS catches wind.

We’re talking about owing back taxes and interest, facing fines, and even dealing with potential legal consequences. What’s worse? Your business might also be held liable since it’s your responsibility to accurately report their additional income, withhold relevant taxes, and ensure those taxes are duly paid. 

Worried your team’s tipping culture isn’t up to code? Don’t stress—grab a pen, and we’ll walk you through the process.

How do you pay tax on tips? 

It’s on management to accurately report and withhold tax on tips. That means it’s important to fully understand your responsibilities and establish a process that makes it easy for your team to track and report their tips. Add these steps to your payroll process to ensure everyone is on the same page when it comes to managing their tip taxes.

Step 1: Set up payroll

To start, ensure everyone on your team is properly set up in your payroll system. This includes providing them with an Employer Identification Number, setting up payroll (ensuring they’ve signed direct deposit, W-4, W-9, and I-9 forms), and establishing a payroll schedule.

Step 2: Implement an easy tip reporting method

Make sure your team knows to keep track of their tips. If your POS or payroll system doesn’t have a tip reporting feature, your team can use this form to record their tips.

Keep in mind that restaurant employees (who earn tips as part of their wages), might be paid less than the standard minimum wage depending on the state’s tip credit regulations. If you manage a team of servers that earn less than the federal minimum wage, they’ll need to report their tips daily to ensure they’re accurately compensated.

Step 3: Use tip reports to determine taxes to withhold

Calculate owed taxes, including Medicare, social security, and federal income tax based on your employees’ wages and tip reports.

Don’t forget to pay the employer’s portion of social security and Medicare taxes.

Step 4: Report uncollected taxes (if applicable) 

Do you have a member of your team whose wages don’t cover all of these taxes? Prioritize withholding federal income tax first, followed by social security, Medicare, and taxes on reported tips. 

Adjust the uncollected amount on their employment tax return.

Report uncollected social security and Medicare taxes on the employee’s W-2.

Step 5: Allocate and report tips

If your team’s total tips equal less than eight percent of gross receipts, distribute the difference among employees who received tips. Base this on their share of gross receipts, total hours worked, or a specific written agreement.

Report these tips on form W-2 in the allocated tips box for each employee.

Step 6: Keep an eye on employee reporting

To help you accurately calculate payroll and relevant taxes, make sure your team continues to report all of their tips.

Remember to keep all tip records in case anyone gets audited.

Handling tips can be overwhelming. When you take charge of the process, you’ll reduce stress and make tax season more manageable. Of course, if your hands are already full with countless other managerial tasks, it never hurts to bring in reinforcements.

With Homebase, you can say goodbye to tedious tax forms and manual calculations. Our payroll system automates everything — from calculating wages and tips to processing taxes and making payments to your employees, state, and the IRS. 

Make tax time easier. Simplify tip tracking and tax management with Homebase Payroll. Try it for free, today.

Tax on tips FAQS

What happens if I don’t report my tips?

When employees don’t report tips to the IRA, they can end up owing back taxes or facing financial penalties—even legal action. Employers also have responsibilities when it comes to reporting tips and withholding taxes. Failure to do so correctly can also result in financial and legal penalties, so it’s important to comply with the tax regulations in your area.

How do I collect tip amounts from employees so they can pay tax on tips?

To collect tip amounts from your employees, establish a simple system that lets them to regularly log and report their tip income. Ideally, this system is integrated into your existing payroll process to minimize additional paperwork and calculations. Make sure your team understands how to use it, and conduct periodic audits to keep tabs on employee reporting. Ensure you’re adhering to local and federal tip-reporting laws.

Related posts

4 Steps For Creating an Effective Balance Sheet

Navigating the financial side of running a small business can often feel complex and overwhelming. As an owner, you know…

Read article

The Payroll Playbook: Which Payroll Taxes are Paid by Employers

“Who’s FICA? And why is he taking all of my money?” — Rachel Green and every newbie looking at their…

Read article

Electronic Federal Tax Payment System: A Guide for Small Businesses

Taxes. One of only two certainties in life, according to Benjamin Franklin. And while paying taxes is obviously the most…

Read article

A How-To Guide For Calculating Double Time Pay

Payroll is one of those things that can drive a small business owner up the wall. The time-consuming, data-entry-driven task…

Read article

What is Retro Pay and How Does it Work?

Everyone understands that payroll errors can happen. But compensation shortfalls that go unaddressed for too long? They’re a quick road…

Read article

Your Complete Guide to the Employee Retention Tax Credit (2024)

Tax credits can be confusing. But for small businesses, every dollar counts, and tax credits and other incentives are a…

Read article
Effortlessly schedule and track your team's time with Homebase.
Try our basic plan free, forever.
Try Homebase for free