What is a tipped employee?

The Department of Labor (DOL) explains that a tipped employee is one who customarily and regularly receives more than $30 per month in tips, which can come from credit cards, debit cards, or cash. 

If an employee usually receives less than that amount, and if tips are not frequent or customary to their occupation, they are not considered a tipped employee for tax purposes — even if they occasionally earn a gratuity. 

As an employer, the Fair Labor and Standards Act (FLSA) only requires you to pay tipped employees a minimum of $2.13 per hour in direct wages, as long as that amount, combined with the employee’s tips, equals the federal minimum hourly wage. 

If it does not, you as the employer must make up the difference. 

It’s worth noting, additionally, that many states or cities require a higher minimum direct wage for tipped employees in some sectors than the FLSA does. In contrast, others do not distinguish between the minimum wage for tipped and non-tipped employees. For example, Arizona’s tipped minimum wage is $9.15, and Alaska’s minimum wage is $10.34 for tipped or non-tipped employees alike. Meanwhile, in New York City, the minimum wage for food service workers is $15 per hour. 

How are tipped employees taxed?

The IRS considers all tips exceeding $20 per month that tipped employees receive to be income. As such, they are subject to federal income tax.

That means the employee must include in gross income all tips they receive directly, charged tips paid to them by their employer, and their share of any tips received under a tip-splitting or tip-pooling arrangement.

The IRS requires both, directly and indirectly, tipped employees to report all tips over $20 per month to their employer and any unreported tips on their individual income tax return.

On the other hand, if the total amount of tips that an employee receives in a single month and through a single employer does not exceed $20, they are not taxable, and the employee does not need to report them as income.

For tax purposes, tips do not only include cash given directly to the customer or left for them through electronic payment methods and tip amounts paid out through pool or sharing systems, but also the value of any noncash tips (such as tickets or other items of value).

Finally, all cash tips exceeding $20 that an employee receives in any calendar month are subject to social security and Medicare taxes. (As above, amounts lower than $20 per month are not subject to these taxes.)

What are the employer’s responsibilities regarding employee tip income?

Employers have some obligations regarding employee tip income, as well. These include recordkeeping and reporting responsibilities, like keeping employee tip reports on record. 

Furthermore, employees must withhold taxes (including income, Social Security, and Medicare taxes) based upon an employee’s wages and tip income and deposit this tax. 

Finally, employers must also pay a share of Social Security and Medicare taxes based on the total wages paid to tipped employees, as well as the reported tip income, and report this information and tax to the IRS by filing the appropriate paperwork. 

If an employee does not report tips to their employer, the employer is not liable to withhold and pay the employee’s share of Social Security and Medicare taxes nor for their employer’s share of taxes on those unreported tips. However, if the IRS subsequently notifies the employer of a demand to pay taxes on unreported tips, the employer would become liable at that time. 

The employer is obligated to withhold a 0.9% Additional Medicare Tax from any Medicare wages or RRTA compensation it pays to an employee exceeding $200,000 in a calendar year, regardless of their filing status. This Additional Medicare Tax is only imposed on the employee and not the employer.  

Generally, the employee must report tips allocated to them by their employer using Form 4137, Form 1040, or Form 1040-SR. The employee must also report other tips not reported to the employer on Form 4137. 

Nevertheless, an employer who operates a large food or beverage establishment must file Form 8027, an annual report of tip income and allocated tips. Moreover, some employers who operate multiple food and beverage establishments must file multiple Forms 8027. 

How are tipped wages calculated?

As touched upon above, the average pay rate for a tippled employee is equal to the amount of direct cash wages plus the tip credit amount claimed by the employer. 

A tip credit is essentially the mechanism that makes it possible for an employer to include tips in minimum wage calculations by crediting the amount of the tip against the employer’s requirement to pay a minimum wage. 

Employers can only apply tip credits to tipped employees. They can further apply them to payment obligations for hours of work that produce tips directly or support tip-producing work (as long as this type of work is not performed for a long time). 

State laws differ when it comes to tip credits, too. For example, California, Nevada, Minnesota, Montana, Oregon, Alaska, and Washington prohibit tip credits, whereas other states allow it but require a higher minimum wage (as mentioned previously). Complicating matters further, other states have their own parameters for when an employer may take a tip credit, which differs from those defined by the FLSA. 

Check the DOL website and your state’s website to find guidance and information when in doubt. 

Another area employers may find confusing is the calculation of overtime for tipped employees. The FLSA requires employers to pay extra wages for work that exceeds 40 hours in a given week. But the nature of tipped employee minimum wage and tip credits can make this a bit less straightforward. 

Assuming a $2.13 tipped minimum wage, to calculate overtime, an employer would need to subtract the employee’s hourly tip credit from the general (not tipped) hourly overtime pay rate and multiply the number of hours of overtime by the employee’s hourly overtime pay. 

To make it simpler: the federal general minimum wage is $7.25 per hour. Most employees receive an overtime rate of one and a half times their regular rate, which equals $10.88 per hour in this example. If the employee worked forty-five hours in a given week, or five hours of overtime, the employer would multiply those five hours by the employee’s hourly overtime pay with the total hourly tipped credit subtracted.

The maximum hourly tip credit permitted under federal law is $5.12. Subtracted from the $7.25 minimum wage, which yields a non-overtime pay rate of $2.13, and an overtime pay rate of $5.76 per hour. Therefore, applying that amount to our example (five hours of overtime multiplied by $5.76 an hour of overtime pay), the overtime pay amount would come to $28.80.

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