For employers with employees who rely on tips as part of their income – restaurants, hair and nail salons, other service industries – it’s important to understand gratuities and how the Internal Revenue Service (IRS) expects them to be reported.
Is there a difference between tips and gratuities? A gratuity can take the form of either a tip or a service charge.
- Tips are discretionary (optional or extra) payments that a customer gives to an employee, such as cash tips, tips added to a credit card bill, or noncash tips like tickets or other items of value. Tips include amounts received from other employees through tip pools or tip sharing.
- The IRS reminds employers that automatic gratuities imposed on the customer, such as service charges for large parties or corkage fees, are not tips. Some employers keep a portion of service charges, and the amounts distributed to employees are considered non-tip wages.
What is tip pooling, and who is eligible? Tip pooling is a sharing arrangement among employees who customarily receive tips, such as waiters, waitresses, bellhops, counter personnel (who serve customers), table bussers, and service bartenders. A valid tip pool may not include employees who do not customarily receive tips, such as dishwashers, cooks, chefs, and janitors.
The employer must notify tipped employees of any required tip pool contribution amount and may only take a tip credit for the amount of tips each tipped employee ultimately receives.
Proper tip calculations are essential so that employers can withhold the correct amount of income taxes and Social Security and Medicare taxes for the employee, as well as pay the correct employer share of Social Security and Medicare taxes based on the total wages paid to tipped employees and reported tip income.
What are the requirements for taking tip credits? Employers with employees who receive part of their compensation in the form of tips must provide oral or written notice to their employees that they are taking a tip credit. With the understanding that most tipped employees make up the difference of the minimum wage of $7.25/hour through tips, employers are allowed to use the tip credit to pay employees $2.13/hour.
While oral communication is legally sufficient, we recommend that all employers who plan to use the tip credit communicate that information in writing and have a place to sign and date these employee notifications. Here is one example to follow for this disclosure.
The Department of Labor has an informative fact sheet, and MarathonHR is happy to share our best practices for the rather complex requirements involved with tipped employees.