No Taxes on Tips? What It Would Mean for Tipping
“No taxes on tips.”
It’s rare that you hear the same messaging on both sides of the aisle, and doubly so during election season. But that’s the world we live in. Vice President Kamala Harris and former president Donald Trump have both signaled that they would eliminate taxes on tips should they win this year’s November elections and enter office in 2025.
It’s not often we see a tax subject that’s interesting not only to tax professionals or business owners, but to the average American. More than 40% of Americans have worked for tips at some point in their lives, according to the Pew Research Center. So this is an issue that will affect the pocketbooks of millions currently working for tips, and be near and dear to the hearts of millions more.
Today, we’re going to look at how tips are currently taxed, which will help explain how much (or how little) people would benefit from new policies that would eliminate taxes on tips.
What Is a Tip?
The answer seems obvious, but there are important technical distinctions.
A tip, as defined by the IRS, is money received from customers for service provided, where the amount is not fixed and is given voluntarily. Tips can be left in cash or credit cards — but even non-monetary tips (like tickets and other items of value) are considered taxable income and must be reported based on their fair market value. And they can be received directly or from a tip-splitting or pooling arrangement.
Employee Responsibilities
- Reporting tips: Employees who receive tips totaling $20 or more in a month must report those tips to the IRS. It should be done by the 10th of the following month, using a written statement, typically on IRS Form 4070 or an equivalent form provided by the employer. Failing to report tips may lead to additional taxes and penalties.
- Paying FICA Taxes: Tips are subject to Social Security and Medicare taxes, collectively known as FICA taxes. These taxes apply regardless of whether the tips are reported to the employer. Employees are responsible for paying their share of FICA taxes on all reported tips; these items are typically withheld from their regular wages.
Employer Responsibilities
- Withholding Taxes: Employers are required to withhold federal income tax, Social Security tax and Medicare tax from employees’ wages based on both the employees’ wages and reported tips. They must also contribute their share of Social Security and Medicare taxes. Employers must accurately track and document all reported tips to comply with IRS regulations.
- Reporting Requirements: Employers who operate a large food or beverage establishment must report the total tips received by employees to the IRS using Form 8027. This form must be filed annually and provides a summary of the tips reported by employees.
- Allocated Tips: In situations where the reported tips are less than 8% of the establishment’s gross receipts, the employer might need to allocate additional tips to employees. These allocated tips are not included in wages for withholding tax purposes but must be reported on the employees’ W-2 forms. Employees then must report these tips on their income tax returns.
How Would Tipped Employees’ Taxes Change?
The most obvious takeaway from a “no taxes on tips” policy is that a swath of lower- and middle-class earners would have their tax burdens reduced — at least, that’s how it would seem at first blush.
However, at least some number of tipped employees would see no benefit because they already have no federal income tax liability, whether that’s through credits like the Earned Income Tax Credit or Child Tax Credit, or because their income falls below the standard deduction.
“No Taxes on Tipping” Could Change Tipping
One of the biggest concerns around “no taxes on tips” is the potential for some businesses to drive a Mack truck through poorly written policy.
This isn’t necessarily a politically partisan worry, either — both the conservative Tax Foundation and liberal Center for American Progress have sounded off on how highly compensated professions could use “no taxes on tipping” to their advantage. The latter points out such a weakness in the recently introduced No Tax on Tips Act, brought forth by Sen. Ted Cruz (R-Texas) and Rep. Byron Donalds (R-Florida):
“The No Tax on Tips Act contains few, if any, guardrails to prevent high-income professionals such as hedge fund managers from shifting their compensation to a tax-free tipping model. Given the difference in tax rates, the tax breaks from exempting part of these high earners’ income from income taxes would be far larger than any tax breaks for lower-income workers. For instance, a married couple making $1 million in wages could get a tax cut of $180,000 by shifting half of those wages to tax-free tips.”
Even if policy is written to exclude these and other roles — the Tax Foundation also listed lawyers and accountants as careers that could take advantage of a loose policy — the service industry itself could begin to transform. Says the Tax Foundation:
“By making one type of income (tips) exempt from income tax, while other types of income (most importantly, wages) remain taxable, the proposal would make more employees and businesses interested in moving from full wages to a tip-based payment approach. That would mean more service industries adopting the restaurant industry approach of a list price up front and an expected voluntary tip at the end of the transaction.”
In other words, you could see a continuation of the past few years’ surge in businesses where workers are requesting tips. That in turn would also make the policy more expensive.
Here’s a Tip: Ask Us Your Business Tax Questions
Whether you want to know more about your company’s requirements and responsibilities for tipped employees, or you need help with any aspect of the business tax code, we can help.
McManamon & Co. offers a wide array of a business services. For instance, our tax services include vigilant tax strategizing and forward planning to keep you in control of your tax situation. We routinely project upcoming tax liabilities and make recommendations to minimize and defer pending liabilities. And we can also help with duties such as payroll taxes, business tax filing and compliance.
Want to learn more? Give us a call at 440.892.8900 or contact us online.
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