Tips are often an essential part of employee compensation in the food service industry, and tip allocation is one strategy that employers can use so employees earn minimum wage. The Internal Revenue Service (IRS) requires all businesses categorized as large food and beverage companies to report tips their employees receive. If the overall reported tips are lower than 8% of the business's gross sales over a period, the employer should allocate the difference. In this article, we discuss what tip allocation is, who uses it and how to calculate allocated tips.
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What is tip allocation?
Tips are optional or extra payments that customers give employees for their services. Tip allocation is the method employers in the food industry use to distribute the tips to employees so that every employee receives an equal share. Tip allocation can help ensure that these employees earn minimum wage.
A tipped employee is an employee who makes a regular income from tips. Tipped employees typically keep a record of the tips they earn because if they don't earn enough tips to at least reach minimum wage, they might receive allocated tips. Common examples of tips may include:
- Cash tips employees receive directly from the customers
- Tips listed on electronic payments, like debit cards, credit cards or gift cards
- Tips from other employees made through tip splitting, tip pools and other tip-sharing arrangements
- Cash value of non-cash tips like tickets, art or other valuable items
Who uses tip allocation?
There are three characteristics that determine whether a business needs to use tip allocation. The first is whether the establishment qualifies as a large food or beverage business. Businesses can qualify as large food establishments by operating within the United States and employing over ten personnel on an average workday. Laws require these businesses to use tip allocation because they experience high volumes of sales that may not always result in consistent tips.
The second characteristic is whether employees receive tips directly from customers. If they do, the establishment can use tip allocation to ensure every employee receives the correct amount of tips, as there's always the chance that a customer might not leave a tip. The final criteria is whether the total amount of reported tips in a particular pay period is less than 8% of the sales that the business makes during the same period. In this case, the business uses tip allocation because 8% is the minimum portion of sales that tipped employees should receive.
How to calculate allocated tips
Here are some steps you can follow to use the gross receipts method of calculating allocated tips:
1. Determine the share of all directly tipped employees
The gross receipts method uses an establishment's total receipts to calculate the number of allocated tips each tipped employee should receive. The first step is determining how much money tipped employees should earn. To do this, you can multiply your gross receipts for the payroll period by 8%, which is the approved portion of sales that tips need to meet or surpass. Then, you can subtract the total value of tips that indirectly tipped employees report. Indirectly tipped employees are employees who receive tips from tip-sharing rather than from customers, like bussers and cooks. These employees don't receive allocated tips.
For example, if a restaurant earns $5,000 in a pay period, 8% of their sales is $400. If the restaurant's indirectly tipped employees receive $100 in tips, the share of 8% of sales that directly tipped employees should receive is $300.
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2. Find each directly tipped employee's share
Once you determine what share of 8% of sales belongs to directly tipped employees, you can calculate how much money each employee should receive. To find an employee's individual share, you can multiply the total share by a fraction that divides the receipts they're responsible for over the pay period by the gross receipts. You can determine the value of receipts that an employee is responsible for by adding up the amounts from all of the bills they process within the pay period being evaluated, not including tips they receive.
Considering the same example where the total share for directly tipped employees is $300, if one server handles $500 worth of receipts for the pay period, you can use the following calculation:
(300 x 500) / 5,000 = 30
This shows that the server should receive $30 in allocated tips for that period.
3. Find any shortfalls
A shortfall occurs when a tipped employee earns less in tips than they should receive based on sales numbers. After finding the amount each directly tipped employee should receive out of the 8% of sales, you can determine whether any employees experienced a shortfall in the tips customers provided. For example, if a server's share of tips should be $100 but they receive $80, their shortfall is $20.
4. Calculate the total allocated tips
To find the allocated tips that each employee should receive, there are two more calculations.The first involves subtracting the total amount of tips that employees receive from the share of 8% that tipped employees should get. Next, for each employee who experiences a shortfall, you can multiply that figure by a fraction that places the individual's shortfall on the top and the total amount of shortfall on the bottom. You can find the total shortfall by adding all of the employee's individual shortfalls together.
For example, consider that after subtracting the tips employees received from 8% of sales, the total amount of tips to allocate is $300. If an employee experiences a shortfall of $20, and the total shortfall across all employees is $200, the calculation can look like this:
(20 / 200) x 300 = 30
This means that employee should receive $30 in allocated tips. You could then repeat this process for each employee, replacing the value of 20 in this equation with each of their individual shortfalls.
Alternative methods for calculating allocated tips
While the gross receipts method is the most widely used method for calculating allocated tips, there are two other methods that establishments can use in special cases. The first alternative method is the hours-worked method, which applies to large food businesses that employ fewer than 25 full-time employees. In this method, employers can allocate tips based on the number of hours each employee works rather than the number of sales they make during each hour.
The second alternative method is the good-faith agreement. A good-faith agreement is a written statement that outlines how an employer intends to allocate tips among their employees. For a good-faith agreement to be valid, at least two-thirds of tipped employees in each category need to sign and accept the agreement.