Don’t skip the tips on your tax return

Businesses in certain industries – restaurants, hotels, and salons, for example – typically hire employees who receive tips as a large part of their compensation. That business model, however, triggers a whole new set of tax regulations at the state and federal levels.

The tax-free temptation

During the campaign, President Trump promised to end taxes on tips. The proposal excited employees and some business owners, but so far, legislation to eliminate taxes on tips hasn’t gained much steam in Congress. For now, employers must continue to follow existing IRS rules until — or if — the law changes.

With that in mind, here are answers to questions about the current rules.

What makes a tip

Tips are optional and can be cash or noncash. Cash tips are received directly from customers. They can also be electronically paid tips distributed to employees by employers and tips received from other employees in tip-sharing arrangements. Workers must generally report cash tips to their employers. Noncash tips are items of value other than cash. They can include tickets, passes, or other items that employees receive from customers. Workers don’t have to report noncash tips to employers.

Four factors determine whether a payment qualifies as a tip for tax purposes:

1. The customer voluntarily makes a payment
2. The customer has an unrestricted right to determine the amount
3. The payment isn’t negotiated with, or dictated by, employer policy
4. The customer generally has a right to determine who receives the payment

There are more relevant definitions. A direct tip occurs when an employee receives it directly from a customer (even as part of a tip pool). Directly tipped employees include wait staff, bartenders, and hairstylists. An indirect tip occurs when an employee who normally doesn’t receive tips receives one. Indirectly tipped employees can include bussers, service bartenders, cooks, and salon shampooers.

Keeping the right records

Tipped workers must keep daily records of the cash tips they receive. To do so, they can use Form 4070A, Employee’s Daily Record of Tips, found in IRS Publication 1244.

Workers should also keep records of the dates and values of noncash tips. The IRS doesn’t require workers to report noncash tips to employers, but they must report them on their tax returns.

What employers must know

Employees must report tips to employers by the 10th of the month following the month they were received. The IRS doesn’t require workers to use a particular form to report tips. However, a worker’s tip report generally should include the:

• Employee’s name, address, Social Security number, and signature
• Employer’s name and address
• Month or period covered
• Total tips received during the period

If an employee’s monthly tips are less than $20, there’s no requirement to report them to his or her employer. However, they still must be included as income on his or her tax return.

Other requirements for employers

A business owner must send each employee a Form W-2 that includes reported tips. In addition, employers must:

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

In addition, larger food or beverage establishments must file another annual report. Form 8027, Employer’s Annual Information Return of Tip Income and Allocated Tips, discloses receipts and tips.

There is a potential perk for an employer who hires tipped workers to provide food and beverages: They might qualify for a valuable federal tax credit involving the Social Security and Medicare taxes paid on employees’ tip income.

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