Restaurant Payroll: Tips, Reporting, Labor Laws & More for Small Businesses

More customers are paying with credit and debit cards than ever before, so it shouldn’t be a surprise that many tipped workers are paid this way. One of the challenges you may face is paying the fee that credit card companies charge for processing each sale.

Federal law allows you to deduct the percentage from the total tip the employee is due as long as the charge doesn’t reduce the employee’s wage below the required minimum wage.

Regardless of whether your employees receive cash tips directly from customers or pool their tips with other employees to divide among one another at the end of their shifts, they must report total tips received. You have to include these tips in payroll so they can be taxed and added to the employees’ W-2 forms.

Non-cash tips are gifts like sports tickets, passes, and other items of value. If your employees receive any non-cash tips as additional payment for their services, they are not required to report to you. Instead, they must report it as income on their tax returns. This means they must pay taxes on it, but you don’t.

It’s standard for some restaurants to add an automatic service charge to a customer’s bill if there is a large party. Because these are imposed upon the customers and not voluntary, you must report this as business income. Even if you collect and decide to distribute some or all to employees, you must report it on your tax return. However, if you pay it out, you should be able to deduct it as a business expense, along with your employee wage expenses.

The IRS also requires you to report any service charges you decide to distribute to employees as wages. This means you must withhold and pay taxes on them. Keep a record of the employee’s name, address, Social Security number, the amount and date of each payment, and the amount of income and FICA taxes collected on the gratuities you distribute. The IRS may pay you a visit and examine your point-of-sale (POS) system to validate your payroll procedures.

If your restaurant has more than 10 employees, the IRS considers it a large food establishment and requires you to comply with allocated tip regulations. Allocated tips are amounts you must pay to tipped employees if the total reported tips in a payroll period are less than 8% (or a lower rate, if approved) of your gross sales during the period. You can allocate tips annually, for the calendar year, or for any period that divides evenly into a year (biweekly, quarterly, and so on).

Use Form 8027 to report allocated tips, and enter the total in the “allocated tip” box on employees’ Form W-2 at the end of the year. Take note that income and FICA taxes are not withheld on these tips.

Here are three methods you can use to calculate the allocated tips you owe for the period.

1. Hours Worked Method. Businesses that have fewer than 25 full-time employees can use this method of calculating allocated tips. Using this method, employers allocate tips based on the percentage of hours an individual employee has worked versus the total number of hours worked by all employees.
2. Gross Receipts Method. The gross receipts method can be used for any size business. It is similar to the hours worked method with the exception that you divide gross receipts attributable to the employee by gross receipts attributable to all directly tipped employees instead of hours worked.
3. Good Faith Agreement. Employers can take on a “good faith agreement” with their employees, meaning there is a written agreement in place that explains the method you choose to use to allocate tips. For details on what needs to be included in the agreement, you can check out the Form 8027 instructions.

Tip pooling occurs when tipped employees combine their tips with other tipped workers on their shift to redistribute among them all. This is sometimes used interchangeably with tip sharing. Tip sharing is similar to tip pooling in that tips are redistributed but different in that both tipped and untipped workers like dishwashers and chefs receive a cut. If you require tip sharing and include non-tipped employees, you must pay tipped employees the full minimum wage.

Federal laws don’t regulate how your employees should collect and distribute tips among themselves, so it’s up to you to create a policy for your restaurant if you want it to be consistent. Some states have specific tip pooling laws that override federal laws, so it’s a good idea to do your research or talk to a professional before setting policy.

Some common tip distribution arrangements are:

• Evenly: Tips are redistributed evenly among eligible staff
• Based on roles: Tips are split based on different proportions determined by position like 10% to bussers, 15% to bartenders, and 75% to servers
• Service benchmarks: Tips are allocated based on total hours or shifts worked

Be sure to notify your employees of your restaurant’s tip pool or sharing policy before they begin participating. Also, decide whether or not non-tipped employees can participate. Federal law allows it, but you can determine what works best for your restaurant. Most importantly, ensure that your management team knows they cannot take tips distributed from the tip pool.

You have numerous obligations regarding employee tip income, including collecting taxes on tips, paying or depositing taxes, filing forms, and maintaining accurate records and reports.

Failure to comply could result in penalties and unexpected tax liabilities. According to federal rules, you must do the following:

• Retain employee tip reports
• Withhold employee state and federal income and FICA taxes based on wages and tips received
• Report all wages and tips paid to the IRS
• Pay your share of FICA taxes based on total wages and tips received by employees

Keeping track of your employees’ tips received is essential for you to determine how much to pay when it’s time to pay quarterly taxes. FICA taxes are generally 7.65% for both you and your employees, so you will need to withhold that percentage from their wages and tips paid in addition to matching the payment yourself. You can use the W-4 form they complete during onboarding to figure out what percentage to take out for income taxes.

Reporting

Your employees can use Form 4070 to report the tips they receive each month, including cash tips, tips from tip pooling, and credit card tips. They can also use Form 4070A as a workbook to help track their tips on a day-to-day basis. As you review, ensure the total tip income they report each period is at least 8% of their total gross sales for the same period, or you may have to pay allocated tips. Don’t include mandatory service charges.

You’re required to submit quarterly tax payments and reports, similar to other businesses. Use Form 941 to report income taxes, social security tax, and Medicare tax withheld from your employees’ paychecks. You will also use it to pay your portion of Social Security and Medicare taxes. Use Form 940 to pay federal unemployment taxes (FUTA). Be sure to include your employees’ tips in the total wages paid to employees.

At the end of the year, you’re required to issue Form W-2 to all of your employees. It should show all wages and tips paid to the employee throughout the year in addition to Social Security, Medicare, and income taxes withheld and paid. You must also file Form W-3, which is essentially a summary of the W-2s you prepared, with the IRS by Jan. 31 of the year after the year you are reporting. Submit it with copies of the W-2 forms you submit to your employees.

FICA Tip Credit

Tip reporting has its challenges, but the FICA Tip Credit you may be entitled to could make it all worthwhile. If your employees receive tips above the federal minimum wage requirement, you can take a partial tax credit. This tax credit will equal your portion of the FICA tax, currently 7.65% of total wage expense, multiplied by the reported tips in excess of the federal minimum wage.

You’re not the only one with tip reporting responsibilities. Your employees are legally obligated as well. According to IRS regulations, all of your employees who receive more than $20 in tips should do the following:

• Create a daily tip record: Maintain a daily record of all tips (cash and credit) to report to you. They can use Form 4070A to stay organized if electronic reporting is unavailable.
• Create a monthly tip report: Report monthly tips of $20 or more to you by the 10th day of the following month. If the 10th falls on a weekend or holiday, the report is due the next business day. You can require more frequent reporting, but it can’t cover more than a one-month period.
• Report tip income in personal income tax: Report tipped income in tax return and document any allocated tips. Allocated tips only apply to large employers with 10 or more employees.

If one of your employees fails to report all of their tips to you, you will not be penalized with late fees or legal action. When the IRS figures out your employee didn’t report all of their tips, you will receive a notice and demand for the taxes, at which time you will need to pay your share of FICA taxes. You won’t be required to withhold and pay the employee’s share of FICA taxes on the unreported tips though.

Since you’re in the business of providing meals, it’s possible you may want to extend this benefit to your employees. Consider creating a meal policy outlining any discounted or free meals you’re willing to provide before, during, or after employee work shifts to minimize confusion. You should also take care to account for employee meals properly to keep reporting accurate.

You may be able to write off employee meals as tax deductions, so it’s important you have a good tracking system. Some restaurant POS systems will allow employees to enter food orders as employee meals, so investing in one could be a good decision for your business.

The IRS provides more guidance on handling different meal scenarios, but the gist is the same. If you’re providing meals for free during an employee’s work hours for your convenience, you don’t have to report them with employee wages.

The Tip Rate Determination Agreement (TRDA) requires you to work with the IRS to determine your tip rates, and at least 75% of your staff must voluntarily sign up for the program and agree to your tip calculation methods.

If you participate in TRDA, you will be required to do the following:

• Maintain records: You must commit to maintaining employee records and tip rates records for at least four years after April 15 following the year they were reported
• Furnish information: You must agree to give the IRS a quarterly report of employees, total employees, and total employees participating in the tip agreement, and an annual report of nonparticipating employees
• Pay federal taxes: File, pay, and deposit federal taxes on time
• File Form 8027: File Form 8027 and pay allocated tips (if applicable) if you have 10 or more employees

The IRS also wants you to use historical information it provides to determine tip rates. A representative will review your tip rates at least annually and, in turn, commit to not pursuing a full tip examination while the TRDA is in effect. The IRS may evaluate you and your employees for compliance, but there won’t be a tip audit.

The Tip Reporting Alternative Commitment (TRAC) agreement focuses on education and tip reporting procedures.

If you participate in TRAC, you will be required to do the following:

• Educate new employees: Establish an educational program for new employees that explains tip reporting requirements per the IRS and your company tip reporting policy
• Educate existing employees: Establish a quarterly tip reporting education program for existing employees
• Establish tip-reporting procedures: Establish tip-reporting procedures that will allow employees to meet their reporting requirements per IRS rules
• File and pay federal taxes: File, pay, and deposit federal taxes on time
• File Form 8027: File 8027 and pay allocated tips (if applicable) if you have 10 or more employees
• Maintain records: Maintain records of gross receipts subject to tipping and charge receipts that show charged tips for at least four years after April 15 following the year the records pertain to
• Make records available: If the IRS service representative requests, you will make quarterly totals of gross receipts subject to tipping, charge receipts showing tips, total charged tips, and total tips reported available

In return, the IRS commits to not initiating any tip examinations of your establishment for any period in which you are under the TRAC agreement, unless it pertains to a tip examination of a current or former employee.

The Employer-designed Tip Reporting Alternative Commitment (EmTRAC) program was created for companies in the food and beverage industry that are interested in designing their own TRAC programs. To participate, your restaurant must have employees who receive both cash and charged tips. Most of the requirements in the TRAC program apply to EmTRAC To participate, you must do the following:

• Educate new employees: Establish an educational program for new employees that explains the law’s requirement that they report all cash and charged tips to you
• Educate existing employees: Establish a quarterly tip reporting education program for existing employees
• Establish tip-reporting procedures: Establish tip-reporting procedures that will allow employees to meet their reporting requirements per IRS rules
• File and pay federal taxes: File, pay, and deposit federal taxes on time
• File Form 8027: File 8027 and pay allocated tips (if applicable) if you have 10 or more employees
• Maintain records: Maintain records of gross receipts subject to tipping and charge receipts that show charged tips for at least four years after April 15 following the year the records pertain to
• Make records available: If IRS service representative requests, you will make quarterly totals of gross receipts subject to tipping, charge receipts showing tips, total charged tips, and total tips reported available

The EmTRAC program gives you autonomy in designing your educational program and tip reporting procedures, which you can combine. According to the IRS, a POS tip reporting system could meet both of these requirements. And as with the other IRS tip agreements, the IRS will not initiate a tip examination unless it pertains to the tip audit of a current or ex-employee.

If you sign up to participate in one of the tip agreements, you can terminate at any time. The IRS may also terminate the agreement if you fail to comply with the requirement or if punitive action is pursued by an IRS service representative. The IRS may also terminate the TRDA if less than 75% of your employees have participated in the program at the end of the year.