Tip income can be a complex matter with regard to taxes. The IRS has regulations that pertain to a variety of situations employees might find themselves dealing with if they receive tips.

Learn more about these miscellaneous circumstances below.

In Rev Rul 2012-18, which modifies and supersedes Rev Rul 95-7, the IRS clarified that the absence of any of the following factors creates a doubt as to whether a payment is a tip and indicates that the payment may be a service charge: (1) the payment must be made free from compulsion; (2) the customer must have the unrestricted right to determine the amount; (3) the payment should not be the subject of negotiation or dictated by employer policy; and (4) generally, the customer has the right to determine who receives the payment. All of the surrounding facts and circumstances must be considered. To the extent any portion of a service charge paid by a customer is distributed to an employee, it is wages for FICA tax purposes.

In a Chief Counsel Advice (CCA 201106010), IRS determined that amounts paid by clubs to taxicab drivers who deliver passengers to the clubs are income to the drivers, but are not tips received by the drivers in the course of their employment with taxicab companies. Rather, the payments are for services separate and distinct from the drivers' employment, and the clubs making the payments are responsible for complying with 1099 reporting requirements.

A Chief Counsel Memo (CCM) concludes that customers' cash contributions to “tip jars” placed in each of a retailer's locations may be treated as tips (not wages) by the employer. As such, the amounts distributed to the employees from the tip jars are governed by Code Sec. 3121(q), which provides that unreported tips won't be subject to the employer share of FICA until IRS makes a notice and demand for taxes from the employer. (PLR 200929004)

No FICA (i.e., social security and (Medicare) hospital insurance taxes) is assessed on tips which are not required to be reported to the employer (i.e., if under $20 in a month), but this does not exempt those amounts from income taxes. All tips should be reported as wages on Form 1040. Tips not reported to the employer, and over the $20 monthly limit, are also reported on Form 4137, Social Security Tax on Unreported Income.

The IRS has a Form 4137 Compliance Program that uses data from employees’ Forms 4137, Social Security and Medicare Tax on Unreported Tip Income, to determine the employer’s share of Social Security and Medicare taxes on unreported tips. While employers in industries where tipping is common generally know that they must pay the employer’s share of Social Security and Medicare taxes on tips, other employers may not realize that they also may be liable for these taxes on tips in excess of $20 per month that their employees don’t report to them is intended to ensure the employers pay their share of the employment taxes on their employees’ unreported tip income. However, the employer’s liability for the employer’s share does not arise until IRS issues a “Section 3121(q) Notice and Demand.” Employers will be sent a Form 4520P “pre-notice” prior to receiving a notice (Form 4520) that requires them to pay the unreported FICA tax. An employer can request an extension. The IRS will not assess penalties or interest on the amount due if the employers cooperate and include the taxes owed on their next Form 941, Employers QUARTERLY Federal Tax Return. (Headliner Vol. 298, May 25, 2010, IRS web site; Pub 5080)

FICA is assessed on both employee and employer for all tips the employee reports to the employer up to the FICA limits.