If you wait tables, drive for Uber, or deliver food, you can always count on pocketing tips after serving satisfied customers. And these tips are probably the biggest part of your monthly income. Like most tipped employees, you may be unsure whether you need to report your tips to the IRS.
This guide will look to answer some of the common questions on do tips get taxed. Let’s get started.
The IRS considers tips as taxable income -- just like monthly salaries and hourly wages. You have to pay income, Social Security, and Medicare taxes on tip earnings. And if you’re in a state that has imposed income tax, you may have to pay state taxes on it, too.
If you receive over $20 in tips in a given month, you need to report your tip earnings to your employer, who then withholds money from your paycheck for payroll tax. You don’t have to report your tip income to your employer if your earnings are less than $20.
Note that the $20 limit only applies to one employer. So if you’re working for multiple employers, then you’ll have to set aside a $20 limit for each one of them.
Let’s say you received $13 and $9 in tips from two gigs in the last month. You won’t have to report your earnings to either employer, as your tips are still within the $20 limit.
That said, according to the IRS, there are generally 4 types of tips, which include:
Tip-sharing agreements are fairly common in most businesses, but they can be confusing for employees when reporting taxes. In such arrangements, workers split the pooled tip amount and report their share to their employer. Often, ‘background employees’ -- such as cooks, janitors, and dishwashers -- don’t receive a share from the tip pool.
With so many people involved, it can be difficult to know how much you need to pay for taxes from the agreement -- or if you’ll pay any tip taxes at all. But the answer is simple: you only need to report the amount you earned rather than the entire pool amount.
Suppose you receive a $200 tip. You give the valet $50 and the server $40, then you’ll only be paying tax on the $110 tip you brought home. When sharing tips, you only must report to the IRS your portion.
If you earn at least $30 in tips per month, then you fall under the “tipped employee” category, according to the Fair Labor Standards Act (FLSA). As a tipped employee, you’re governed by a different set of regulations compared to the ordinary worker.
Minimum wage laws, especially, are applied differently. The federal minimum wage laws require employers to pay tipped workers at least $2.13 per hour in regular wages -- less than the $7.25 standard wage for other employees. The reason why? Tipped employees often earn enough tips to ensure their wage per hour at least equals the minimum threshold.
So, the FLSA gives employers greater leeway, allowing them to pay you less as long as your tip earnings make up the difference between your cash wage and the minimum wage. But what if you don’t earn enough in tips?
In such a case, your employer needs to pay the difference. This difference is known as the “tip credit”, and is a common payment practice in the industry. Here’s how you can calculate it:
Federal Minimum Wage - Tipped Minimum Wage = Tip Credit
Given the standard minimum wage is $7.25 per hour and the minimum wage for tipped employees is $2.13 per hour, then the tip credit is equal to:
$7.25 – $2.13 = $5.12 maximum tip credit
Note that the maximum tip credit varies from state to state and can often be as high as $9.17, as each state has its own standard wage and tipped minimum wage.
So, what happens when you earn more tips than what’s required to bring your earnings up to the standard wage? Can your employer take the remaining tips? You should realize that, according to the FLSA, an employer can’t force you to turn over your tips under any circumstances, unless there’s a legitimate tip pooling process.
Even if you receive the full federal wage from your employer, you can still retain all of your tip earnings.
Service charges are fees that your employer automatically adds to a customer’s bill, and they can include:
For this reason, the IRS doesn’t consider service charges as tips. Because for a payment to qualify as a tip, it needs to meet the following conditions:
To the IRS, service charges are like regular wages. Your employer has to withhold income tax and social security tax on them. So you’ll probably receive your portion of service charges on payday rather than after your regular shifts.
When you receive tips through credit cards, debit cards, or online payment platforms, tracking your earnings is often straightforward. However, in some businesses -- like casinos -- reporting tip income can easily overwhelm you, as you’re mostly receiving them in cash (which you'll still be responsible for paying taxes on).
That’s why you need to record your total tips received or earnings after each shift to simplify the process and make it less cumbersome.
The IRS requires you to report tips to your employer by the 10th day of the following month that you earned them. You need to submit this report in writing, which should include:
Let’s say you receive $350 in tips in May. The deadline for reporting these tips to your employer is June 10. If 10th June falls on a weekend day or holiday, then you need to submit your report the next business day.
It’s advisable to keep copies of documents, such as charge slips and bills, that prove your tip income. Alternatively, you can keep a personal tip diary and update it daily with accurate tip amounts and dates.
But the best option is to use Form 4070A: Employee’s Report of Tips to Employer. The form is similar to a workbook; it has space for daily entries that you can use to keep accurate records.
When you receive Form W-2 from your employer, you’ll typically find your total tip earnings for the year in Box 1. This amount is crucial as you’ll use it to report your tips to the IRS using Form 1040. You need to add this amount as well as all the other tips you didn’t report to your employer throughout the year. For instance, the tips that fell under the $20 limit need to be reported as taxable income to the IRS.
It can be tempting to hide your tip income and avoid taxes. With all the late-night shifts and tasks at hand, you probably don’t have the time to keep track of $25 tips. But you need to be careful; underreporting your tip income carries some dangerous consequences.
For one, you risk being audited. Even though the chances of it happening are rare -- especially if you are a server or a taxi driver -- you can claim a tipped income that’s too low for the organization to ignore.
The IRS usually compares your reported income to the earnings of other tipped employees in your area. Unreported tip income often warrants an investigation.
Also, remember that credit card and debit card tips leave a paper trail that the IRS can trace.
If found out, the penalties can be harsh. Underreporting tax income attracts a fine of up to 50% of the Social Security and Medicare taxes you owe, plus an additional 20% of the income taxes you haven’t paid. Also, keep in mind that intentionally hiding your income is treated as a criminal offense by the IRS.
Here are other reasons why you need to avoid underreporting your income:
For employers, the consequences of failing to misreport tips also apply. If the IRS suspects that an employer hasn’t been reporting accurate tips, then they’ll likely send a series of notices. And if the employer still doesn’t comply, then they’ll get audited. When the IRS discovers that an employer has been intentionally hiding their income, then the organization can fine them up to $10,000.
To avoid all the hefty IRS fines that come with misreporting your income, you can use a 1099 tax calculator. Knowing the exact amount you owe the IRS can help you save money; you won’t pay more taxes than required and you won’t lose money from penalties.
There are some situations when you might accidentally misreport your income when filing your returns. For instance, tips worth less than $20 -- which you didn’t report to your employer -- can easily go under the radar.
If you want to catch up on the tips you’ve overlooked throughout the year, then you’ll need Form 4137. It allows you to report tip income that your employer isn’t aware of, calculate the additional taxes you owe, and come clean on your returns.
Be aware, though, the IRS can still slap you with the penalties we mentioned earlier: 50% of owned Social Security and Medicare tax and 20% of owed income tax (plus the additional taxes you’ve underreported).
But you can escape these fines by making certain to the organization that you didn’t have any malicious intent when you failed to report your tips. You can state your case by attaching a return statement to your income tax return.
Form 4137 is readily available on the IRS website, where you can get instructions on how to fill out the form.
A verbal contract (formally called an oral contract) refers to an agreement between two parties that's made —you guessed it— verbally.
Formal contracts, like those between an employee and an employer, are typically written down. However, some professional transactions take place based on verbally agreed terms.
Freelancers are a good example of this. Often, freelancers will take on projects having agreed on the terms and payment via the phone, or an email. Unfortunately, sometimes clients don't pull through on their agreements, and hardworking freelancers can find themselves out of pocket and wondering whether a legal battle is worth all the hassle.
The main differences between written and oral contracts are that the former is signed and documented, whereas the latter is solely attributed to verbal communication.
Verbal contracts are a bit of a gray area for most people unfamiliar with contract law —which is most of us, right?— due to the fact that there's no physical evidence to support the claims made by the implemented parties.
For any contract (written or verbal) to be binding, there are four major elements which need to be in place. The crucial elements of a contract are as follows:
Therefore, an oral agreement has legal validity if all of these elements are present. However, verbal contracts can be difficult to enforce in a court of law. In the next section, we take a look at how oral agreements hold up in court.
Most business professionals are wary of entering into contracts orally because they can difficult to enforce in the face of the law.
If an oral contract is brought in front of a court of law, there is increased risk of one party (or both!) lying about the initial terms of the agreement. This is problematic for the court, as there's no unbiased way to conclude the case; often, this will result in the case being disregarded. Moreover, it can be difficult to outline contract defects if it's not in writing.
That being said, there are plenty of situations where enforceable contracts do not need to be written or spoken, they're simply implied. For instance, when you buy milk from a store, you give something in exchange for something else and enter into an implied contract, in this case - money is exchanged for goods.
There are some types of contracts which must be in writing.
The Statute of Frauds is a legal statute which states that certain kinds of contracts must be executed in writing and signed by the parties involved. The Statute of Frauds has been adopted in almost all U.S states, and requires a written contract for the following purposes:
Typically, a court of law won't enforce an oral agreement in any of these circumstances under the statute. Instead, a written document is required to make the contract enforceable.
Contract law is generally doesn't favor contracts agreed upon verbally. A verbal agreement is difficult to prove, and can be used by those intent on committing fraud. For that reason, it's always best to put any agreements in writing and ensure all parties have fully understood and consented to signing.
Verbal agreements can be proven with actions in the absence of physical documentation. Any oral promise to provide the sale of goods or perform a service that you agreed to counts as a valid contract. So, when facing a court of law, what evidence can you provide to enforce a verbal agreement?
Unfortunately, without solid proof, it may be difficult to convince a court of the legality of an oral contract. Without witnesses to testify to the oral agreement taking place or other forms of evidence, oral contracts won't stand up in court. Instead, it becomes a matter of "he-said-she-said" - which legal professionals definitely don't have time for!
If you were to enter into a verbal contract, it's recommended to follow up with an email or a letter confirming the offer, the terms of the agreement , and payment conditions. The more you can document the elements of a contract, the better your chances of legally enforcing a oral contract.
Another option is to make a recording of the conversation where the agreement is verbalized. This can be used to support your claims in the absence of a written agreement. However, it's always best to gain the permission of the other involved parties before hitting record.
Fundamentally, most verbal agreements are legally valid as long as they meet all the requirements for a contract. However, if you were to go to court over one party not fulfilling the terms of the contract, proving that the interaction took place can be extremely taxing.
So, ultimately, the question is: written or verbal agreements?
Any good lawyer, contract law firm, or legal professional would advise you to make sure you formalize any professional agreement with a written agreement. Written contracts provide a secure testament to the conditions that were agreed and signed by the two parties involved. If it comes to it, a physical contract is much easier to eviden in legal circumstances.
Freelancers, in particular, should be aware of the extra security that digital contracts may provide. Many people choose to stick to executing contracts verbally because they're not sure how to write a contract, or they think writing out the contract terms is too complicated or requires expensive legal advice. However, this is no longer the case.
Today, we have a world of resources available at our fingertips. The internet is a treasure trove of invaluable information, platforms, and software that simplifies our lives. Creating, signing, and sending contracts has never been easier. What's more, you don't have to rely on a hiring a lawyer to explain all that legal jargon anymore.
There are plenty of tools available online for freelancers to use for guidance when drafting digital contracts. Tools like Bonsai provide a range of customizable, vetted contract templates for all kinds of freelance professionals. No matter what industry you're operating in, Bonsai has a professional template to offer.
A written contract makes the agreement much easier to prove the terms of the agreement in case something were to go awry. The two parties involved can rest assured that they're legal rights are protected, and the terms of the contract are sufficiently documented. Plus, it provides both parties with peace of mind to focus on the tasks at hand.
Bonsai's product suite for freelancers allows users to make contracts from scratch, or using professional templates, and sign them using an online signature maker.
With Bonsai, you can streamline and automate all of the boring back-office tasks that come with being a freelancer. From creating proposals that clients can't say no to, to sealing the deal with a professional contract - Bonsai will revolutionize the way you do business as a freelancer.
Why not secure your business today and sign up for a free trial?