Tip income is taxable and must be reported

People who work in restaurants, salons, hotels and similar industries often receive tips for the customer service they provide. Tips can be taxable income, but it's important for people working in these areas to understand important details involving tips.

What are tips?

Tips are optional cash or noncash payments that customers make to employees.

• Cash tips include: those received directly from customers, electronically paid tips distributed to the employee by their employer and tips received from other employees under any tip-sharing arrangement. All cash tips must be reported to the employer.
• Noncash tips are those of value received in any other medium than cash, such as: tickets, passes or other goods or commodities that a customer gives the employee. Noncash tips aren't reported to the employer.

Four factors determine whether a payment qualifies as a tip. Normally, all four must apply:

• The customer makes the payment 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 employer policy; and
• Generally, the customer has the right to determine who receives the payment.

Direct and indirect tips

A direct tip occurs when an employee receives it directly from a customer, even if it is part of a tip pool. Examples of directly-tipped employees include waiters, waitresses, bartenders and hairstylists.

An indirect tip occurs when an employee, who normally does not receive tips directly from customers, receives a tip. Examples of indirectly-tipped employees include bussers, service bartenders, cooks and salon shampooers.

Keeping a daily tip record

Employees must keep a daily record of the cash tips they receive. They can use Form 4070A, Employee's Daily Record of Tips, which is included in Publication 1244, Employee's Daily Record of Tips and Report of Tips to Employer, to keep daily track of the cash tips they receive.

They should also keep a record of the date and value of any noncash tips, such as tickets, passes or other items of value. Although they don't report noncash tips to their employer, they must report them on their tax return.

Reporting tips to employer

There is no required form, but the statement must include:

• Employee signature;
• Employee's name, address and social security number;
• Employer's name and address (establishment name if different);
• Month or period the report covers; and
• Total of tips received during the month or period.

Employees must report tips to the employer by the 10th of the month following the month the tips were received.

The employee can use Form 4070, Employee's Report of Tips to Employer, available in Publication 1244, an employer-provided form or other electronic system used by their employer as long as it includes the above elements required for reporting.

Employees don't have to report tip amounts of less than $20 per month per employer.

Reporting tips on individual income tax return

Tips reported to the employer by the employee are included on the employee's Form W-2, Wage and Tax Statement, for reporting on an individual tax return.

Any tips that the employee didn't report to the employer must be reported separately on Form 4137, Social Security and Medicare Tax on Unreported Tip Income, to include as additional wages with their tax return. The employee must also pay the employee share of Social Security and Medicare tax owed on those tips.

Requirements for employers

Employers with tipped employees are required to:

• Keep employee tip reports.
• Withhold taxes, including income taxes and the employee's share of Social Security tax and Medicare tax, based upon employee's wages and tip income.
• Pay the employer share of Social Security and Medicare taxes based on the total wages paid to tipped employees as well as the reported tip income.
• Report this information to the IRS on Form 941, Employer's Quarterly Federal Tax Return.
• Deposit the withheld taxes in accordance with federal tax deposit requirements.

More information:

• Tip Recordkeeping and Reporting
• Publication 531, Reporting Tip Income
• Publication 15, Employer's Tax Guide PDF