Anyone who receives pay in the form of tips should know that tips are taxable income, but there are quite a few misconceptions about how the IRS views tip income.
Most people believe you don’t have to pay taxes on tips unless you get more than $20. The fact is that if you get more than $20 per month in the form of tips, you must report it to your employer. Your employer then processes the tip income through the payroll system to ensure all the taxes applicable to tips are withheld. They also pay a share of employment taxes on your tip income.
Certain large employers whose main business is the serving of food and beverages where tipping is customary and that hire more than 10 employees may be subject to tip allocation. This means that 8% of total sales must be allocated to all employees in the form of tip income. This is to ensure that every employee who receives tips and who are not reporting their total tips to their employer will be allocated a fair sum.
There is a requirement that recipients of tip income must keep contemporaneous records, which means keeping a diary of your tip income. The IRS provides a tip diary in Publication 1244. Note that tip outs to other employees are not taxable income to you. You only pay taxes on the net amount of tips that you keep.
At year end, compare the tip income in your diary to what is reported on your W2 box 7 – Social Security tips and/or box 8 Allocated tips. If what you collected exceeds that shown on your W2, you must report the difference on your income tax return. IRS Form 4137 is used to report the additional income.
It only takes a few minutes each day to fill in the form, and it’s important to keep a log. If the IRS ever questions the amount that you are reporting as tip income, the easiest way to prove you are correct is to show this log. If you don’t have a log to verify the amount you are claiming as your income, the IRS might not be willing to work with you on it.