Thea Kruger, J.D., LL.M.
07.09.2018 | Berdon Industry Insights
For restaurant owners, navigating the requirements surrounding employee tip income can prove challenging. Nevertheless, complying with the various tax and labor requirements is crucial. Mistakes can invite unwanted scrutiny; resolutions, therefore, can be extremely costly and time-consuming to implement.
Defining a Tip
What is a tip? The IRS defines a tip as income that meets four primary criteria:
- A payment made free from compulsion;
- The customer has the unrestricted right to determine the amount;
- The payment is not subject to negotiations; and
- The customer, generally, has the right to determine who receives the payment (subject to voluntary and required tip-pooling arrangements among employees.)
All tips earned by employees are considered taxable income. Employees can earn tips in different ways, but it is the employer’s responsibility to implement a system to track the relevant tips earned by employees.
- Cash Tips: Employees need to report cash tips to their employers in order that the employers can properly track, and correctly report, the amount in the employees’ wages to the government, as well as ensure they are withholding all necessary taxes.
- Credit Card Tips: For tax purposes, credit card tips are equivalent to cash tips. Since these are usually entered and reconciled through the restaurant’s POS system every time a sale is made, the tracking of credit card tips is often easier than the tracking of cash tips. Under the Fair Labor Standards Act, an employer may charge its employees a fee of up to 3% of credit card tips to offset the charges it incurs from the credit card company. However, an employee cannot be charged the 3% fee if it would bring his/her wages below the applicable minimum wage for the pay period.
- Nonmonetary Tips: These include sports or concert tickets, and do not have to be reported to the employer. However, the value of items received is still considered taxable income to the employee.
- Service Charges and Other Automatic Fees: Service charges are not considered tips. Amounts added to a restaurant bill as automatic gratuity, passed through to employees, are considered additional wages to the employees, not tips. Other types of charges that are not automatically passed through to employees, such as automatic charges for large parties, are considered additional sales to the employer.
By law, employees who earn more than $20 per month in tips must track all tips earned on a daily basis, and report cash and credit card tips to their employer in any given month, no later than the 10th of the following month. The IRS provides Form 4070 for tracking daily tips; however, the official form does not have to be used, as long as all the information on it is captured by the employee. There are also computer programs and smartphone apps, such as TipSee and ServerLife, that tipped employees may use. Although the IRS requires monthly reporting to employers from tipped employees, restaurants often require employees to report their tip earnings more frequently – at least once every pay period.
Once tip earnings are reported by an employee, it becomes the employer’s responsibility to report earnings to the IRS for that employee and to withhold all applicable taxes. These taxes may include federal income tax, federal payroll tax, and state and local income taxes. Employers file quarterly on Form 941 (Employer Quarterly Payroll Tax Return) and must issue employees Form W-2’s each year that include employee wages and tips. State and local income tax reporting and withholding rules also apply.
In the case of an IRS audit, if a restaurant is found to have unreported tip income, the restaurant will be held liable for its share of the employment taxes (i.e., FICA) on unreported tips, and would be required to pay out of pocket for that amount, which payment could be significant if it covers multiple years.
Each year, a restaurant employer with more than 10 employees must file Form 8027 with the IRS, summarizing total sales, charged sales, charged tips, and total tips. This form is organized in a way that draws attention to restaurants with abnormally low-reported tips. If a restaurant is reporting total tips of less than 8% of gross sales, then employees must be allocated additional tip income on their W-2 in order to meet the 8% of gross sales threshold, set by the IRS, as an absolute minimum to be allocated as income to employees.
A Common Misconception
Some tipped employees, as well as employers, mistakenly believe that they are only required to report tips equal to 8% of sales or that tips earned over 8% of sales are not considered taxable income. This is not the case. As described above, all tip income is taxable. The misconception stems from IRS use of the 8% threshold.
Tips allocated to employee, as shown on Form 8027, to meet the 8% threshold are reported to employees on their W-2, in Box 8. Employees need to file Form 4137 with their personal income tax returns to report these allocated tips. The amounts will generally be taxable to the employees at that time, unless employees have records verifying that they received tips of less than the allocated amounts during the year.
The tax rules surrounding tip reporting and withholding can be complex. However, it is in a restaurant owner’s best interest to establish and enforce strict policies and procedures to ensure compliance with these rules.
If you have questions regarding tip reporting or any other matters impacting the hospitality industry, please contact Thea Kruger at (212) 699-8865 or TKruger@berdonllp.com; or you may reach out to your Berdon advisor.
Berdon LLP, New York Accountants