Most of us have visited coffee shops, ice cream parlors or other small businesses that have jars out on the counter to collect tips for the team members’ college funds, car funds, vacation funds, etc. Many people automatically drop their change (and maybe something extra) into the jar, but did you ever wonder about the tax treatment of those tips? This article summarizes what the IRS recommends for funds collected in this manner.
While tips are freely given directly from a customer to an employee rather than being paid by an employer, the IRS and the tax code, nevertheless, place certain tax reporting and collection responsibilities on employers. Employers are responsible for the withholding of taxes as well as payment of the employer’s share of the FICA tax, a U.S. payroll tax deducted to fund the Social Security and Medicare programs, which is based upon wages and reported tip income.
Special rules apply to withholding of tips. Generally, the total amount of cash and charge tips received by an employee are considered as taxable wages for FICA purposes. However, if tips are required to be turned over to the employer and then distributed among employees, this rule does not apply. Instead, these amounts become categorized as wages when paid by the employer and are subject to the normal rules on FICA payments and withholding. Employers must withhold federal income taxes and pay FICA taxes on cash tips of $20 or more in a calendar month if the employee makes a written report of the tips to the employer. Cash tips of less than $20 in a month and noncash tips are not subject to FICA taxes but are subject to income taxes. The employer is not liable for the FICA taxes on unreported tips.
The IRS uses four factors to determine whether a payment qualifies as a tip:
- The customer makes the payment free from compulsion;
- The customer must have the unrestricted right to determine the amount;
- The payment should not be the subject of negotiations or dictated by employer policy; and
- Generally, the customer has the right to determine who receives the payment.
In 2018, the IRS clarified that amounts collected in “tip boxes” (or “tip jars”) did not lose their identity as tips because of how they were collected or due to the employer’s procedures for the storage and distribution of such funds.
The guidance reviewed a specific case of an employer who placed receptacles in the vicinity of where the employees performed services in order to encourage customers to contribute cash amounts to the individuals. The cash tips were then distributed among the employees at the end of each shift, in allocation amounts determined by the individuals working that shift. The employer did not require customers to make cash contributions, and customers had the discretion on how much cash to contribute (including zero.) Additionally, there was no employer policy dictating tips (as in the case of a restaurant that mandates patrons pay a certain tip percentage if their party is a certain size.)
As such, the funds collected in the tip boxes qualified as tips based on the criteria noted above. Although the employer was aware that customers made cash contributions that were distributed to the employees, it was the burden of the employees to report these distributions to the employer for tax purposes. Since the cash amounts retained their character as tips, any unreported tips were not subject to the employer share of FICA tax at the time the amounts were distributed to the employees. Unreported tips are only subject to the employer’s share of FICA when the IRS provides a notice and demand for the taxes from the company.
If you have questions or need further information about an employer’s responsibility regarding tips, please reach out to Grossman Yanak & Ford LLP at 412-338-9300.
IRS Rev. Rule 2012-18 – Guidance for Employers and Employees Regarding Tips
IRS Publication 3144, Tips on Tips – A Guide to Tip Income Reporting for Employers
IRS Publication 3148, Tips on Tips – A Guide to Tip Income Reporting for Employees
IRS Publication 531 – Reporting Tip Income
IRS Publication 1244, Employee’s Daily Record of Tips and Report to Employer
Noah Trimble, who is earning his BS/MBA from Robert Morris University, assisted with the research and writing for this post. In his role as a GYF Tax Intern, Noah helped to prepare individual and corporate tax returns.