As a tax preparer, it’s important to understand the difference between services charges and tips and how they are treated for tax purposes. In this article, we’ll look at what constitutes a tip vs. a service charge, and how each should be reported to the IRS.
What is the difference between tips and service charges?
The primary difference between tips and service charges is that tips are voluntary, while service charges are an automatic gratuity added to the bill.
Tips are paid at the customer’s discretion and can be given directly to an employee or pooled among staff, including employees who don’t usually receive them, like dishwashers, cooks, chefs, etc. Oftentimes, tips are paid in cash or charged to a debit or credit card, but they can also be non-cash items of value.
A service charge, on the other hand, is mandatory. The amount is determined by the business/organization, and it is added directly to the customer’s bill. For example, when a gratuity is automatically added to the bill for a large dining party, that is a service charge – not a tip.
Understanding the distinction between a service charge and tip is important for accurate tax reporting. Misclassification can lead to IRS penalties, back taxes, or tax audits.
Who qualifies as a tipped employee?
According to the U.S. Department of Labor, a tipped employee is someone who receives tips regularly as part of their income and consistently earn at least $30 per month from tips. A directly tipped employee, such as a bartender or server, receives tips directly from the customer.
An indirectly tipped employee, like a busser or cook, typically receives tips through a tip pool (or tip sharing) rather than directly from patrons. Both directly and indirectly tipped employees are required to report all tips received, regardless of how they are distributed.
How should tip income be reported for tax purposes?
If your client is a tipped employee and receives more than $20 per month in cash tips, they are responsible for reporting these amounts to their employer. Tip income must also be reported on your client’s individual tax return and will be used to calculate their Social Security and Medicare tax liability.
If your client is the employer/business owner, they will need to know how much their tipped employees are receiving in tips and include all tip income on the employee’s wage payments for each payroll. They will also need to:
- Withhold income taxes and FICA taxes on tip income
- Pay the employer share of FICA taxes on tip income
- Include employee tip income and withholding in payroll tax reports
- Keep tax records of employee tip reports
The One Big Beautiful Bill signed into law in July 2025 introduces temporary federal income tax exemptions for tips and overtime pay. This exemption allows an above-the-line deduction for qualified tips up to $25,000 beginning with 2025 tax returns (filed in 2026).
How should service charges be reported for taxes?
Service charges are not considered tips. They are mandatory fees set by the business owner/employer and paid for by the customer. Because the employer controls the amount and distribution, the IRS requires service charges be included in the business’s gross income, regardless of whether they are kept by the employer or passed onto the employees.
When service charges are distributed to employees, they must be treated as regular wages. This means the amounts are subject to withholding for federal income tax, Social Security tax, and Medicare tax, and must be reported on the employee’s W-2.
