Tax on Gratuity

If you run a business in which employees accept tips as part of their wages, you are required to account for that gratuity on your taxes. Tipping is ubiquitous in service industries like the dining and beverage industry, hotels, and ride sharing, but this payment model comes with some very specific tax requirements. 

Gratuity vs. Service Charge 

In order to understand your tax obligation as it pertains to tips, you must first recognize the key distinction between a gratuity and a service charge. The Internal Revenue Service defines gratuities and service charges as follows: 

A gratuity is a voluntary tip provided by a customer to an employee. The operative word is “voluntary.” It’s a reward for excellent service. A gratuity can be paid via cash, debit card, credit card, or even gift card, but if it appears on the company’s official receipt, the company must leave the tip line blank for the customer to fill out. A gratuity may also come in the form of a non-cash perquisite, such as any item of value. 

A service charge is a mandatory gratuity. For example, it’s not uncommon for a restaurant to impose a mandatory 18% service charge for parties of 6 or more. The IRS also recognizes charges such as banquet event fees, cruise-trip package fees, and nightclub bottle service charges as being in this category. Even if this money is distributed entirely to the employees, it’s considered a service charge and not an actual gratuity in the eyes of the IRS and is therefore subject to different tax requirements. 

Accurate tracking of tips and service charges is important because it all factors into an employee’s salary. Most states allow businesses to pay tipped employees less than minimum wage because tips are calculated into the total wages. The employer is then responsible for providing the necessary withholdings and SS/Medicare tax benefits based on what the employee actually earns. 

Note that, in California, employers are still required to pay at least minimum wage to tipped employees. 

Do You Need to Pay Sales Tax on Gratuity? 

Most states will require you to pay sales tax on service charges, but different states have different requirements when it comes to gratuity. Voluntary gratuity is generally not subject to sales tax, but some states consider mandatory gratuity separate from service charges for the purposes of sales tax. 

In New York, for example, mandatory gratuities are not subject to sales tax so long as they meet all of the following three conditions:

• The gratuity is listed separately on the bill

• The charge is identified as a gratuity 

• 100% of the charge is distributed to the employees 

If any of the above conditions are not met, the charge is considered a service charge and is subject to sales tax. 

But not all states operate this way. For example, California distinguishes gratuities and service charges much like the IRS. Any gratuity that is automatically imposed is considered a service fee and is subject to sales tax. Voluntary tips are not subject to sales tax. This is noted in California Publication 115. 

It’s important to review the laws in your state or local jurisdiction to determine whether or not your automatic gratuities are subject to sales tax.  

Is Gratuity Taxed as Wage Income? 

All monetary tips are considered taxable income by the IRS, so long as the tips exceed the tax-exempt gratuity amount of $20. When it comes to federal income taxes, the filing requirements for gratuity will once again depend on whether the tips are voluntary or mandatory. 

All gratuity must be reported by the employee to the employer. It must then be reported as wage income to the IRS by both the employer and the employee. Service charges are reported as regular (non-tip) wages. If you only allocate a portion of the service charge to the employee, you would only include that portion as non-tip wage income. 

Gratuities and service charges are also treated differently in terms of tax withholdings. Because service charges are treated as regular wages, advance withholding is required. Advance withholding is not required for voluntary gratuities, as these are ultimately calculated based on the employee’s own tip reports.

Because gratuities and service charges are both forms of wage income, employers are required to keep detailed records of both and pay their share of Social Security tax and Medicare tax based on the employee’s total earnings. Failure to do so can result in hefty fines and other penalties. 

Note that the maximum tax-exempt gratuity limit is $20, so any employee who earned more than $20 in tips for the entire year must report their gratuity as part of their earnings. 

How a Tip-Sharing Arrangement Affects Taxes

If tips are pooled at the end of the day and divided among multiple employees, each employee’s share is taxable as part of their wages. This assumes that the tips were generated via voluntary gratuity and not via mandatory service charges (in which case the rules for service charges apply). 

For example, if $100 in tips is divided evenly among four employees, each employee will earn $25 in taxable income that must be reported in addition to their basic salary. 

Note that many states have very specific rules about tip pooling. For example, many states require that the tips be allocated only among employees within the “chain of service” to a given customer (such as the waiter, busser, and bartender who served the customer). Managers are ineligible to accept any individual portions of any tip. 

It’s important to have an official policy in place if you opt for tip pooling. Informal tip sharing arrangements can be a tax nightmare and may create liability on your part. 

How to Handle Tax on Gratuity — A Recap

If you have to manage employee gratuities as part of your tax filing, just remember the following: 

• Research your local and state laws as they pertain to sales tax for gratuity 

• Ensure that all tips and service charges are calculated as part of your employees’ wages (but only in the amounts allocated to each employee) 

• Treat service charges as regular wages; treat voluntary gratuities as tip wages 

• Work with a knowledgeable Los Angeles CPA who specializes in business tax services. They can help you to remain in compliance with the often-complex IRS requirements 

Accurate reporting of gratuity is essential at tax time, so make sure you understand what’s required and keep accurate records all year long.