In restaurants and certain other service-based businesses, tips comprise a significant portion of employee compensation.
In addition to receiving a base salary from the employer, employees receive tips from customers as a way of expressing their gratitude for exceptional service.
No big deal, right? Customers pay service workers directly and the employer is removed from the process. Unfortunately, that's not quite how it works – especially when it comes to the employer's tax liability for unreported employee tips.
Despite the fact that most wait staff and service workers receive tips directly from customers, you're still responsible for including tips in your employees' taxable compensation. Failure to adhere to IRS guidelines can flag your business for an audit or result in fines and penalties that could have been avoided.
Tip Reporting Requirements
Although there are a lot of rumors and misperceptions surrounding the taxability of employee tips, the simple fact is that 100% of your employees' tips are taxable. It doesn't make any difference whether the tips are paid in cash or by credit card. Your employees are responsible for tracking their tips and including them in the total compensation reported in their annual income tax return.
Employers should encourage their employees to keep their own daily tip record. IRS Publication 1244 includes a convenient form that tipped employees can use to keep track of daily totals. However, all employees are required to report their tips to their employer no later than the 10th day of the following month. In general, employers are advised to require their workers to report tips more frequently, usually on a weekly basis
Form 8027 & Tip Allocation
If you own a restaurant with more than ten, full-time equivalent employees on a typical day, each February you will be required to file Form 8027, Employer's Annual Information Return of Tip Income and Allocated Tips. This form contains data fields for sales, credit card totals, credit card tips and reported tips. If the total tips reported on this form fall below 8% of total sales, you will then be required to conduct a tip allocation process that allocates tips according to each directly tipped employee. The IRS uses this information to flag employees who may not be reporting all of their tip income.
The 8% Rule?
Many restaurant workers believe they are only required to report tips in the amount of 8% of their total sales. This simply isn't the case – the 8% rule only applies to Form 8027 and tip allocation. Reinforce the reality that employees must report all of their tips as taxable income.