Many Workers Rely on Tips — Are Tips Taxable Income?

For the millions of Americans who work in a service-related industry and receive part of their wages in tips, knowing what's taxable income can be complicated. Tips are additional payments from customers to workers, who often rely on them to bring up their low hourly wages. Are tips taxed, and how do workers report them?

Tips received for work such as restaurant service are often given in cash. This might make workers believe that those tips aren't considered taxable income, but that isn't the case. Here's how to handle taxes on your tips.

We all are familiar with tips, at least in terms of the extra 15 percent to 20 percent we add onto our restaurant bill for the service. The IRS explains that tips are "optional cash or noncash payments that customers make to employees."

The IRS has four qualifications to make a payment a tip:

• they're non-compulsory (not required)
• the customer decides the amount
• they're not regulated by employers
• and the customer decides who gets the payment.

These are partly why there's so much debate about tipping for carryout.

Workers may receive either direct tips (paid from the customer, even if part of a shared tip pool) or indirect tips (tips to those who normally don't get tips, such as bussers or cooks).

Are you wondering why tips are taxed? Although as a service worker you may feel entitled to keep all of your tips to make up for earning a lower hourly wage, the IRS still views tip money as taxable income. This isn't only for restaurant staff, but also for those working in salons, hospitality, and similar industries.

If you didn't know about reporting tips on your tax returns, here's a rundown of how it works. First of all, workers must report all cash tips to their employer. The IRS explains that workers should keep a daily tip record, including cash and non-cash tips. However, you only report cash tips to your employer, and the non-cash tips you keep a record to include on your taxes.

As the IRS states, there isn't a required form, but you can use Form 4070 to keep track of tips and report them to your employer. Turn this in by the 10th of the month after the month you received the tips. If not using the form, you must include the following:

• employee signature
• employee name, address, and SSN
• employer name and address
• month or period of tips
• total tip amount received

The IRS says you don't need to report tips less than $20 per month per employer. In addition, if you receive tips that your employer automatically added to a bill (for example, for large parties), that will be included in your W-2 and taxes will be deducted already.

After keeping track and reporting tips to your employer each month, when it's time to file your taxes, you need to report all tip income. That includes the tips you reported to the employer as well as noncash tips (tickets or other noncash benefits).

The forms to use for tips are:

• Form W-2 will include tip income that you reported to your employer
• Report noncash tips on Form 4137 (Social Security and Medicare Tax on Unreported Tip Income)

You'll need to pay the employee share of Social Security and Medicare tax on noncash tips.

As Fox Business reported, the IRS is considering a change in how tips are reported. The Service Industry Tip Compliance Agreement (SITCA) would include means for businesses to track tip income from point-of-sale (POS), time and attendance systems, and electronic payment systems.

TurboTax notes that the IRS could impose a 50 percent tax equal to the Social Security and Medicare tax you fail to pay if you don't report tips to your employer.