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 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.
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.
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.