Do you have to track your employees' tips?

Let's say you own a string of restaurants in Maryland and adjacent states, and you have hundreds of employees at all of those locations. Many of those employees earn tips as a part of their standard compensation. Obviously, the exact amount earned varies dramatically from one shift to the next.

This complicates things from a tax perspective. It is not the same as taking employees' taxes out of monthly paychecks that never change or only vary slightly if hours change. What responsibilities do you have for the taxes on those tips?

Reporting to the IRS

Though people sometimes think of tips as "under the table" earnings, the reality is that they must get taxed just like other earnings. It does not matter if the customer leaves a tip on a credit card, pays with a check or simply hands the employee cash -- or leaves it on the table -- after the meal. All tips have to get reported and taxed appropriately because they are part of that employee's income.

As an employer, you need to:

  • Keep accurate records of tips collected
  • Report those tips to the government and tax collection agencies
  • Collect taxes from the employees
  • File all appropriate forms and paperwork
  • Deposit or pay the taxes

Just as you withhold employee income tax from traditional paychecks -- and from the hourly wages that you pay those employees on top of their tips -- you also need to withhold income tax, Medicare taxes and Social Security taxes. The IRS needs to know exactly how much you withheld and how much employees earned.

The myth of tax-free tips

Understanding these rules helps to break down one of the most common myths about tips, which is that they are tax-free. Many people cite this when talking about how much tipped workers earn. The implication is that they earn more than hourly workers because they only pay tips on a small hourly wage and get the rest tax free. People see making $20 per hour in tips as significantly more than earning $20 per hour in wages.

This is a dangerous myth that can lead employees and employers alike to make critical tax mistakes. They cannot treat tips as tax-free wages or "under the table" payments. The structure of these payments may be unconventional, but the wage and hour laws specify that these are still wages. As such, the government still taxes them just like wages.

Understanding your role

Do not let this mindset cause you to make mistakes. Look into all of your legal obligations. Make sure you understand what the government requires of you and what steps you need to take to follow all applicable tax laws.

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