If you’re a business owner and are thinking about hiring tipped employees for the first time, it can be challenging to get up to speed on all the rules and requirements regarding pay, recordkeeping, and reporting. Yet it’s critical to process payroll correctly for these workers or you could face penalties. What do you need to do to stay compliant? Let’s find out.
In this article, we’ll discuss the top things you should consider before hiring tipped employees, including unique wage rules, tax implications, and reporting responsibilities. After reading this, you’ll have a good understanding of the steps you need to get payroll for tipped workers right.
Who is considered a tipped employee?
According to the Fair Labor Standards Act (FLSA), a worker is considered a tipped employee when they customarily and regularly receive more than $30 per month in tips, regardless of their exemption status. Tips are voluntary and discretionary payments customers make to employees. These payments can be in the form of cash or through electronic payment like a credit card. Keep in mind that some payments you may think are “tips” are actually service charges, such as an automatic gratuity for a large dining party, and are considered non-tip wages.
What should I know before hiring tipped employees?
When you’re thinking about hiring tipped workers, there are several factors you’ll want to consider.
Wages
The top wage considerations for tipped employees include:
- Minimum Wage: The FLSA requires that employers pay a minimum wage for tipped employees of $7.25 an hour (or higher if state or local law mandates it). That means that an employee’s combined cash and tip rate must total at least that amount. If your tipped employees don’t make enough in tips, you’ll have to pay the difference so their pay totals the federal minimum wage of $7.25/hour.
- Tip Credit: If your employees earn enough in tips to make up the difference, you’re only required to pay a cash wage of $2.13/hour; the other $5.12 is considered a federal tip credit that counts toward your minimum wage obligations. The tip credit can be applied to employees’ hours of tip-producing work as long as that time is 80% or more of the hours for which you’re taking a tip credit; work such as rolling silverware or setting tables must be 20% or less of their total work time (this is what’s known as the 80/20 rule).
Keep in mind that, in some states, the amount of the tip credit may differ from the federal requirements. For example, in New Hampshire, the maximum tip credit is 55% of the minimum wage, or $3.99. That means you could claim up to a $3.99 hourly credit against the employee’s minimum wage and pay $3.26 an hour although the total hourly rate is the same as the federal minimum wage at $7.25/hour.
In addition, seven states don’t allow you to take a tip credit on tipped employees at all. In these states, Alaska, Washington, Oregon, California, Nevada, Montana, and Minnesota, you’re required to pay tipped employees the full state minimum wage before tips.
- Tip Pooling: A tip pooling arrangement is one where employees share tips. This most often happens with groups that provide customer-facing services and regularly receive tips, like wait staff, bartenders, counter personnel, and bussers. Pooled tips cannot be shared with “back-of-the-house” staff such as line cooks, chefs, or management if you claim a tip credit for any employee in the pool, which we’ll discuss next.
If you opt to have a tip pooling arrangement, you’ll need to inform your employees. As a best practice, you should put the policy in writing and have your employees review and authorize it, especially because written notice is a legal requirement in some states. In Utah, for instance, employers must alert new hires of their tip pooling practice in writing when offered the position.
You’ll also want to make sure your state allows you to require your employees to participate in a tip pool before you implement one. For example, New Hampshire employers can’t require tip pools but employees can agree to take part voluntarily.
- Allocated Tips: Allocated tips are tips that you assign to an employee in addition to what they report. If you’re a large food and beverage establishment and the total tips reported by all employees equal less than 8% (or approved lower rate) of the gross receipts, you’ll have to allocate the difference among employees who receive tips.
The IRS outlines 3 methods you can use to calculate allocated tips:
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- Hours-worked method
- Gross receipts method
- Good-faith agreement
Allocated tips must be shown separately in Box 8 on Form W-2.
Tip Reporting
If you have tipped employees, the IRS requires you to meet certain reporting requirements, including:
- You’ll need to report income tax and Social Security and Medicare taxes withheld from their wages and your share of Social Security and Medicare taxes on Form 941 quarterly.
- Most employers will also have to file Form 940 for FUTA taxes and deposit those taxes.
- Tips that your employees report to you must be included in Box 1, Box 5, and Box 7 of the worker’s W-2 statement.
- If you operate a large food or beverage establishment, you’ll also have to file Form 8027. This form is used to report your receipts from food and beverages and tips employees report to you. This form is also used to determine allocated tips. A large employer is defined as one that:
- Is located in the 50 states or the District of Columbia
- Provides food and beverages for consumption on site
- A customary practice is tipping of employees
- Normally employed more than 10 employees on a typical day in the last year
Tax Implications
There are two primary things you need to worry about when it comes to the tax implications of having tipped employees on staff.
- Paying Taxes on Tips: All cash and non-cash tips are treated as a form of income and are subject to federal income taxes. Like wages, you as the employer must withhold income taxes and the employee’s share of FICA (Social Security and Medicare) taxes on their tips as well as pay your share of FICA taxes and FUTA.
In order to calculate these amounts correctly, employees must report all cash tips to you by the 10th of the month after tips are received unless the total is less than $20 in any month. Tips should be reported to you in a written statement, although no particular form is required. However, it must be signed by the employee and include:
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- The employee’s name, address, and social security number
- Your name and address
- Month or period covered
- Total tips received during the month or period
- FICA Tax Credit: If you’re in the food and beverage industry, you can receive a credit for part of the FICA taxes you pay on your employees’ tip income that is greater than the federal minimum wage level of $5.15/hour (the federal minimum wage rate in 2007 when the credit was enacted).
So, for example, if you pay an employee $5.00/hour and they receive tips that equal $5.00/hour, that totals $10/hour. If the employee worked 5 hours and they earned gross wages of $50.00 (including tips), you’d only be responsible for paying FICA taxes at a $5.15/hour rate and would receive a FICA tax credit for the difference.
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To calculate the tax credit you can claim, you would multiply the difference, $24.25 in this case, by the FICA tax rate of 7.65%. For this example, your credit would be equal to $1.86 (that is, $24.25 x .0765). You could take this tax credit on your tax return as long as you complete and file Form 8846 with your return.
With the FICA tax credit recordkeeping, you can generate thousands of dollars a year in federal tax credits. In fact, on average, you could expect to generate a $500 credit for each part-time tipped employee and over $1,000 for a full-time one. The tax credit amount you’re eligible to receive is uncapped.
How can I get payroll for tipped employees right?
Processing payroll for tipped employees can be complex. From calculating wages and tax withholdings to reporting requirements, it may be challenging to understand all the rules you need to follow to avoid violations of the FLSA or IRS penalties.
If you’re ready to bring on tipped employees, but are worried about the risk of mismanaging their payroll and the impact that could have on your business, one way to avoid problems is to outsource payroll to a payroll provider. In addition to staying compliant, a provider can also help you save on taxes by tracking your tip credit each period and providing you with the proper year-end reporting to take advantage of the credits.
To see if using a payroll provider may be a good solution for your business, learn more about the pros and cons of outsourcing versus keeping payroll in-house. If you’re ready to outsource and think CPS could be a good fit, see how we can help businesses like yours.
Editor’s Note: This blog was originally published in December of 2020 and was updated in March of 2023 for accuracy and comprehensiveness.
