As a tax preparer, it’s important to understand how tips and service charges are treated for tax purposes. In this article, we’ll look at what constitutes a tip and a service charge, and how each should be reported to the IRS.
What is the difference between tips and service charges?
Tips are voluntary. A paying customer chooses the amount they want to pay as a tip for services, and they can choose who receives the tips. Tips might be split or pooled to include 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.
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.
Reporting tips for taxes
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 records of employee tip reports
*Your client will report the taxes withheld from their employees’ wages using Form 941, Employer’s Quarterly Federal Tax Return.
Reporting service charges for taxes
Service charges aren’t tips. Instead, they are mandatory fees set by the business owner/employer and paid for by the customer. For this reason, the IRS says service charges should be included in the business owner’s gross income. This is true whether they distribute them to their employees or keep them.
If the service charges are distributed to the employee(s), the amounts each employee receives are subject to withholding, just like regular wages (including Social Security tax, Medicare tax, and federal income tax withholding).
This article was last edited on September 3, 2021.