If you’ve ever worked in a tipped position, you know that talking about how and when you receive your tips is an extremely divisive issue. Everyone has the method and timeline they prefer, and you bet they are not gonna settle for anything else. When it comes to running a business that employs tipped employees, this is one of the biggest decisions you’ll have to make. As such, there are any number of questions involved: should you payout tips every night, every week, or bi-weekly? Do you house pool or have everyone keep their own individual tips? What about reporting? Do you make everyone turn over their cash and only pay out tips on their check? We can keep on listing questions, but we’re here to help alleviate your stress, not make it worse.
At Payday HCM, we’re constantly receiving questions from our clients about tipped employees. It makes sense: the process can be confusing and convoluted. Without the proper guidance, you risk upsetting your employees and, at worst, you may also have to pay out of pocket to cover wages not covered by tips (we’ll get into that later on). Since we receive such a high volume of questions on the topic, we want to ensure that, client of ours or not, everyone has access to the resources they need to answer their most pressing questions.
So, in this article, we’ll be going over tipped employees and payroll, and what you need to know about doing payroll with tipped employees. We’ll start by comparing the payroll processes between a business without tipped employees and one with. Then, we’ll get into the different ways a business can pay out and treat tips, as well as some of the laws and regulations surrounding tipped employees. Finally, we’ll go over some common things to avoid when it comes to tipped employees and payroll. By the end of this article, you’ll have all the information you need to run your next payroll with confidence.
In this article, you will learn:
- How Do Tips Work?
- Paying Out Tips To Your Employees
- Common Mistakes To Avoid With Tipped Employees And Payroll
How Do Tips Work?
Before we dive into how tips work within payroll, we’ll first take a look at how tips work and what defines a tipped employee.
What Is A Tipped Employee?
The U.S. Department of Labor defines a tipped employee as “any employee engaged in an occupation in which he or she customarily and regularly receives more than $30 a month in tips.” Generally, when we think of a tipped employee, we think of servers at a restaurant or cashiers and baristas at more cafe-style establishments.
The Department of Labor makes this distinction between a tipped employee and any other employee because there are different rules that come with being a tipped employee. On top of tips appearing in a different place on a W-2 tax form, tipped employees are also eligible to receive a “tipped wage” as opposed to minimum wage.
Tipped Wage vs. Minimum Wage
The biggest difference between a regular employee making minimum wage and a tipped employee is that tipped employees can be paid a tipped wage. While this varies by state, the federal minimum wage law outlines that tipped employees are only required to be paid $2.13 an hour as opposed to the minimum wage of $7.25 an hour.
Now, there’s a big qualifier that comes with the tipped wage, and that is that tipped employees can be paid the tipped wage so long as the tipped wage, combined with the amount they make in tips, would be equivalent to the federal minimum wage at the same hours worked. If not, the employer must make up the difference.
As we said earlier, though, these laws do vary by state. The U.S. Department of Labor has a breakdown of the different minimum and tipped wage laws by state that dives into which states have or don’t have a tipped wage, have a lower tip threshold for defining a tipped employee, or a different hourly rate that the combined tipped wage plus tips amount must equal.
Paying Out Tips To Your Employees
Now that we understand a bit more about how tipped employees are defined as per U.S. labor law, we’ll dive into how paying tipped employees works.
Tipped Employees And Payroll
Generally speaking, paying tipped employees and non-tipped employees looks essentially the same on the payroll end. However, Payday’s Director of Operations, Liz Mink, explained that there are different earnings codes to separate the amount earned in tips versus regular wages for tax purposes. This is also so that the payroll system knows to perform the calculation to determine if an employee made minimum wage with their tips and tipped wage.
“So, there are specific earnings codes that we have to use within isolved so that it calculates that minimum wage correctly. So, for a non-tipped employee, I will just put all of their hours under regular hours. On a tipped employee, they will be noted as tip regular hours. When we use that specific earnings code, it then tells the system that this employee is paid under minimum wage with this hourly rate, and they're expecting tips to come in, so it knows to do that calculation,” Mink said.
Mink said that, in situations where a tipped employee’s tips aren’t enough to bring them up to the required hourly rate to match the minimum wage, the employers will have to make up the missing amount. This will show up as “minimum tips” for the employer, but won’t be visible for the employee.
Reporting Tips And Paying Out Tips
When it comes to tips, one of the more confusing but important elements is reporting tips and how those tips are paid out. When it comes to reporting, it’s crucial for employees to record and report all tips received, as tips are subject to federal income taxes. The IRS recommends employees keep a daily tip record using Form 4070A, although any type of record would work.
An employee is then required to report tips received by the tenth of the month following the month they received the tips. These tips will show up on a W-2 form as Social Security tips. Employees should also use Form 4137 to report any additional tips that should be reported as income on their tax return.
On the employer side, employers are required to withhold the proper federal income taxes from an employee’s tips. This means employers are also required to pay the employer’s share of these income taxes as well. However, if an employee does not report their tips to an employer, the employer is not required to pay the employer share of the federal income taxes that would have been withheld on those tips until the IRS demands collection of those taxes.
When it comes to paying out tips, employers have a number of options (although all tips must be reported regardless of when they are received). Employees can choose to keep cash tips received during their shift or provide the employers with their cash tips to receive with their hourly checks. The advantage of receiving tips with their check is that taxes are withheld altogether with the total earned wage amount instead of just the hourly wages.
Common Mistakes To Avoid With Tipped Employees And Payroll
Now that we understand how payroll with tipped employees works, we can go into some common mistakes employers may run into when it comes to tipped employees.
Tipped Wage And Minimum Tips
One thing that employers with a tipped wage need to keep in mind is that employees must earn enough in tips so that their tipped wage plus tips is equal to or more than the amount made at minimum wage. One key thing here: this amount is calculated with the amount in reported tips—if the tips aren’t reported, they can’t count toward this calculation.
“I'd have clients get confused on what does this minimum tip thing mean? What do I do? And I said, well, first of all, your employee either isn't reporting enough tips to you… or they’re not making enough tips… So, a lot of restaurants will tell their employees you need to report 10% or 12% or whatever,” Mink said.
On the employee side, reporting these tips is also important when it comes to taxes. As we said earlier, any earned tips are still eligible for withholding federal income tax. According to Mink, if there aren’t enough wages to cover those social security or Medicare taxes, these amounts will come back to be owed on an employee’s tax return.
Making Your Tip Payout Process Clear
When it comes to starting a restaurant, it’s vital that you clarify how you are going to treat tips from the start in order to avoid any confusion later on. For Mink, this means ensuring you know when you’re paying out your tips, if you’re sharing or pooling tips between employees, and the hourly wage you’ll be paying tipped employees.
“You really need to make those decisions on… what pay rate are you gonna pay those employees, what are you expecting in tips? And then, also whether you wanna do pool tips or you're gonna let the employees… take them at the end of the night, or if you're gonna pay them on their paycheck. And I would just go through all of those things with that client if they were opening up a new entity, whether it be a restaurant or anything… And then also, I'm gonna make sure my employees are reporting the right amount of tips,” Mink said.
Tips On Managing Tipped Employees
Everything else aside, and much to the chagrin of your friend who went to Europe one time and made such a big deal about how you don’t have to tip employees there and tip culture is so much different there, tips are one of those things you’ll have to navigate when it comes to running a restaurant or most other service-based businesses. Sometimes, though, this can be easier said than done. There are a number of factors that affect how it is you have to handle tips in regards to payroll, whether that be your state’s minimum wage laws or how tips are reported for tax purposes. All of this can get very confusing and very stressful, very fast. With the pointers provided in this article, though, you’ll have what you need to start your tip journey off on the right foot.
Tipped or not, it can be easy to get lost in the sauce when it comes to running payroll for your business. One crucial thing to understand when it comes to payroll is the kinds of taxes you’ll be expected to pay as an employer. Check out our article for a breakdown of employer taxes to gain a better understanding of what you’ll need to pay (or what you’re already paying).
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