Tax exemptions for tips received by certain workers have been proposed by the Democratic presidential nominee, Kamala Harris, and the Republican presidential nominee, Donald Trump. To date, neither candidate has offered concrete details about how the exemption would work. However, if enacted, the exemption could have significant implications for business payroll departments. Here's an overview of current rules and a peek at what might be coming.
In recent years, tipping has become commonplace in a wider range of professions and workplaces. Tips have long been routine in full-service restaurants and salons. But tip jars and electronic "prompts" to leave a tip surged during the COVID-19 pandemic and are now seen in self-service restaurants, coffee shops and grocery stores.
For tax purposes, tips are discretionary payments made by customers to workers. They may include:
The IRS treats all cash and noncash tips employees receive as taxable income. Therefore, cash tips of $20 or more received by an employee in any calendar month are subject to federal payroll tax and must be reported to the worker's employer. Employees must also keep accurate records and provide detailed statements on tips to their employers. Tip income is taxed at ordinary income tax rates.
Employees aren't the only ones with tip-related responsibilities. In general, employers are required to:
Suppose an employee fails to report tips to his or her employer. In that case, the employer isn't liable for failing to withhold tax from these earnings or failing to pay the employer's share of Social Security and Medicare tax until they're contacted by the IRS.
It's important to recognize how tips differ from service charges because they have disparate tax treatments. For example, one restaurant might provide patrons with checks that have blank tip lines. The checks also offer calculations that represent 15%, 18% and 20% of the totals to help customers compute their preferred gratuity — or they can decide to pay nothing additional for service. Because the gratuity is discretionary, it's considered a tip, not a service charge.
Another restaurant might automatically add a 15% service charge to every check. Customers are obligated to pay these amounts with the rest of their bills. If this restaurant distributes service charges to employees, the amounts are treated as wages. The employer must keep records of the employees' names, addresses and Social Security numbers (SSNs); the amounts and dates of payments; and the amounts of payroll taxes collected.
Employers may be entitled to deduct service charges distributed to employees if the amounts otherwise qualify as "ordinary and necessary" business expenses. If, on the other hand, an employer doesn't distribute service charges to employees, those amounts are considered taxable income to the employer.
Current federal tax rules regarding tips could change. Proposed legislation recently introduced in both the U.S. House and Senate would provide a 100% above-the-line deduction for cash and cash-equivalent tip income. Presumably, noncash tips would remain taxable. Another law proposed in the House would exempt tips from income and payroll taxes. It remains to be seen what form any legislation would take. The results of the November elections may prove critical.
For these reasons, employers with tipped employees need to stay on top of any developments. In the meantime, you should continue to adhere to all applicable rules.
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