Payroll

Service charge vs. tips: Basics and examples

Many employees, especially those in the service industry, receive tips in the course of their work. Waiters, bartenders, and barbers are just a few occupations where employees commonly receive tips. And, while it’s nice to have cash in your pocket after finishing a shift, how do you account for these tips come tax time? Do you pay tax on gratuity? Are tips and service charge taxes treated differently than regular income?

In this article, we’ll answer all of these questions and more. We’ll start by explaining the differences between service charges vs. tips and then go into the tax rules for each. By knowing who’s responsible for paying certain taxes and the reporting requirements, you can stay in compliance with the Internal Revenue Service (IRS).

To learn more about the difference between tips and service charges and find out how each is taxed by the IRS, read on. Alternatively, you can use the links below to navigate to any section in the article.

What is the difference between service charges and tips?

There are some key differences between tips and service charges. Let’s get started by giving a clear definition of tips. The IRS defines tips as optional or extra payments given to employees by customers. According to the IRS policy on tips, tips can include:

  • Cash tips given directly to workers from customers
  • Tips given through electronic payment methods and credit cards
  • Any non-cash tips (gift cards, tickets, or other items of value)
  • Tips distributed through tip pools, whether this is a formal or informal arrangement

Generally, all cash and non-cash tips are considered taxable income. All cash tips an employee receives in a given month must be reported to their employer. However, if total tips received in said month amount to less than $20, then the tips do not need to be reported.

Note that there generally isn’t a difference between a gratuity vs. tip—these terms are often used interchangeably.

Service charges are separate from tips, although some venues may use the terms interchangeably. However, if a charge is compulsory, demands a specific amount, and must go to a certain party, this is considered a service charge. For tax purposes, it doesn’t matter how a company self-classifies or names its charges or tips.

There are many examples of service charges, ranging from a hotel room service charge to a mandatory gratuity. Other examples include an automatic gratuity for a large dining party, bottle service charge, banquet event fee, or cruise trip package fee. In fact, if any of the following factors are present, a payment will likely be considered a service charge rather than a tip:

  • The payment is compulsory
  • The customer isn’t allowed to determine the amount paid
  • The customer doesn’t determine who receives the payment
  • The charge on the customer’s bill cannot be negotiated

In any case, neither an employer nor employee can decide whether a payment is a “tip”; the above four factors must be used to determine whether the payment is categorized as a tip or service charge.

Are tips and service charges taxable?

Yes, employee tips and service charges are both considered taxable income by the IRS. These wages aren’t like tax-deductible meals that you can’t write off at the end of the year. For tips, it’s the employee’s responsibility to report tip income to their employer on a monthly basis.

You have to pay taxes on reported tip income. But, there are two main exceptions when it comes to reporting tips to an employer. First, if your total tips for the month are equal to $20 or less, you don’t have to report them. Second, you don’t have to report non-cash tips to employers, although these wages are subject to federal income taxes.

In contrast, service charges don’t have to be reported to employers. Employers can track service charges since these are typically more standardized than cash tips. Any portion of service charges given to employees are treated as regular wages.

Are tips and service charges taxed differently?

Tips and service charges are taxed the same as regular wages. They are both considered forms of income by the IRS, so you must pay federal income tax and FICA tax on these wages.

Who pays tip and service charge taxes?

Tips and service charges are treated the same as normal wages when it comes to taxes. This means that payroll taxes still apply to these types of income. Therefore, both employees and employers are responsible for paying tip and service charge taxes.

Like other industries, employers in the tipping industry withhold income taxes from employee wages. For tipped workers, employers must take tips and service fees into account when calculating withholdings. Once tipped wages are reported, employers will deduct the proper payroll taxes directly from an employee’s paycheck.

Tips and service charges can also affect the total amount of employer payroll taxes that must be paid. Employers are responsible for paying a share of Social Security and Medicare taxes, as well as state and federal unemployment taxes. More tips and service charges result in higher gross wages, which in turn increase the employer’s tax liability.

IRS reporting requirements

Employees and employers have different reporting requirements when it comes to tips and service charges. Below, we’ll go into more detail about the reporting requirements for tips and service charges and look at each separately.

Tips

In general, an employee is responsible for reporting all tip wages to their employer. According to the IRS , if you’re an employee who receives tips, you must:

  • Maintain a daily tip record
  • Report tips to your employer—this is often done at the end of each month
  • Report all tips you received during the year on your individual tax return

Both directly and indirectly tipped employees are responsible for reporting tips to their employer. Directly tipped employees are workers who receive tips directly from customers, such as waiters or barbers. Indirectly tipped employees are workers who may receive a portion of a tip-sharing arrangement, such as dishwashers or bussers. For indirectly tipped workers, consider reviewing tip pooling laws in your local area to ensure they align with employer policy.

Once tips have been reported to an employer, the employer becomes responsible for paying applicable payroll taxes on those tips. They must pay Federal Unemployment Tax Act (FUTA) taxes for employees whose tips total more than $20 in a month. They must also collect federal income tax, Social Security tax, and Medicare tax on their employees’ tipped wages. As a small business owner, you can report tips, as well as collected and uncollected payroll taxes, on Form W-2 and Form 941, if applicable.

In addition to paying federal payroll taxes, employers should also research applicable local tax laws. If you happen to use independent contractors in your business, you may look into  tax deductions for 1099 contractors .

Service charges

Service charges are classified as non-tip income by the IRS. This means that companies charging service fees should treat these payments as regular income. If a percentage of service charges are distributed to employees, take note of this in your payroll system. The wages employees receive from service charges will need to be added to their net pay.

There are other resources if your employees need additional guidance regarding their responsibilities and reporting requirements when it comes to tips and service charges. Advise them to review the IRS Publication 531 fact sheet, which outlines tip income reporting requirements. Or, employees can also use the IRS Interactive Tax Assistant to determine whether their tip income is taxable.

Service charge vs tip in California

It’s important to consider state laws regarding service charges and tips, as well. For example, under California law, service charges cannot be considered tips. They are characterized as an amount a patron must pay under the terms and conditions of purchasing products (generally, food and drink) from the restaurant. In California, service charges go directly to the business, not the employees.

If you’re a small business owner, it can be challenging to monitor tips, record sales tax, and track expenses, especially during busy seasons. However, choosing the right payroll software can make the process a lot simpler.

Accurately track payroll and taxes

In some ways, tips and service charges are similar types of payments. Some companies even self-classify certain service charges as tips. But the primary difference to remember is that tips are optional payments made by customers, while service charges are mandatory.

When it comes to recording tips and service charges for tax purposes, things can get tricky. Employees have to report tips to their employer, and both parties have to pay applicable payroll taxes to the IRS. In this case, there are plenty of windows where costly mistakes can occur, both for employees and you as a small business owner.

When you invest in a payroll service like QuickBooks Payroll, you can get rid of much of the confusion surrounding tips and service charges. Our easy-to-use payroll software allows you to track employee wages, quickly run payroll, and automatically calculate payroll taxes. We even offer tax penalty protection for QuickBooks Payroll Elite users who are eligible. Streamline your payroll process, save time, and run your small business from your smartphone when you use QuickBooks Payroll.


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