Unreported Tip Income: Watch Out for the IRS

The IRS is after unreported tip income. Here’s what you can do as a tipped employee or business owner with tipped employees.

Are tips taxable?

The simple answer is that tips absolutely, 100% are taxable income.

Remember, tips are a replacement for wage income. The reason that most servers prefer getting tip income isn’t that tips aren’t taxable income but because getting tipped usually results in a higher income than a restaurant would otherwise pay.

One of the most common arguments people make is that tips should be nontaxable gifts because tips aren’t actually mandatory. The IRS has repeatedly shot this down.

Under the tax law, any compensation you receive for work you did is taxable income whether you get paid a fixed rate or tips.

Why is the IRS going after servers and other retail workers instead of billionaires?

Joe Biden promised that taxes wouldn’t go up for people making less than $400,000 per year. Now that the IRS has funding for 87,000 new agents, they’re going after low and middle-class workers struggling to get by due to inflation.

What gives?

The IRS has been moving for years to make more tax reporting automatic. You may have previously seen things like additional checks on the Earned Income Tax Credit or new 1099 reporting rules.

Since working-class people have simpler tax returns than billionaires, it’s easier to automatically check their tax returns. If the IRS adds just one reporting rule, it can now better track the income of millions of people at once.

If you don’t have unreported tips you haven’t been paying taxes on, that’s actually a good thing. People have asked for years why the IRS can’t just do your taxes for you and mail you a bill like how taxes work in Europe.

If your employer reports all of your tips, you never have to worry about the IRS trying to audit you for alleged unreported tip income. You also don’t have to worry about tracking your tips since your employer will report tips for you.

How is the IRS going to track cash tips?

The IRS is going to start tracking more information during the year and adding more employer responsibilities.

Currently, you’re supposed to keep your own daily tip record and give your employer a monthly tip report. The tips you report then get added to your W-2 for the year.

Usually, the IRS will audit an employer if employees report less than 8% of a restaurant’s gross sales as tip income. There’s no hard rule for auditing individual servers, but many people choose to report tips as if they got tipped 10% or 15% even if they got more in cash tips.

The truth is that it’s currently fairly easy to get away with not fully reporting tip income. That’s why the IRS is changing the rules.

The two big components of the new rules are:

• Requiring tipped employees to report their tips for the day when they clock out. Instead of just pushing a button to end your shift, you’ll enter your tips in your employer’s time-tracking system.
• Getting more data from the employer’s point of sale system. The IRS will start determining the average expected tips for an establishment by looking at total sales versus tips. For example, if noncash tips usually average 25%, they might no longer believe that your cash tips only averaged 10%.

What about tip pools?

The money you get from tip pools counts as a tip for taxes.

Also, if you have to turn tips into a tip pool, the entire tip you received is not your income. Only the tips that you actually keep are actually part of your taxable income.

The new IRS rules for reporting tip income can actually make things better for servers that have to share tips.

Currently, servers can get burned when an employer uses allocated tips but the server gets stiffed on a big table. That can lead to paying in (and getting taxed on) tips that you never actually received.

With the new rules bringing in more frequent and more precise tip reporting, you shouldn’t have to worry about allocated tips at all. Instead, your employer should know exactly what your tip income is.

How should tipped employees handle reporting tips?

Again, the new rules should make it easier to report tip income.

Currently, you need to keep a daily tip record. Some people use a paper notebook, while others pay for accounting software like QuickBooks.

With the new rules, you should no longer have to worry about keeping your own records. You’ll use your employer’s daily tip reporting form, and all of your tips will be on your W-2 at the end of the year.

Benefits of Reporting Tips

Most people who don’t fully report their tips do it to pay less in taxes. Obviously, that can save money if you never get caught and have to pay back taxes plus fines.

However, in addition to income taxes, you pay Social Security and Medicare taxes on your tips.

Your Social Security retirement benefits are based on a percentage of your highest 35 years of earnings during your career. So underreporting tips on your tax return can lower your Social Security benefits.

And if you really push it with not reporting your full income, you may even not pay enough in Medicare taxes to qualify for Medicare once you turn 65.

In addition, if you need to prove your income for a mortgage or other loans, you may need to show your individual income tax return. If your reported tip income is too low, you may not qualify for a loan.

Finally, many servers who had been underreporting their income lost out on COVID-19 relief money. That’s because many of those programs were also based on your tax return income.

“My Employer Says to Report Less Tips”

When your employer tells you not to report tips, it’s often not to help you avoid paying taxes.

Your employer also has to pay Social Security and Medicare taxes on the tips you report. That’s because the employee pays half of those taxes through FICA withholding, and the employer pays the other half.

So your employer is actually cheating you out of future benefits to reduce his own tax bill.

“I Don’t Think Social Security Will Be Around”

Social Security definitely has issues. But the 2023 State of the Union Address showed that it’s virtually untouchable.

At the end of the day, no politician wants to be on the record as cutting benefits for seniors.

Yes, there’s a chance that you might get back less than you would get investing in your own retirement fund. There’s also a chance that you might do better with Social Security.

Betting against Social Security isn’t a bet you can undo. And whatever your reason, trying to avoid paying the Social Security tax that you owe can get you in trouble with the IRS.

How should employers handle reporting tips?

Again, the new rules should actually make things easier. While more employee responsibilities might sound like a headache, it makes things more black and white.

You’ll have much less worrying to do about whether employees are reporting their tips. Reporting tips will become a regular part of each employee’s workflow using your existing point of sale and time-tracking systems.

You’ll also have real-time access to the same data the IRS will use. Instead of having to do manual calculations or worry about what will make the IRS happy, you’ll be able to easily compare the reported tip income for each employee.

Audit Danger

I actually think that the biggest danger of IRS tip audits is right now. Again, the new rules should make it easier for everyone to accurately track everything.

Until those rules formally pass, you get a combination of the old rules that leave gray areas with 87,000 new IRS agents looking for easy ways to find unpaid taxes.

So right now, go make sure you have a good system for accurately tracking and reporting tip income. If you haven’t been paying your full taxes, you might want to talk with a tax professional about amending your past tax returns before the IRS catches you and imposes big fines.