Section 61 of the Internal Revenue Code (IRC) defines gross income for individual taxpayers as including all income earned, regardless of the source. Waiters, waitresses, and others in the restaurant industry generally receive compensation in the form of both wages and tips. As a result, the employer faces the challenge of reporting employees’ total compensation to both the Internal Revenue Service (IRS) and the individual employees. Although employees may like to view tips as nontaxable gifts, tips are taxable income.
TIPS VS. SERVICE CHARGES
The IRS issued a fact sheet (FS-2017-08, April 25, 2017) reminding employers of the difference between service charges and tip income and the reporting of these incomes to their employees. Service charges are the amounts an employer requires a patron to pay. The most common examples of service charges are the automatic gratuity that’s added to a patron’s bill for hosting a large dining party, banquet event, or even hotel room service, to name a few.
For example, ABC Restaurant adds an 18% service charge to the bill for parties of six or more customers. Jane and seven of her friends have dinner at the restaurant one night. With a party of eight, the bill they receive from ABC includes an amount on the tip line equal to 18% of the charges for food and beverages. The 18% amount is considered a service charge and not a tip because Jane didn’t have an unrestricted right to determine the amount on the tip line; rather, ABC dictated the amount. Jane may decide to add an additional tip amount to the 18%. If she does, the 18% is still treated as a service charge, and the additional amount is treated as a tip.
Since the employer applies the service charge to the bill, the service charge amount belongs to the employer. If ABC passes on some or all of that amount to an employee, which is likely, that passed-on amount is considered wages to the employee and not tip income. This distinction is relevant to the calculation of allocated tip income, as we will see.
Tips, on the other hand, are discretionary payments determined by the patron. The IRS provides four factors to consider when determining whether a payment qualifies as a tip:
- Payment must be made 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 employee policy; and
- Generally, the customer has the right to determine who receives the payment.
For example, ABC Restaurant doesn’t include a service charge for a party smaller than six. Rather, the patron receives a bill that includes sample calculations of tip amounts at the bottom to assist in determining a proper tip amount. David’s bill, for example, includes a blank tip line, with sample tip calculations of 15%, 18%, and 20% of the charges displayed beneath the signature line at the bottom of the bill. David is free to enter any amount on the tip line, including the suggested amounts or a different amount entirely. Whatever amount he includes is treated as tip income to the employee.
Employee income derived from service charges and tips are reported differently by the employer on Form W-2. Service charges distributed by the employer are treated as regular wages. Any service charge amounts given to an employee are subject to Social Security and Medicare withholdings. In addition, the amount is listed on the employee’s Form W-2 in Box 1 (Wages, tips, and other compensation), Box 3 (Social Security wages), and Box 5 (Medicare wages and tips).
Tip income that has been reported by the employee to the employer or by the patron on the bill is likewise subject to Social Security and Medicare withholdings. But the tip amount is included on Form W-2 in Box 1 (Wages, tips, other compensation), Box 5 (Medicare wages and tips), and Box 7 (Social Security tips). An employee isn’t required to report the value of any noncash tips to the employer. Moreover, the employee isn’t required to pay any Social Security, Medicare, additional Medicare, or railroad retirement taxes on these tips.
When an employee fails to report to the employer all the tips received, the employee bears the burden of reporting the Social Security, Medicare, and Additional Medicare taxes on his or her return (Form 1040 or similar return). The employer in this case isn’t liable for the employer share of FICA (Federal Insurance Contributions Act) taxes on the unreported tips until notice and demand for the taxes is made by the IRS. Likewise, the employer isn’t liable to withhold and pay the employee share of FICA taxes on the unreported tips (see Rev. Rul. 2012-18, Q&A 8). But when the employer does pay the FICA taxes, it’s able to claim a credit on the amount paid.
Apart from the tips an employee reports to his or her employer, an employee may also have allocated tips that are reported in Box 8 of the employee’s Form W-2 and not Box 1. Allocated tips are tips that the employer assigns to the employee if the employee worked in an establishment (restaurants, cocktail lounge, or similar business) that must allocate tips to employees and if the total tip income of the employee is less than the employee’s share of 8% of food and drink sales (see IRS Publication 531, p. 6).
Allocated tips may be one of the crucial elements in understanding why there’s a difference in reporting of tips vs. service charges. The tips allocated to the employee are the share of an amount figured out by subtracting the reported tips of all employees from 8% (or an approved lower rate, though not less than 2%) of food and drink sales (other than carryout sales and sales with a service charge of 10% or more). The employee’s share of that amount will be figured using either a method provided by employer-employee agreement or a method provided by IRS regulations. If the employer allocates tips to an employee, the allocated tip amount is shown separately in Box 8 on the employee’s Form W-2.
For example, XYZ Restaurant had total sales of $20,000 for its foods and beverages in July. Of that total, $5,000 is attributable to assigned service charges of 10% or more. In addition, employees reported tips for the month equal to $800. The total allocable receipt amount would be $1,200, which is calculated as 8% of $15,000 ($20,000 – $5,000). The allocable tip amount distributed among the employees equals $400, which is the total allocable receipt amount ($1,200) less the reported receipts ($800).
The final step is to allocate that $400 among the employees. Assume that XYZ allocates tips by the number of hours worked by each employee. If an employee worked 40 hours during the month out of the 80 hours worked by all employees, then this employee is allocated $200 ((40/80) 5 $400).
Tip income is one of those situations where the employer and employee share responsibility in determining the correct reportable amount. Employers should take the time and initiative to educate employees about their responsibilities in reporting tip income. Regardless of the form of tips an employee receives, the fact is that tips aren’t gifts—they’re compensation.
© 2017 A.P. Curatola