How Do I? Differentiate tips from service charges for tax purposes

Although the employee may end up with the same amount whether something is designated a tip or a service charge, the IRS reporting requirements for the employer do differ. Basically, any amount required to be paid by a customer rather than at the customer’s discretion is considered a service charge by the IRS.

Tips

Tips are optional payments received by employees and determined by customers. Tips include cash; tips made through a credit card or other electronic payment; the value of noncash tips; and tips paid through tip splitting.

Tips include:

  • Cash tips received directly from customers.
  • Tips from customers who leave a tip through electronic settlement or payment. This includes a credit card, debit card, gift card, or any other electronic payment method.
  • The value of any noncash tips, such as tickets, or other items of value.
  • Tip amounts received from other employees paid out through tip pools or tip splitting, or other formal or informal tip sharing arrangements.

Employees are required to report cash tips to their employers except for tips from any month that total less than $20. Employers are required to retain employee tip records and credit card tip designations, withhold employee income taxes and the employee share of social security and Medicare taxes and report this information to the IRS.

Both directly and indirectly tipped employees must report tips to their employer.

A “directly tipped employee” is any employee who receives tips directly from customers, including one who, after receiving the tips, turns all of them over to a tip pool. Examples of directly tipped employees are waiters, waitresses, bartenders and hairstylists.

An “indirectly tipped employee” is a tipped employee who does not normally receive tips directly from customers. Examples of indirectly tipped employees are bussers, service bartenders, cooks and salon shampooers.

Tips reported to the employer by the employee must be included in Box 1 (Wages, tips, other compensation), Box 5 (Medicare wages and tips), and Box 7 (Social Security tips) of the employee’s Form W-2, Wage and Tax Statement. Enter the amount of any uncollected social security tax and Medicare tax in Box 12 of Form W-2.

Service charges

Tips must be made free from compulsion; the customer must have the unrestricted right to determine the amount; the payment may not be subject to employer policy, and the customer has the right to determine who receives the payment. Service charges do not have any of these qualities and are generally reported as regular wages to employees. So-called “automatic gratuities” and any amount imposed on the customer by the employer are service charges, not tips.

Examples of service charges commonly added to a customer’s check include:

  • Large dining party automatic gratuity
  • Banquet event fee
  • Cruise trip package fee
  • Hotel room service charge
  • Bottle service charge (nightclubs, restaurants)

Service charges are generally wages, and they are reported to the employee and the IRS in a manner similar to other wages. On the other hand, special rules apply to both employers and employees for reporting tips. Employers should make sure they know the difference and how they report each to the IRS.

Generally, service charges are reported as non-tip wages paid to the employee. Some employers keep a portion of the service charges. Only the amounts distributed to employees are non-tip wages to those employees.

Written by

Steve Moss, CPA is a partner at Holden Moss CPAs and loves helping businesses and their owners grow to be the very best they can be. Our other offices include Raleigh, Oxford and Warrenton. We are a little different at Holden Moss CPAs. While we still provide traditional tax and accounting services, years ago we realized many clients wanted help in running their businesses and were hungry for ideas, solutions, strategy, and execution. In response, we expanded our skill set and joined Ran One, a global network of business consulting firms. Our membership with Ran One gives us access to proprietary resources and analytical software to help our clients grow, become more profitable and valuable, and have the lifestyle they desire. Now, blended into the fabric of our normal tax and accounting needs, we are focused on our clients’ businesses in a very different way. While our approach is not right for everyone, for those whom it is, incredible results may be obtained. Whether you have a new, or established, business, or for those in transition of selling or retiring, or for those who simply need to develop an exit strategy or succession plan, our unique approach to client service may be the edge you need.

No Comments Yet.

Leave a Reply

Message

< !-- {/literal} END JIVOSITE CODE -->