Restaurant wait staff and bartenders depend heavily on tips for their income. In Pennsylvania, employers are permitted to pay wages below minimum wage to those who are likely to get tipped, as long as the expected tips plus wages would be at least minimum wage. However, those tips must be reported to the employer monthly so that taxes (federal, state, local), Medicare, and Social Security deductions can be withheld.
If you have tax clients who receive tips as part of their income, help them understand the way tips are taxed, how to best keep track of them and report them, and how to deduct job expenses to decrease their taxes.
What counts as a tip?
Simply defined, a tip is any voluntary, non-mandatory gratuity given to whomever the customer chooses. In other words, if the customer can choose how much to give and whom to pay, it’s a tip. In the hospitality industry, this is usually in the form of cash (although tickets to a sporting event or a gift card would also be considered a tip if a customer left it for the server of his or her own choosing). Money received from a tip pool also counts as a tip.
Tips can also be put on a credit card, but then the employer would have a record of it and the server would not need to record and report that to the employer. This is also true for service charges paid out to the server.
Why carefully report?
While it may be tempting to servers who usually get paid so little by their employer to underreport their tips, there are several reasons to dissuade your clients from doing so. First, unemployment gets paid out based on the person’s income. If a server has consistently underreported tips, that server will not see as large an unemployment check as he or she might like should they qualify for unemployment benefits. This also goes for Social Security, which is calculated based on income over the years. Lower income means lower social security payments when retirement rolls around.
Another big reason to avoid underreporting is the chance of an audit. People who depend heavily on tips for income are on the radar of the IRS for the very reason that underreporting is so common. An audit is not only a hassle, but the IRS can impose on the server heavy fines, up to 50% per month of overdue taxes, and a civil fraud penalty as high as 75%. Underreporting is simply not worth the risk.
How to keep track of tips
By the 10th of the following month, tipped employees need to submit a log of their tips to their employer. They don’t have to track each individual that left a tip, but rather the collected amount of tips received each day. The IRS provides Form 4070A to help track tips. Tracking includes:
- Shift worked
- Cash tips received
- Tip outs paid to other bartenders or servers or tip pools
Servers should deduct any tips shared with other employees so that only net tips are reported to the employer.
The employer will already know about credit card tips and service charge payouts to servers, but the server should also keep track of these in order to have complete records in case of an audit.
Servers do not need to submit a monthly report if tips were under $20 that month but should report those tips on the 1040 Form at tax time.
Tax deductions for servers
While your clients in the hospitality industry should always report tips, they should also carefully track deductible expenses to decrease their taxable income. Help them list out and track any expenses that are specific to their jobs. These could include the purchase of a uniform, costs for required training or trade organization memberships, and any special equipment or tools purchased for the job. If the employer charges the employee a portion of credit card fees from tips paid by credit card, that is a deduction. Others may be the cost of laundering the uniform and the use of a car between venues or when making deliveries. Fees for tax services are also tax deductible.
Help your hospitality industry clients find as many legitimate deductions as possible so they can keep as much of their hard-earned tips as they can.