Who is a tipped employee?

Tipped employees are workers who earn the majority of their compensation from tips. While tips can be accepted in all manners of work, from making coffee at Starbucks to washing cars at the gas station, tipped employees earn the vast majority of their income from tips. As such, pay rates are lower for these employees, as most compensation doesn’t come directly from the employer.

In the United States, numerous industries are predicated on tipping. While tipping may be considered polite or generous in some spaces, like maid service at a hotel, in other industries, like sit-down food service, tipping is all but required. In these industries, due to the virtual expectations of tips, employers are permitted to pay a separate minimum wage.

In the United States, as of May 2021, the federal tipped minimum wage is $2.13 per hour. Some states have higher tipped minimum wages, but this is the lowest permitted under federal law. This amount may sound criminally low to those used to receiving the federal minimum wage of $7.25 or one of the state minimum wages that are nearly double that amount, but tipped minimum wage functions this way due to the existence of an additional source of income. Employers must pay the higher of state minimum wage or federal minimum wage. Some states have laws against tipped wages, regardless of context; in these states, the standard minimum wage applies.

Tipped minimum wage can be applied to any job in which employees regularly and customarily receive more than $30 per month in tips. Employers don’t have to pay this wage to tipped employees—and some choose not to, due to variable tips in some industries—but in general, restaurant servers and bartenders are always paid a tipped wage. Other jobs that may be paid with a tipped wage include:

• Baristas
• Hairstylists
• Tattoo artists
• Taxi drivers
• Casino dealers
• Bellhops

Under a tipped wage structure, employees are expected to meet or exceed the federal or state minimum wage, whichever applies, between the total of wages and income from tips. For example, if an employee is paid $2.13 per hour in a state with a $7.25 minimum wage, tips are assumed to make up at least $5.12 per hour.

What is considered a tip?

A tip, though commonly understood as a voluntary contribution to compensate for quality service, is actually a legal construct in the context of tipped employees.

To qualify as a tip for the purposes of determining compensation, the following must be true:

• The customer has control over who receives the tip
• There is no negotiation involved in the payment of a tip
• The amount tipped is decided solely by the customer
• Tips are given freely and voluntarily with no strings attached.

Payments that function like tips but don’t meet these criteria are generally considered service charges. Under this rule, tips automatically added to a check in a restaurant for large parties, for example, are classified as service charges. These amounts are still usually paid to employees in the same way a tip would be but are not classified in the same way. Service charges are mandatory; tips are always voluntary.

Forms of tips

Tips can be paid in numerous forms. Most often, tips are paid in cash or via an addition to a credit card payment. Cash tips are usually handed to an employee at the time of receipt. Credit card tips are collected by the employer and paid to an employee once the payment processes. These amounts are usually added to an employee’s paycheck. It is common for taxes to be withheld directly from the tip amount when tips are paid out as a part of a paycheck.

In some cases, customers may leave noncash tips, such as tickets to an event. Noncash tips are still considered compensation for tipped employees.

Rules for employees and employers

As with all forms of income, how tips are treated is subject to the legal requirements involved with paying employees a tipped wage.

As tips are given by customers versus being paid by employers, tipped employees are required to track their own tips. How this works can vary from one business to another. Some companies, most notably restaurants, use point of sale (POS) systems in which employees declare their tips when cashing out for the day. Once settling any money owed to the restaurant, many restaurant managers will ask employees to enter a number equalling the total tips earned during the course of a shift. This allows for accurate reporting on a W-2 at the end of a tax year.

While this process is becoming increasingly common as modern technological solutions are implemented, some employees are expected to track their tips in a logbook and report them on a semi regularsemiregular basis. Under these circumstances, tips must be reported regularly using IRS Form 4070. If a daily system is not in use, tips for a month must be reported by the 10th of the following month.

In some cases, like jobs in which tips are less customary or when business is very slow, employees may not make enough tips to earn at least minimum wage. In these circumstances, employers are required to make up the difference to ensure a fair salary. In these situations, employees are required to keep tip logs to demonstrate that tips received do not adequately comprise the applicable minimum for an hour’s work.

Are tips taxable?

Per the IRS, any tips over $20 per month must be reported for tax purposes.

While credit card tips collected by an employer and added to a paycheck are taxed like normal income, cash tips are untaxed. Any tips that aren’t reported to a restaurant and included on a W-2 at tax time are required to be reported on IRS Form 4137.

Technically, all tips over this threshold are required to be reported to the IRS for tax purposes. However, on a more practical level, this doesn’t always happen. In many cases, tipped employees only declare tips that are trackable, like those paid with a credit card. Cash tips are then taken under the table and not reported on an annual tax return. This isn’t legal, but many employers look the other way. Employers who want to remain compliant with the law are encouraged to use tracking software such as modern POS products to enforce employee compliance.

Processing payroll for tipped employees

Even when tips aren’t being paid directly from an employer to an employee, tips are still considered income and must be accounted for by the employer when processing payroll.

Employers must maintain accurate records of employee tips. They can require monthly logs from employees or use a POS system that tracks tips when employees cash out for the day. FICA (Federal Insurance Contributions Act) taxes must be properly withheld from all tips, the same as for any standard hourly or salaried wage. Overtime laws still apply to tipped workers and must be calculated per state or federal law when applicable.

Tipped income must be, at minimum, at least 8% of gross receipts, not including service charges or carryout fees. If the amount of income from tips is less than this amount, the difference between total tips and the 8% threshold must be allocated to gross receipts.

It is legal to deduct credit card processing fees from employee tips. If a business pays a 3% fee to credit card processors, for example, employers are permitted to pay an employee $9.70 for a $10 tip.

Fringe benefits, such as meals during shifts for restaurant workers, can be included as taxable income per IRS rules.

Tipped Employees FAQs

What is a tip credit for tipped employees?

The FICA tip credit minimizes the employer burden for Medicare and Social Security taxes paid on tipped wages. Once known as the “Credit for Portion of Employer Social Security Paid with Respect to Employee Cash Tips,” this opportunity can save employers money via a credit against federal income tax. This credit is calculated by determining the amount in tips that exceeds the federal minimum wage; this amount is referred to as creditable tips.

To calculate this, an employer multiplies the federal minimum wage times the number of hours an employee worked. For example, if an employee worked 1,800 hours in a year, the wage amount is equal to $13,050. Then, the employer must subtract the actual amount of wages paid to an employee to determine the ineligible tips. If the employer paid the federal minimum wage of $2.13, the difference is $9,216. This amount is then subtracted from the total amount of tips an employee reported.

In this case, if an employee reported $20,000 in tips, the eligible creditable tips equal $10,784. Finally, the amount of creditable tips is multiplied by the FICA and Medicare tax rate of 7.65% to determine the credit amount. For this employee, the employer would be allowed a credit of $825.

Service charges are not eligible for tip credits. Tip credits are only applicable for tips that meet the legal definition.

What is the difference between tip pooling and tip sharing?

On the surface, tip pooling and tip sharing sound similar, but there is a legal delineation between these two concepts.

Tip pooling is a model in which all tips received by a business are pooled and distributed to employees in equal shares. This is seen as a way to level the playing field, so to speak. If one server worked a big party while another had a few small tables that didn’t tip well, the second server wouldn’t be penalized for an off night. Pools can work on a nightly, weekly or monthly basis.

Tip pooling is fully legal when all employees engaged in customer service functions are included. However, it is not legal to include workers who don’t interact directly with customers.

Tip sharing is a model in which tips are required to be shared with other members of a service staff who supported those earning tips. This is a way to compensate for the help provided by service staff members who don’t directly open and close tabs for customers, including barbacks and bussers. Tip share percentages are usually small, maybe 3% to 5% of total tips earned or, in some cases, a percentage of gross sales. Tip shares are legal as long as all participating members contribute to customer service.

Are tips taxed more than wages?

Tips are not taxed more than wages. It may feel as though tips are taxed more than wages if employees owe taxes when filing a return due to previously unreported tips entered on to Form 4137, but the same general rates apply.

How are tips calculated?

How tips are calculated depends on the preferences of the customer. Most customers tip on a percentage of the total price, usually between 10-20%. However, a tip of any amount given freely and voluntarily counts for income purposes; there is no minimum or maximum dollar amount for a tip to qualify as such.