Do I Have To Pay Tax On My Tips?

One of the questions we receive frequently is on the subject of tips. Should tips received at work be taxed as income? Who is responsible for reporting tips? What happens if I don't report tips?

Some of us who earn tip income tend to think of our tips as a bonus: pocket change, quick cash, or beer money, if that's what you're into. But the truth is that this money is legally the same as your regular wage or salary. This means that you should be keeping track of all of your tips throughout the year and then reporting it as part of your income on your tax return. No exceptions.

According to IRS Publication 531, you need to 1) keep a daily record of your tips, 2) report these tips to your employer, and 3) report them on your tax return. Note that this does not apply to you if you make less than $20 per month in tips.

So, what happens if you don't do all of this? If you're very unlucky, you could face a penalty of 50% of the Social Security and Medicare payments that you were supposed to pay on your tips - that is, 50% in addition to what you owe already.

In the end, this should be more of a concern for restaurant owners who are not encouraging or tracking tip-related income than for individual employees. If the IRS does decide to crack down on unreported tips, then going after owners and large companies seems the most likely (and practical) route for it to take. That does not, however, relieve the employee receiving the tips from responsibility in reporting the income.

Employers looking to avoid trouble with the IRS can join the TRAC (Tip Reporting Alternative Commitment) program, a voluntary agreement in which restaurants set up a system to report their employees' tips. This appeals to owners because it protects them from the IRS' tip audits. For some reason, though, I doubt that the program is very popular with employees.

Even though many skirt the rules and ignore the facts, guidance from the IRS is very clear that tips are taxable income.

While the tax consequences are clear, from a broader and cultural standpoint, tipping is a strange and complicated practice. It allows employers to pay less than minimum wage to servers and wait staff. It places a higher tax burden on the individual receiving the tip, since they are responsible for paying both halves of employment taxes (the employer would otherwise be responsible for their half otherwise). Because tipping is quasi-optional, it places customers in an awkward position of determining how much to tip, and sometimes whether or not to tip at all. It allows for customers to discriminate for or against certain kinds of servers - perhaps even rewarding based on criteria that would otherwise be illegal, such as by race, physical appearance, or gender. On the other hand, causes the waiter to possibly discriminate against certain kinds of customers based on expectation or likelihood of receiving a generous tip. Lastly, because many tips are received in cash, there is a strong likelihood of tips going unreported as income.

Several of these issues are examined by Stephen Dubner of Freakonomics, including a new type of restaurant that bans tipping entirely: The No-Tipping Point. Last year, Dubner looked at whether or not it was legal for certain kinds of restaurants (Mexican, or Italian, for example) to hire servers who matched the profile of the restaurant itself.

On the issue of taxation, however, the matter is clear: tips must be reported as income, and taxed accordingly.