Businesses in certain industries employ service workers who receive tips as a significant part of their compensation. These businesses include restaurants, hotels, and salons. Ensuring compliance with federal and state tax regulations is essential for any employer with tipped employees. Understanding tax deductions, the Section 179 deduction, and other tax benefits can help reduce taxable income and lower your overall tax bill.

Are Tips Becoming Tax-Free?

During recent political campaigns, there was talk about eliminating taxes on tips, generating interest among employees and business owners. However, no laws have been passed to implement this change. For now, employers must continue following existing IRS rules. Until new legislation is enacted, current tax regulations remain in effect.

How Are Tips Defined?

Tips are voluntary payments made by customers. They can be either cash or non-cash:

• Cash tips: Payments received directly from customers, electronic tips distributed by employers, or tips received in a tip-sharing arrangement.
• Non-cash tips: Items of value, such as tickets or gifts, received from customers. While non-cash tips do not need to be reported to employers, they must be included in the employee’s tax return.

To determine whether a payment qualifies as a tip for tax purposes, consider these four factors:

1. The payment is voluntary.
2. The customer determines the amount.
3. The payment is not dictated by employer policy.
4. The customer decides who receives the tip.

There are also distinctions between direct tips and indirect tips:

• Direct tips: Received directly from a customer (even as part of a tip pool). Examples include waitstaff, bartenders, and hairstylists.
• Indirect tips: Received by employees who don’t traditionally receive tips, such as bussers, service bartenders, and cooks.

Recordkeeping for Tax Purposes

Employees who receive tips must keep daily records of their cash tips. The IRS provides Form 4070A, Employee’s Daily Record of Tips, which can be found in IRS Publication 1244. This form helps workers track their tips and ensures they report them accurately on their tax return.

Workers should also track the dates and values of non-cash tips, as these must be reported on their tax returns, even though they are not reported to employers.

How Employees Report Tips to Employers

Employees must report their tips to employers by the 10th of each month for the tips received in the previous month. The IRS does not require a specific form for this, but the report should include:

• The employee’s name, address, Social Security number, and signature.
• The employer’s name and address.
• The month or period covered by the report.
• The total tips received during that period.

If an employee earns less than $20 in tips per month, they are not required to report those tips to their employer. However, they must still include them as income when filing their tax return.

Employer Responsibilities

Employers with tipped employees must follow several tax obligations, including:

• Issuing Form W-2 to employees, including reported tips.
• Keeping records of employee tip reports.
• Withholding taxes—including income tax, Social Security, and Medicare taxes—on employee wages and reported tips.
• Paying the employer’s share of Social Security and Medicare taxes on wages and reported tips.
• Reporting tip income to the IRS on Form 941, Employer’s Quarterly Federal Tax Return.
• Depositing withheld taxes in accordance with federal tax deposit requirements.

Large food or beverage establishments must also file Form 8027, Employer’s Annual Information Return of Tip Income and Allocated Tips. This report helps track tip income across the industry.

Tax Benefits and Deductions for Employers

Employers can take advantage of certain tax benefits and deductions related to tip income, which can help reduce their taxable income:

The FICA Tip Credit

If you own a business with tipped employees who provide food and beverages, you may qualify for the FICA tip credit. This allows you to claim a tax credit for the Social Security and Medicare taxes paid on your employees’ reported tip income. This tax credit can help offset your total tax liability.

Section 179 Deduction

The Section 179 deduction is another valuable tax tool for businesses. This deduction allows companies to write off the cost of certain business equipment and assets, including heavy vehicles used for business purposes. By leveraging this deduction, business owners can lower their taxable income and reduce their tax bill.

Bonus Depreciation

Businesses can also take advantage of bonus depreciation, which allows them to deduct a significant percentage of the cost of eligible assets in the year they are placed in service. This deduction can apply to equipment, machinery, and business vehicles, further reducing taxable income.

Common Tax Mistakes to Avoid

Employers must be mindful of common tax errors that can lead to penalties or compliance issues:

• Failing to report all employee tips: The IRS requires accurate reporting of all tip income. Underreported tips can trigger audits and penalties.
• Not maintaining proper records: Keeping thorough documentation of tip income and employee reports is crucial for IRS compliance.
• Misclassifying employees: Ensure that tipped workers are classified correctly for tax purposes to avoid legal and financial complications.
• Ignoring tax credits and deductions: Employers should take full advantage of available tax deductions, such as the Section 179 deduction and the FICA tip credit, to minimize their overall tax burden.

How Should Employers Proceed?

Running a business with tipped employees requires more than just good customer service. It demands strict compliance with wage and hour laws, accurate recordkeeping, correct tax reporting, and staying up to date on regulatory changes.

While proposals to eliminate taxes on tips have not yet become law, it is essential to stay informed on any updates. In the meantime, businesses should continue following current IRS guidelines and ensure proper tax compliance.

Maximizing tax deductions and credits, understanding taxable income, and filing accurate tax returns can help businesses manage their tax obligations efficiently. If you need assistance with tax tips, business income strategies, or filing taxes correctly, contact Thomas Howell Ferguson for expert CPA guidance. We are here to help you navigate the complexities of tax compliance and optimize your financial strategies.