In the foodservice industry, tips are an important part of employee compensation. Tips are added to employee wages so they can earn at least minimum wage. But, what happens when a tipped employee earns few tips?
What are allocated tips?
Allocated tips are amounts given to tipped employees in addition to the tips they report. If the total reported tips in a payroll period are less than 8% of your business’s gross sales during the same payroll period, you must allocate tips to your employees. The length of a payroll period will depend on your company’s pay frequency.
Which employers must allocate tips?
You must allocate tips to employees if your business meets all of the following requirements:
- You run a large food or beverage establishment.
- You have employees who receive tips directly from customers.
- The total reported tips during a pay period are less than 8% of your business’s food and drink sales during the pay period.
Your business qualifies as a large food establishment if it is located in the 50 states or the District of Columbia, customers tipping employees is customary, and you employed more than 10 employees on a typical business day during the preceding year.
How do you calculate allocated tips?
There are three ways to calculate allocated tips:
- Hours-worked method
- Gross receipts method
- Good-faith agreement
For detailed explanations of each method, look at the IRS Instructions for Form 8027. The instructions also explain how to do the calculations for each method.
Hours-worked method
Only large food establishments with fewer than 25 full-time equivalent employees can use the hours-worked method. To find out how to calculate full-time equivalent employees for the purposes of allocated tips, look at the hours-worked method in the Instructions for Form 8027.
With the hours-worked method, you allocate tips based on the percentage of hours an employee worked compared to the total hours all employees worked.
This method can be inaccurate because it does not factor in the sales made during the hours each employee worked.
Gross receipts method
Any large food establishment can use the gross receipts method. With this method, you allocate tips based on the percentage of gross receipts an employee earns compared to the total gross receipts for your business.
Good-faith agreement
You can allocate tips based on a good-faith agreement between you and your employees. This is a written agreement that explains how you will allocate tips among employees. You and two-thirds of employees in each occupational category who receive tips (e.g., waitstaff, bussers, bartenders) must accept the good-faith agreement.
The Instructions for Form 8027 provide the details of what should be in a good-faith agreement.
Are there payroll taxes on allocated tips?
How does accounting for tip income work? With regular tip income received directly from customers, you must withhold taxes, including federal income tax, Social Security tax, and Medicare tax.
However, you do not withhold any taxes from allocated tips. Instead, employees will use Form 4137 to calculate their Social Security and Medicare taxes.
Can you get a lower rate?
You can request a rate lower than 8% of your total gross receipts. The lowest rate you can get is 2%.
To get a lower rate, you must send a petition to the IRS. The IRS must then approve your petition before you can begin using a lower rate.
The petition must include specific information about your business to justify why you should have a lower rate. You must also pay a fee for the petition. For more information on what to include in a petition and where to send it, look at the Instructions for Form 8027.
How do you report allocated tips?
You must report tip income and allocated tips on Form 8027, Employer’s Annual Information Return of Tip Income and Allocated Tips. For each employee who received allocated tips, you will also report the allocated tips in box 8 on Form W-2. Do not report allocated tips in box 1 with wages and reported tips.
Employees will use Form 4137 to calculate Social Security and Medicare taxes on the allocated tips. Employees should then report those taxes on their income tax returns.
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This article has been updated from its original publication date of April 18, 2016.
This is not intended as legal advice; for more information, please click here.