Anyone who derives pay in the form of tips should know that tips are taxable income, but there are quite a few misconceptions about how the IRS views tip income.

MYTH: You don’t have to pay taxes on tips unless you get more than $20.

TRUTH: The truth behind that misconception is that if you get more than $20 per month in the form of tips, you must report it to your employer. The employer then processes the tip income through the payroll system to ensure all the taxes applicable to tips (federal income taxes, Social Security, Medicare, and applicable state taxes) are withheld and that the employer pays his share of employment taxes on your tip income. All tips are taxable. The first $20 is not a freebie.

MYTH: You only have to report 8% of tips. My employer already shows this on my paycheck.

TRUTH: Certain large employers whose main business is the serving of food and beverages where tipping is customary and that hire more than 10 employees may be subject to tip allocation. This means that 8% of total sales must be allocated to all employees in the form of tip income. This is to ensure that every employee who receives tips and who are not reporting their total tips to their employer will be allocated a fair sum.

There is a requirement that recipients of tip income must keep contemporaneous records, which means  keeping a diary of your tip income. The IRS provides a tip diary in Publication 1244. Note that tip outs to other employees are not taxable income to you. You only pay taxes on the net amount of tips that you keep.

At year end, compare the tip income in your diary to what is reported on your W2 box 7 – Social Security tips and/or box 8 Allocated tips. If what you collected exceeds that shown on your W2, you must report the difference on your income tax return. Use IRS Form 4137 to report the additional income.

It only takes a few minutes each day to fill in the form, and it’s important to keep a log. Here’s why:

I once represented 29 servers from a major restaurant in an IRS audit of tips. The IRS had made tipped employees its target for audit that year and sent out letters stating that tip income was underreported and then billed these servers huge sums. Almost everyone who came to me was in shock admitting that they had in fact underreported, but certainly not to the extent the IRS claimed. Taking a look at their tax returns and comparing the income to the IRS’ letters I had to agree. These servers weren’t performing brain surgery so why was the IRS concluding their taxable incomes were at that level?

I took the first five cases to the auditor in Oakland, Calif. She refused to entertain any negotiating on behalf of the taxpayers because they had not kept contemporaneous records. I moved the audit to the taxpayers’ tax home – San Mateo, Calif. – to see if I had better luck with someone else. I did.

I had created a formula based upon the employer’s sales allocated to each employee less tip outs to determine a fair amount that the auditor agreed upon. For some it was a break even. One person received a refund and many others had to pay but the average was about one third of what the IRS had originally billed.

I was fortunate to have found an auditor who was cooperative--she could have been like the one in Oakland, so be sure to use Form 1244 and keep those tip records.

 

Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all 50 states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, Calif., and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know.” Her new e-book Taxpertise for the Creative Mind Murder, Mayem, Romance, Comedy and Tax Tips for Artists of all Kinds is available at all major booksellers. Follow Bonnie Lee on Twitter at BLTaxpertise and at Facebookhttp://global.fncstatic.com/static/v/all/img/external-link.png