How to Process Payroll for Tipped Employees
Tips can make up a large percentage of an hourly worker’s wages. A study by PayScale found that tips can make up an average 25 percent of restaurant employees’ salaries (bartenders, servers, chefs, and cooks), with some roles taking home over 60 percent of their wages from tips.
These tips are taxable income and employees are responsible for reporting them to their employers. Employers are then required to account for those tips and withholdings in the payroll process.
Accounting for tips and tipped employees can be a little complicated. But knowing the rules and having a system in place can help you master payroll in no time.
We go over some of the basics here. As with all our articles, this contains general information only and is not a substitute for legal or tax advice. For advice specific to your business and the state(s) in which you operate, be sure to consult with a qualified professional.
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Who is a tipped employee?
Depending on the kind of business you run, any number of people may get tips. But there’s a legal requirement to be considered a tipped employee. Under federal law, a tipped employee is a worker who customarily and regularly receives more than $30 per month in tips, according to the United States Department of Labor. State laws may be different.
What should tipped employees be paid?
Under the federal Fair Labor Standards Act (FLSA), all nonexempt (hourly) employees must be paid a minimum wage of at least $7.25 per hour. However, the minimum wage can vary widely based on the state, county, and even city where the worker is employed, so you want to check in your locale to see what wage you should be paying.
In some states, employers can take a tip credit against the minimum wage for “tipped employees.” Under federal law, an employer is permitted to credit up to $5.12 per hour in tips toward the minimum wage, provided that the employer pays the employee at least $2.13 per hour in cash wages (i.e., $7.25 minus $5.12), makes up the difference if the employee does not earn sufficient tips, and satisfies certain other requirements that are discussed here.
Who qualifies as a “tipped employee” and the credit (if any) that can be taken varies by state — some states follow federal requirements only, while other states impose additional requirements/limitations. In California, for example, an employer cannot count tips toward its minimum wage obligations.
What are tipped employees responsible for reporting?
Employees are responsible for reporting to their employer any tipped income of $20 or more (including cash, debit, and credit card tips as well as tips from other employees) and the cash value of non-monetary tips (such as a bottle of wine) each month.
Instructions and forms for reporting tips to employers are found in Publication 1244. Employees can use this form or they can also create a custom form or even just write down a record of tips with pen and paper. You should communicate to your employees how you would like them to report on tips.
Whatever that format looks like, the employee must include:
- Name, address, and Social Security number
- Employer’s name and address
- The month the report covers
- Total tips received
These reports should be submitted to the employer on the 10th day of the month following the month when the tips were received. And employees should keep copies of these reports for their own records.
What are employers responsible for reporting?
As an employer, you are responsible for reporting tips on a quarterly basis, as part of your quarterly tax return. You also must collect employee income, Social Security, and Medicare tax on tips reported by employees.
When you report tips to the IRS each quarter, you must ensure that the total tip income you report is, at a minimum, equal to eight percent of your total receipts for that period. When you calculate that eight percent, don’t include receipts for carryout sales or those for which there’s a service charge of 10 percent or more. (Learn more about tipping on the IRS website.)
When the total amount of tips reported to you is less than eight percent, you then need to allocate the difference between the tip income reported and eight percent of your total receipts.(If you operate a large food or beverage business, you must also file Form 8027 to report your employees’ tip income.
This is defined as an establishment where food or beverage is provided for onsite consumption; tipping is a customary practice; and there are more than 10 employees, who work more than 80 hours, and are employed on typical business days.)
How do you calculate and process overtime for tipped employees?
To qualify for overtime under federal law, an employee must work more than 40 hours in a single workweek. Under the FLSA, those overtime hours must be paid at one and a half times the usual regular rate for the time worked. Some states impose additional overtime requirements.
(If you’re using a tip credit, you must still calculate the overtime rate based on the full hourly wage, not the discounted tip credit.)
If you use an automated payroll system, the overtime rate should be calculated for you when you enter how many hours of overtime your employee worked.
6 tips for managing payroll for tipped employees
Remember that while tips belong to your employees, as an employer, you are responsible for accurately reporting tipped income. And if there’s a discrepancy or inaccuracy, the first place the IRS will check is your payroll.
If you’re managing payroll for the first time, we recommend consulting with a professional to get set up. But here are a few things to keep in mind as you’re getting started.
1. Learn the laws and follow them
The FLSA can help guide how you pay your hourly employees. For example, you need to provide an hourly wage that equals or exceeds the federal, state, county, or city minimum wage (whichever is higher).
You also need to pay overtime wages, unless your employees qualify as exempt. (It’s difficult in the restaurant or salon setting to be considered exempt, so be sure to review the three rules of exemption under federal law — and play it safe.) Additional requirements may apply based on your city, county, and state, so be sure to check local rules as well.
If you’re going to use the FICA tip credit, get familiar with those guidelines and work with an accountant to figure out how that factors into your payroll process. (And don’t forget to tell your employees that you’re using the tip credit to calculate their wages.)
2. Be fair
Remember the tips do not belong to you, the employer, they belong to your worker who earned them. The FLSA prohibits any arrangement in which any of the tips received become property of the employer.
3. Mandatory service charges are not tips
According to the FLSA, mandatory service charges are not tips. That means a mandatory 15-percent service charge that is paid out to waitstaff cannot count as tips received for use as a tip credit.
4. Your employees’ time matters
Often, tipped employees may perform the duties of a nontipped worker during their shift. For example, waiters may make a pot of coffee or prep table settings. The FLSA allows employers to use the tip credit for time spent doing such tasks, even though they do not directly generate tips.
However, you can’t use the tip credit when the tipped employee spends more than 20 percent of their time on related duties that do not generate tips. So be aware of how you’re allocating your resources.
5. You may be able to recoup credit card processing fees
Customers who pay by credit card typically write in their tip. As an employer, you may need to pay a fee to process the credit card transaction. Depending on your state, you may be allowed to recoup the portion of the fee applicable to your employee’s tip, provided that doing so does not drop the employee below the applicable minimum wage.
For example, assuming a 2.75-percent fee, the FLSA permits an employer to pay the tipped employee $9.72 of a $10.00 tip if charged on a credit card. However, you cannot withhold the tip while waiting for reimbursement.
6. Don’t forget about other benefits
When you process payroll for your tipped employees, you should factor in other perks your employees get, such as a free meal. This can be considered a fringe benefit by the IRS, and therefore part of taxable income.
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