In most businesses, employees work for wages paid at regular intervals. But in many service-oriented entities, employees receive much, sometimes nearly all, of their income in the form of tips, or gratuities. But that doesn’t mean this income is tax free — which is why the IRS has outlined special rules in Topic 761 – Tips – Withholding and Reporting.

First, companies should make sure their employees are aware that they can use Form 4070A, Employee’s Daily Record of Tips, to keep a daily record of their tips, and Form 4070, Employee’s Report of Tips to Employer, to report their tips to their employer. (Look for these on the IRS website in “Publication 1244, Employee’s Daily Record of Tips and Report to Employer.”) An in-house electronic system for tip reporting may also be acceptable.

After getting the report, employers can use the data to figure the amount of Social Security, Medicare and income taxes to withhold for the pay period on both wages and reported tips. Even though staff may be paid mostly in tips, employers are still responsible for paying the employer’s portion of the Social Security and Medicare taxes.

Employers should collect employees’ portions of these taxes from the wages paid, or from funds the employee gives the owner. If the employer doesn’t have enough money from the employee’s wages and funds that the employee gives the owner, the employer should withhold taxes in the following order:

  • Social Security and Medicare taxes on the employee’s wages;
  • Federal income taxes on the employee’s wages;
  • State and local taxes imposed on the employee’s wages;
  • Social Security and Medicare taxes on the employee’s reported tips; and
  • Federal income taxes on the employee’s reported tips.

For the purposes of these ordering rules, the rules for withholding an employee’s share of Medicare tax on tips also apply to withholding Additional Medicare Tax on tips.

Preparing the Form W-2

Again, employing a tip-based staff does not give employers a free pass when it comes to preparing the annual Form W-2. It must include wages, tips and other compensation in the box labeled “Wages, tips, other compensation.”

Employers must include Medicare wages and tips and Social Security tips in their respective boxes. When employers figure out the liability for federal unemployment tax, they should add the reported tips to the employee’s wages.

Finally, certain establishments above a certain size (generally employing more than 10 people whose combined hours are more than 80 hours in a typical business day) must file Form 8027, Employer’s Annual Information Return of Tip Income and Allocated Tips, for each calendar year, and may be required to allocate tips to their employees.

These are just the key rules. Tip-based businesses should read the full IRS guidance and consult with a qualified financial professional. Contact Complete Payroll Services and we’ll be happy to go over your operations and take a closer look at your payroll and HR needs!