Tips and Taxes: Processing Payroll for Employees That Earn Tips

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Do you own or manage a bar or restaurant? Perhaps you oversee staff at a hotel or resort? Maybe you work in payroll for a company in the service industry?

Either way, knowing the ins and outs of some of the tax laws pertaining to the service industry and how to process payroll with tips and taxes is necessary.

Read further to learn some valuable info and ensure you don’t make any mistakes come tax season.

What Constitutes a Tip?

A tip is a payment a customer makes that’s not required. The customer has the right to tip or not to tip. It’s completely up to their discretion.

Your establishment should not have a policy rule about tips or tipping. If so, this negates any payment of cash from being a tip. These payments would then be called service charges, not tips.

For example, if you own a restaurant that doesn’t allow tipping but there is a mandated gratuity or service charge that gets split among all of your employees, that’s not a tip.

If an employee doesn’t make or report more than $20-$30 (depending on your state) in cash tips in a month they are not taxable.

Once the employee reaches the $20-$30 thresholds the cash tips are considered wages and taxable including the initial $20-$30. This needs to be reported by the 10th of the following month.

Tipped Employees

What should tipped employees be paid? That question differs in pretty much every state in the union. Under the FLSA (Federal Labor Standards Act) any nonexempt hourly employee has to be paid a minimum wage of $7.25.

But, most states have different laws and establishments can adhere to those instead. Sometimes even city laws can have precedence, so it’s best to look within those jurisdictions.

Your state may allow you to take a “tip credit”. A tipped credit goes against the minimum wage for tipped employees.

In this case, you’re able to credit up to $5.12 per hour toward the minimum. This is allowed if you are paying the employee a minimum of $2.13 per hour. basically, this makes up for the difference towards minimum wage that they didn’t earn in tips. 

Employee Responsibilities

The responsibility falls on both the employer and employees when it comes to reporting tips and taxes. Your employees need to report any tips over the $20 threshold or $30 in some states. (I’ll use $20 from here on in for brevity.) 

The 20 dollars can be cash, credit, or debit card tips. This also includes any tip outs from other employees during the shift. To get even more technical any non-monetary tips such as a gift card or bottle of alcohol are included. You report their cash value.

There are several ways to record this. You can hand out form 1244 that has instructions for employees of what and how to report. Or, you can create a custom form for them to fill out.

They can even just write down on paper their weekly/monthly tips. That’s entirely up to you. Just make sure the following is required:

  • Name, Address, and Social
  • Month Covered
  • Total Tips
  • Employer Name and Address

As mentioned above, these forms or reports need to be turned in by the 10th of the following month they were earned. Urge your employees to keep a copy of these for their records.

What Are You Responsible for Reporting?

You need to report tips for each quarter. You also need to collect the employee’s Medicare Tax, Social Security, and Income. 

There is a minimum you need to adhere to when reporting tips to the IRS each quarter. It needs to be equal to eight percent of the total receipts during the period.

However, when you report this don’t include carryout sales or any receipts with a service charge of more than 10%.

If the total of the reported tip income is less than eight percent, you need to fix the difference. Allocate the difference between the eight percent and the tipped income.

If you have an establishment that’s considered a large food and beverage business, you need to file Form 8027.

If you run a place where food and beverages are provided and consumed onsite, tipping is customary, you have more than 10 employees that work over 80 hours; then you need Form 8027.

Managing Cheat Sheet

Here is a cheat sheet or a reminder of things you should do to maintain an upstanding payroll reporting policy. 

Know the Laws

Take time to get the tax laws straight. Research federal, state, and local laws each year. They tend to change often. Refer to the FLSA and have it handy when doing payroll. Know overtime requirements and policies.

Know the rules of FICA tip credit if you’ll be using it. Make sure your employees are aware you’re using it also.

Use Tools

Use tools such as a paystub maker to make things easier. Find software or app that simplifies payroll. Payroll is already complicated and if you’re running a larger establishment it’s even more complicated. 

Service Charges Aren’t Tips

You’d be surprised or even shocked how many companies don’t follow this rule. They’ll get service charges mixed up with tips and it hurts the employees. Businesses think it’s in their best interest to do this, but it’s bad etiquette.

Be Fair

Believe it or not many companies in the service industry have had to pay settlements to its workers because it withheld tips. The FLSA prohibits an employer from withholding any amount of employee tips or tipped income.

Side Benefits

Remember to include any extra benefits when reporting an employee’s tipped income. If your employees get a free meal with work it’s a fringe benefit according to the IRS. This can be included as taxable income.

Tips and Taxes

Tax season is upon us and if you process payroll for tipped workers you have a lot to think about. Your employees or colleagues depend on you to get everything straight. They depend on you to be honest and follow the rule of law.

Plus, if you don’t do things correctly it could mean a lot of trouble for you, whether it’s your job or personally. So, make sure you use these tips to know the ins and outs of tips and taxes.

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