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Payroll Taxes

Basic Principles on Reporting Employee Tips for Payroll

November 23rd, 2016

For any small business that may involve tips, it is important for the employer to keep track and report tips correctly to the IRS. The IRS has extensive explanations on the record keeping and reporting of employee tips at its website and in its publications. If you own a small business with employees that receive tips, you should understand these few key concepts on tips to make the subject a little easier

All employee tips are taxed.

All incomes are taxable, including tips. Therefore, the employer needs to keep track of the amounts, withhold payroll taxes, and report accordingly.

What is regarded as tips.

  • Tips are the actual amount of money received by the workers—voluntary client contributions, cash and credit card payments. If the worker receives tips directly, all tips need to be reported to the employer for the purpose of tax withholding. Total reported tips are subject to Social Security tax.
  • Allocated tips.  Your business may be required to report allocated tips. These are tips that you assign to each employee. Your business may be required to do this if
    • You run a business establishment (restaurant, cocktail lounge, or similar business) that must allocate tips to employees, and
    • The tips you reported for your employees are less than your share of 8% of food and drink sales.

    The IRS does not believe there are many Scrooges. Here is an example of how it works:

    • Restaurant made $100,000 in 2 weeks (excluding tips)
    • The sum of all tips (reported & credit card sales, etc.) equals $5,000
    • Total Allocated tips = (100,000 x 8%) – $5,000 = $3,000
    • Assuming there are 4 waiters (typically receiving tips), working 80, 60, 40 & 20 hours respectively, the allocated tips will be $1,200, $900, $600, $300 respectively. There could be other ways to allocate the tips, but it is commonly done by working hours.

    Because social security, Medicare, or Additional Medicare taxes were not withheld from the allocated tips, you must report those taxes as additional tax on your return.

  • Service charge is not a tip. It is treated as regular income and reported on Form W-2 and is excluded from the gross sales total for calculating allocated tips, etc. For example, a restaurant could have a policy that adds 18% “service charge” for any party of 10 or more customers. Because it is compulsory and the customer cannot change the amount, it is not a tip.

The issue of tips can be complex but these basic principles will help make the subject a little easier and allow your small business payroll to report tips correctly.

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