If you run a service business, such as a restaurant, hair salon, hotel, etc., it is very important that you understand your reporting requirements for the tips and service charges earned by your employees.
Section 61 of the Internal Revenue Code defines gross income for individual taxpayers as “including all income earned, regardless of the source.” Employees of service businesses usually receive compensation in the form of both wages and tips. Employers who run a service business, particularly small “mom and pop,” restaurants, often make the mistake of believing that tips earned by wait staff are nontaxable gifts. Under Section 61, that is not true. Tips are taxable income, and it is up to the employer to keep a record of tips earned for each employee, and properly report tips along with their regular wages, as total income to the IRS. The same is true of “service charges” which may be automatically added to customers’ bills, and distributed among employees.
Tips Vs Service Charges – What’s the Difference?
According to the IRS, it is the employer’s responsibility to report both tips and service charges as income. However, it is important that operators of service business understand the difference between the two as defined by the IRS.
- 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.
- Tip amounts received from other employees paid out through tip pools or tip splitting, or other formal or informal tip sharing arrangements.
Four factors are used to determine whether a payment qualifies as a tip. Normally, all four must apply. To be a tip:
- The payment must be made free from compulsion;
- The customer must have the unrestricted right to determine the amount;
- The payment should not be the subject of negotiations or dictated by employer policy; and
- Generally, the customer has the right to determine who receives the payment.
If any one of these doesn’t apply, the payment is likely a service charge.
What Are Service Charges?
Amounts an employer requires a customer to pay are service charges. This is true even if the employer or employee calls the payment a tip or gratuity.
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)
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.
Employees must report to their employer all cash tips and non-cash tips received (except in any month where such compensation is less than $20.00). Employers are required to include all cash tips and noncash tips in an employee’s gross income and are subject to federal income taxes.
Tips and service charges are subject to the same payroll withholding taxes as other wages.
Also keep in mind, that if your business retains some portion of service charges, the IRS will consider the amount you keep as “revenue” for your business, just as the agency considers the portion you distribute to your employees as “income.”
How MBAF Can Help
At MBAF we want to make sure that all businesses thoroughly understand their reporting requirements, and are in compliance with all tax laws. Service businesses are unique in several ways, and it is easier for employers to innocently report incorrect earnings for their employees, and face the consequences.