The IRS considers all tips received as income subject to federal income tax. This includes all tips received directly, tips paid to an employee that were charged by the employer, and all shares of tips received under a tip-splitting or tip-pooling arrangement with other employees. Because tips are treated as income by the IRS, proper recording and reporting practices must be followed by all taxpayers who receive tips. For tax purposes, a taxpayer must 11) keep a daily tip record, 2) report tips the employer, and 3) report all tips on the Form 1040 tax return. By following these steps, a taxpayer will be able to accurately include all tip income on returns and avoid penalties from the IRS.
Step 1: Keep a Daily Tip Record
The IRS recommends two different methods for keeping daily tip records: keeping a written “tip diary” and maintaining a file of documents from bills, credit/debit card chards, and any other document that may evidence the receipt of a tip. It is best practice to maintain both the tip diary and a tip document file. To assist in keeping a tip diary, the IRS has provided a worksheet called a Form 4070A. The Form 4070A is a chard that provides employment information and spaces to record daily tip information (date of tip, types of tip, tip sharing with other employees, etc.) An important note is that any mandatory service charges, (e.g. 18% gratuity for parties greater than 6,) are considered part of wages and not tips. These service charges will be reported on the annual W-2. Including them as tips would result in double taxation.
Step 2: Reporting Tips to the Employer
Once a tip record is compiled, copies of it should be provided to the employer within ten days of the end of each month. This will allow the employer to withhold Social Security and Medicare taxes and provide credit to for benefit calculation purposes. Only copies of these records should be provided to the employer as the originals should be kept in case of any inquiry by the IRS.
Step 3: Reporting Tips on the Tax Return
If all tips have been reported to the employer per Steps 1 and 2, reporting tips on the tax return is fairly straight forward. The employer will provide the total amount of tips earned on the Form W-2 that is issued at the end of each year and is used to file personal tax returns. The total amount of tips is included in the wages reported in Box 1 of the W-2. If tips are not reported to the employer and total $20 or more, they will need to be reported on a Form 4137, to account for Social Security and Medicare contributions, as well as the Form 1040 regardless of whether the minimum income threshold for filing was met.
If regular records are maintained, reporting tips to the employer and claiming them on the income tax return are not difficult tasks. By taking diligent steps in keeping track of all tips received throughout the year, filing end-of-the-year tax returns will be not only less confusing, but there will also be a greater chance that all Social Security and Medicare benefits will be accounted for and there will be a lesser chance of the IRS applying penalties for misfiling or understating income tax received.