The IRS has published a Fact Sheet for employers, summarizing what kind of payments qualify as “tips” and what kind of payments fall into the “service charge” category. Remember, there is a difference in how tips and service charges should be reported for tax purposes.
Tips are optional extra payments, the amount of which is determined by a customer. The tipped employee receives a tip directly from the customer -- not from the employer, and this even includes when the tip was left on a credit/debit/gift card. A tip can also take the form of something other than cash – something of value, like event tickets. Tips can be paid to employees out of pools where tip money is shared by all of the tipped employees at an establishment. Tips are never compulsory. The customer always determines the amount of a tip. A tip is never negotiated by the employer, and the customer has the right to decide who receives his/her tip.
These should be reported as tip income by the employee to the employer in any month when the employee earns at least $20 in tips. Cash and noncash tips are includable in the employee’s gross income and are subject to federal income taxes. Whether the employee received the tips directly from customers, or indirectly (for example bus boys tipped from a tip pool), these tips should be reported as tip income.
Service Or Banquet Charges
Service or banquet charges are added to a customer bill by the employer to cover the gratuity for the staff working the event. A large party dining at a restaurant may have an automatic gratuity added to the bill. A cruise guest will have a tip fee added to the final bill. Some establishments charge a bottle service for opening wine brought by guests. These are examples of services charges and should be reported as non-tip wages paid to the employee and reported in W2 Boxes 1, 3, and 5.
The Bottom Line
Employers of tipped employees should keep employee tip reports, withhold federal income taxes, social security and Medicare taxes on wages and tip income, as well as pay the employer portion of social security and Medicare taxes on wages and tip income. W2 Box 1 should include Wages, Tips, and Other Compensation, Box 5 should include Medicare wages and tips, and Box 7 should include Social security tips. Often tipped employees have shortfalls where there are not enough wages to collect the Social security and Medicare taxes they owe, so any uncollected Social security and Medicare taxes should be listed in box 12 on Form W2.