Tipped Employee Payroll Challenges

Restaurant owners and other organizations face many responsibilities regarding employment tax and reporting obligations with tipped employees. While tips are a great way for staff to make money, having tipped employees can pose a unique set of challenges for business owners, especially when it comes to payroll and payroll taxes, including how tips are taxed. Read below to find out more about such challenges, as well as effective ways to navigate through them.

What Is a “Tipped Employee”?

According to the U.S. Department of Labor (DOL), a tipped employee is one who engages in an occupation in which they customarily and regularly receive more than a certain amount of money per month in tips. The U.S. Department of Labor provides state and federal minimum wage and minimum tips received to be considered a tipped employee. Tipped employees are commonly found in service industries, examples of which include waiters, bartenders, hair stylists, bellhops, and others.

What Is Considered a Tip?

A tip is an optional extra payment that a customer or client gives directly to an employee. It is up to the discretion of the customer or client to determine the tip amount, if any, as well as who receives this additional payment. A tip can be given in cash or added onto a bill total during electronic payment. Tipping is common in many service industries throughout the United States, but its prevalence varies around the world. In some European countries, for instance, tipping isn’t customary.

It’s worth noting that a tip is distinct from a service charge, which is an additional fixed amount that a business adds onto the price for certain goods or services. For example, a restaurant may add an automatic gratuity or service charge onto the bill (e.g., 20 percent) for parties over a certain number of people. In this case, the customer must pay this charge in addition to their bill amount.

By law, employers are not allowed to take or benefit from an employee’s tip for any reason other than as a tip credit toward the minimum wage obligation.

What Is a Tip Credit?

Tip credits are a way for employers to include gratuities in minimum wage requirement calculations. Under the Fair Labor Standards Act (FLSA), an employer may credit a portion of an employee’s tips toward the employer’s obligation to pay minimum wage. However, employers cannot deduct tip credits from employees’ pay. Instead, they can claim a certain amount against their minimum wage requirement. If an employee’s combined wages and tips do not reach minimum wage levels, the employer is required to make up the difference.

Some states, such as California and Minnesota, don’t allow tip credits, and employees working in these jurisdictions must be paid at least the applicable (i.e. local, state, or federal) minimum wage, not including their tip income.

Do Employees Have to Pool Tips?

A common question around gratuities is whether an employer can withhold employee tips. Generally, employers are prohibited from retaining employee tips, but under federal law, they can require employees to participate in a tip pool or otherwise share their tips with other staff members. In a tip-pooling arrangement between tipped employees, a portion or all the tip money from the shift is collected and redistributed amongst the tip-earning staff. For instance, servers, bar staff, hosts and hostesses, and bussers working on a given evening shift may pool their tips. Tip pooling can occur between tipped and traditionally non-tipped employees but is only allowed for employers who pay the full minimum wage and take no tip credit. Additionally, some state laws may restrict or insert additional requirements to tips pools.

Common Challenges Employers Face

Employing tipped workers requires paying particularly scrupulous attention to your payroll and tax obligations. Specific areas to pay attention to include, but aren’t limited to, accurately calculating wages including overtime wages, adhering to tipped minimum wage requirements based on the state(s) in which you operate and employee’s coverage under applicable state and local laws, ensuring accurate employee reporting, and meeting certain tax requirements.

Calculating Wages

It can be tricky to calculate wages for tipped employees. The FLSA has set the current federal minimum hourly wage to $7.25. An employer who has properly notified employees in advance is permitted to take a tip credit toward the minimum wage obligation equal to the difference between the required cash wage (which must be at least $2.13) and the federal minimum wage. However, tipped employees must still be paid at least $7.25 per hour, including cash wages and tips. If an employee does not make that much over the course of the workweek, the employer is required to make up the difference in cash.

State and local requirements around tipped employees may prohibit tip credits or vary on other provisions for tipped employees. Just as there are differences between the federal minimum wage and individual state and local minimum wage, there may also be a discrepancy between federal tipped minimum wage and state and local tipped minimum wage. Employees are entitled the highest rate applicable based on coverage rules of the specific state and local laws. Additionally, a state or city/county definition of who qualifies as a tipped employee may differ from the federal definition.

Tipped Minimum Wage by State

Given the variations between federal and state requirements regarding wages, tipping, and tip credits, find the location(s) below where you operate to determine the correct rates for tipped staff. The Department of Labor provides the 2022 tipped employee minimum wage rates by state.

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Employee Reporting

Employers with tipped employees are required to report all the employee’s income to the IRS — including tips that employees receive. To make sure that your employees report the accurate amount of tips they receive, employees should submit a “tip report” for each payroll period. Although it’s not required, encourage your tipped employees to document a daily record of tip income with Form 4070A, Employee’s Daily Record of Tips.

One of the primary benefits of your employees recording the tips they earned during their shift is that this practice can help you keep better track of what they’re earning and efficiently report your company’s income and wages to the IRS. Additionally, accurately reporting the tips that workers receive may give you access to the FICA tip tax credit, a valuable tax incentive for employers.

Tax Requirements: Are Tips Taxed?

You may be wondering if employers must pay taxes on tips. If you’re an employer with tipped employees, your employees’ tips may constitute taxable wages for payroll tax purposes. You may have more requirements come tax time, including withholding, reporting, and payment requirements. The IRS details the amount of tips required to be taxable. Tips are not taxable unless an employee makes more than a certain amount per calendar month. If your employee does make more than that amount in tips per month, you are responsible to withhold income, Social Security, and Medicare taxes on reported tips. You are also required to pay the employer’s portion of Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) taxes on the tips. That is why it’s so important that employees accurately record and report tips to their employers.

Since tips can make up a percentage of an employee’s overall earnings, underreporting on tips can have significant consequences. For employees who underreport tip earnings, they may face a 50 percent penalty on Social Security and Medicare taxes owed, since their employer didn’t have the accurate figures to withhold the required amount in the first place. They may also face an additional 20 percent penalty from the IRS.

Processing payroll for your restaurant and keeping up with tax requirements can be complicated, but it doesn’t have to be. While you may experience challenges with tipped employees, more information on the requirements you have as an employer on additional payroll tax withholdings and reporting are available on the DOL’s website and state websites.