To the IRS, tips are taxable income just like wages. If you earn tips, you're responsible for paying income, Social Security and Medicare tax on the tip money you receive. The IRS requires your employer to withhold enough money from your wages; however, the amount withheld is based on the total of your wages plus the tip income you report, even if you receive the tips directly from the customer in cash.
Step 1: Record how much tip income you bring in
The IRS requires you to report your total monthly tips to your employer by the 10th of the following month. If your employer doesn’t have a process for reporting tip income, you can use Form 4070. If you fail to report your tips to your employer, the IRS can impose a penalty equal to 50 percent of the Social Security and Medicare tax you fail to pay.
Your employer will pass along your figures to the IRS and take money out of your wages to cover tip withholding. If you don’t earn at least $20 in tips during the month, you don’t have to report the tips to your employer. If you work at more than one job, apply the $20 limit to each one. However, you still need to include these tips in taxable income when you prepare your income tax return.
Step 2: Keep track of any tips you pay, share or pool with other employees
You can reduce the amount of your reportable tips if you share some of it with other employees. For example, if you receive a $125 tip and give the busboy and bartender $35, then you only need to report $90 in tips.
Step 3: Check your W-2 when you receive it
If you didn't earn enough in wages and tips that your employer pays to you directly to cover your tax withholding, the W-2 will show how much tax you still owe. If the amount you underpay is significant, you may be liable for estimated tax penalties after you file your tax return.
Step 4: Fill out Form 4137 for any unreported tip income
This will cover the months when your tips total less than $20, as well as the value of any non-cash tips you receive. Add this amount to your reported tips and wages to get your total taxable income. Form 4137 includes instructions for calculating the Social Security and Medicare tax you must pay on your unreported tip income.
Things You'll Need:
- IRS Form 4070
- IRS Form 4137
- The IRS assumes that restaurants and similar businesses generate tips equal to at least 8 percent of sales. If a business only reports annual tips equal to 6 percent of sales, for example, the IRS requires the employer to allocate the remaining 2 percent of sales among employees, and you must include your share in taxable income.