In some countries, tipping is frowned upon or even illegal. In the U.S. and some other countries, tipping is common, and the nature of your business may mean that you only pay part of what your employees earn; the balance comes to them in the form of tips from customers. This is so in restaurants and bars, beauty and nail salons, taxis, hotel cleaning staff and porters, and casinos. What does this arrangement mean for your business?
1. Special minimum wage requirements may apply
An employee who is engaged in an occupation in which the employee customarily and regularly receives at least $30 per month in tips is treated as a “tipped employee” for federal purposes. As an employer of a tipped employee, you are only required under federal law to pay $2.13 per hour in direct wages if that amount combined with the tips received at least equals the federal minimum wage. Today, most tipped employees receive a higher hourly rate. Nonetheless, if the employee’s tips combined with your payment of direct wages of at least $2.13 per hour do not equal the federal minimum hourly wage, you must make up the difference.
Most states may have their own rules for tips, which are more employee-friendly than federal rules. In fact, some states such as California, Minnesota, and Oregon, require full minimum wage payments to tipped employees; employers cannot get any credit for the fact their workers are tipped.
2. Employers pay FICA on tips
Tips are treated just like regular wages when it comes to employment taxes. This means the employer must pay the employer share of FICA and withhold the employee’s share from the employee’s wages. In order to do this, an employer needs to know the extent of monthly tips. The IRS requires employees who are tipped to keep a daily record of the tips and report them to the employer on a monthly basis, unless they total less than $20 per month. The IRS has a recordkeeper that employees can use for this purpose. There are also free apps that can be used for this purpose, such as TipSee and TipTracker.
As an employer, educate, encourage, and remind tipped employees to track their tips so they can be properly reported to you.
3. You may be able to make tip reporting agreements with the IRS
Because you are required to withhold income tax and the employee’s share of FICA from tips as well as paying the employer’s share of FICA, there is concern by the IRS that employers aren’t submitting to the government the full amount due and you face audit exposure. If you are in a certain industry, you may be able to enter into a voluntary agreement with the IRS to ensure compliance with income and employment tax rules. The agreements fix a rate for tips, and as long as these calculated amounts are reported, the IRS won’t audit the employer for tips. Currently, these agreements for the restaurant industry are:
- Tip Rate Determination Agreement (TRDA)
- Tip Reporting Alternative Commitment (TRAC)
- Employer designed TRAC (EmTRAC)
Casinos have their own agreement, called the Gaming Industry Tip Compliance Agreement (GITCA) program.
In February 2023, the IRS announced it was going to implement a new program called the Service Industry Tip Compliance Agreement (SITCA) program. It’s designed to take advantage of advancements in point-of-sale, time and attendance systems, and electronic payment settlement methods to improve tip reporting compliance. It will be available to employers in all industries except gaming.
4. Understand tax withholding and reporting for tips
As mentioned earlier, tips are subject to income tax withholding as well as Social Security and Medicare (FICA) taxes. Tips are payments directly from customers, amounts allocated to employees under tip-sharing agreements, and customer tips on credit and debit cards.
Tips do not include service charges added to a bill, such as a large party charge or a room service charge. If these charges are paid to an employee, they are non-tip wages. They are still subject to income tax withholding and FICA. The only difference: the impact on a possible tax credit, explained next.
For reporting on the employee’s Form W-2, tips and non-tip wages are lumped together.
5. Employer tax credit for tipped employees
Currently, employers in the food and beverage industry can claim a federal tax credit for FICA taxes paid on tip wages for employees, but not on service charges allocated to them. The credit is figured on IRS Form 8846.
Note: Bipartisan legislation (H.R. 45) would expand this tax break tax break for tips at beauty salons, barber shops, nail care, esthetics, and body and spa treatments. If enacted, with would apply after 2023.
Be sure to understand and comply with your responsibilities as an employer with tipped employees. Check with your industry associations for information to help you. And when it comes to taxes, the IRS offers Tips on Tips: A Guide to Income Reporting for Employers in Businesses Where Tip Income Is Customary. But be sure to check with your state tax/revenue/finance department for state and local level tax rules for your tipped employees.