Money Matters

Are You Reporting Your Tips?

The IRS wants its fair share of your taxes and it’s trying to make it easier for salon professionals to follow the rules. IRS analyst Don Segal answers common questions.

Why are we writing about taxes if tax season just ended? Because it’s the perfect time to offer you some useful information for next year. Although the Internal Revenue Service insists it’s not singling out the salon industry, salon owners and nail techs are on higher alert because of a relatively new program called Tip Reporting Alternative Commitment (TRAC) that’s designed to ensure taxes (and Social Security) get paid on all salon income — including tips. The IRS is well aware that nail techs and hairdressers earn tips and may not fully report them. The reporting system is new, but the law is not.

It is important to remember that any tip income that you receive as an employee or booth renter is considered taxable income. And if you are an employer, you are required to pay taxes on your employees’ wages — which include their tips. If you, as an employee, report your tips to your employer and she does not include them in wages, your employer has not complied with the tax law. If she is audited, it may result in penalties in addition to paying interest and the employment tax due on the tips you reported to her. Your employer’s failure to properly report the tips will reduce the Social Security credit you get for your earnings as well. It is in your interest to make sure she reports your earnings as well.

Here, Don Segal, senior program analyst for the Small Business and Self-Employed (SBSE) Division of the Internal Revenue Service, answers questions posed by nail techs (employees and booth renters) and salon owners (the employers). We also included a handy list of references at the end that should help you out if you are still confused.

From the Employee’s Point of View

If I have to declare my tips to my employer every pay period, do I still declare them on my tax return at the end of the year? If you declared all of your tips to your employer during the year, they will already be included in your Form W-2 Wage statement, which you receive in the beginning of every year that includes all money earned the prior year. Include the total wages from the W-2 on your income tax return as wages.

What kind of records do I need to keep? A contemporaneous record [which means do it as you go along] of tips received, both charge and cash. A booklet is provided for your use by the IRS, Publication 1244, Employees Daily Record of Tips.

What if a customer tips me with a gift? Say I have a customer who owns a car wash and she gives me free wash tokens? The fair market value of those tokens should be reported to your employer as a tip. If the car wash token is worth $10, you must report $10 in tip income.

If my salon has a “No Tipping” policy, and it’s posted in plain view, will the IRS still hold me accountable for tips that I have not received? I have heard that the IRS will average out what the tip income should have been and charge accordingly. If it is clear that the salon has a policy of no tipping, and tips are turned down by the employees, there should be no tips received and no taxes due on them. Unless there is other evidence indicating a contradictory policy, no one should be asked to report tips that were not received.

If the tips are reported on my paycheck, will taxes be taken out? If taxes are taken out won’t I make less money? Yes, taxes will be taken out, and yes, you will take home less money than if you had not reported the tip income you received. But that is true for every worker. Taxes are one of the necessary expenses associated with income. Failing to honestly report income and pay taxes is not only illegal, it is unfair to all those who do file honest tax returns.

Do I have to report everything? Yes, all tips received in the course of your work are taxable and reportable as compensation. Compensation includes such things as commissions on services, commissions on sales of products, cash paid to you by the employer for work performed, and cash or charge tips.

My customers are seniors and tend to tip very little. Do you always assume that I receive a certain percentage of the service as a tip? No, that’s why keeping a log of those tips is important. You only have to report the tips you actually receive, and your log should substantiate the correct amount.

If I am donating my service (like in a hospital) and receive a tip on that free service, do I need to report it? Yes, you should report the tip as “other income” on your tax return and pay income tax on it. If the work is not associated with a salon, and the person is donating her services to a hospital on her own, the tip is considered “other income” received, which should be reported on a Form 1040, Individual Income Tax Return.

I am not going to report my tips. What can my boss do to me? What can the IRS do? It is the employee’s responsibility to report her tips to the employer. The employer’s responsibility starts when those tips are reported to her. The IRS may discover that you are not reporting all of your income and can call you in for an audit. In addition to paying the tax and interest on the unreported income, you may be subject to a negligence penalty of 20% of the unpaid tax, or even a civil fraud penalty of 75% of the tax.

How will my employer even know if I don’t report all my tips? Your employer will know if you do not report at least the charge tips she sees on the charge receipts to her. Your employer will know what the policy of tipping is in her own salon.

What if I report my tips to my employer but she doesn’t report them? What if the employer does not acknowledge tips at all? If you report your tips to your employer and she does not include them in wages, your employer has not complied with the tax law. If she is audited, it may result in penalties in addition to paying interest and the employment tax due on the tips you reported to her.

Your employer’s failure to properly report the tips will reduce the Social Security credit you get for your earnings as well. It is in your interest to make sure she reports your earnings as well.

Is the employee responsible for reporting tips directly to the IRS? And if so, how does one do that? Who would be responsible for the employer’s share of taxes? Does the employee have to pay the entire amount? What are the penalties for employee or employer if tips are “ignored?” Tips must be reported to the employer and the employer reports that (to you and the IRS) via the W-2 she provides at year-end. If tips are not reported to the employer for some reason, then the employee can report them on Form 1040, Individual Income Tax Return and on Form 4137 Social Security and Medicare Tax on Unreported Tip Income. Form 4137 computes the employee portion of Social Security and Medicare Tax due by the employee.

Once Form 4137 is filed, the IRS may assess the employer portion of Social Security and Medicare Tax against the employer based on the Form 4137 information.

If the client gives my tip to the front desk, is the front desk person required to report it on the books? Consider it like a charge — the front desk will know your tip but isn’t required to track for your individual tips.

From a Booth Renter’s Point of View

I am an independent contractor. What kind of records do I need to keep? Please see Publication 583, Starting a Business and Keeping Records. This publication outlines all of the record keeping requirements. Some of these include recording your sales and expenses. You should also keep records documenting gross receipts (income received from services) such as cash register tapes and bank deposit slips. Records documenting purchases for resale such as invoices and cancelled checks should also be kept.

How do I show my reported tips in my books? Tips for an independent contractor are just another source of income that must be reported (under income received from the business activities). Tip income would be included as part of the sale of services. It is not treated any differently than any other service income.

None of the other renters in my salon are reporting tips, why should I? The IRS may discover that you are not reporting all of your income and can call you in for an audit. In addition to paying the tax and interest on the unreported income, you may be subject to a negligence penalty of 20% of the unpaid tax, or even a civil fraud penalty of 75% of the tax.

I don’t have time to keep track of each customer by name and how much she tipped me! You are only required to keep records showing how much you received in tips and include them in income. There is no requirement to show the name of each person who tipped you.

I am only working a couple of days a week since I had my baby. I don’t make enough to report, do I? If you earned more than $20 in tips in any one month, you are required to file a tax return. Even if your total income is not enough to owe any income tax, you may have to pay Social Security and Medicare taxes on your income. All tips received in the course of your work are taxable and reportable as compensation. Compensation includes such things as commissions on services, commissions on sales of products, cash paid to you by the employer for work performed, and cash and charge tips.

You may also be eligible for the Earned Income Tax Credit, a special benefit for workers with incomes below certain levels. In some cases, you can get a refund from the government even when you don’t have to pay any income tax.

If I tell the IRS how much I really make in tips, will they come after me for all the tips I didn’t report in past years? Criteria for determining audit potential are varied. There is no program that currently selects people for audit who start reporting tips. If a taxpayer is selected for audit, the expansion of the audit to other years is determined on a case by case basis.

It has been an IRS policy that employees who are participants in either TRAC, the Tip Rate Determination Agreement (TRDA), or the Employer Developed TRAC (EmTRAC) — and who are complying with the reporting requirements of those agreements — generally will not be examined for unreported tips in prior years.

I am a booth renter. How will the IRS ever know what I have received in tips? Ask yourself that question. If you were trying to determine what a worker received in tips, how would you go about doing that? The IRS is experienced in reconstructing income for those who haven’t properly reported it.

In addition to owing tax and interest on the unreported income, you may be subject to a negligence penalty of 20% of the unpaid tax, or even a civil fraud penalty of 75% of the tax.

When should I start reporting them? As soon as possible.

I receive gifts at Christmas. Will the IRS want me to report them as tips or do I have to pay taxes on their value? If your employer gives you cash or an item that you can easily exchange for cash (like a gift certificate), you include the value of that gift as extra salary or wages. If your employer gives you an item of nominal value (like a turkey), you do not have to include the value of the gift in your income.

“Gifts” received in the course of doing business from customers are income to you, whether you are an employee, an independent contractor, or a booth renter. And their value is taxable.

How do I report tips? For example, the service is $20 and the tip is $5. The client writes a check for $25. Do I have to separate this amount in my paperwork or just say $25 for the service? Does the IRS need to know on the record how much of this $25 check is for a service and how much a tip? Booth renters and independent contractors just need to report total income. That income may be made up of tips and charges for services, but it all ends up being recorded as gross receipts. In the example above, you would record $25.

From a Salon Owner’s Point of View

How do I know if my employees are truthful about the tips they have received? Will I be liable if they under-report and cause me to under-report? If employees are audited and unreported tips are discovered or if employees report tips on their own on Form 4137, the IRS can take that information and determine what the employer portion of Social Security and Medicare taxes would be due from the employer and make that assessment. There would generally be no penalties if the amount assessed was paid with the next filed Form 941.

What about the salons that will only accept cash — do you think they are going to report tips? Why not go after them for the income they are not reporting? The IRS uses various criteria to determine businesses with audit potential. Based on that criteria, some are selected for audit. Whether the business is a cash business or not is one of the criteria used.

My staff members are all employees. Why should I have to match their FICA [Social Security tax] tip income when the salon is making nothing on it? This is going to raise my payroll taxes without raising the salon’s income. This doesn’t seem fair. The law considers tips reported to the employer as wages and requires the employer portion of Social Security and Medicare tax to be paid by the employer. It is a cost of doing business. If a salon owner doesn’t pay these taxes, the owner has unfairly benefited against competitors through this non-compliance. (That is, her cost of doing business is lower because she is breaking the law.)

Salon owners with employees who have reported tips as required by the law have been operating at a disadvantage when compared to the salon owner with employees who choose to be non-compliant.

I asked my accountant about reporting my tips and he told me not to worry about it. How come he doesn’t know anything about this? This is a surprising statement, considering the frequent news articles in professional tax publications as well as in the general press on tipping issues. However, it could be that your accountant is not familiar with the laws regarding tips. Remember that you, not your accountant, are responsible for the taxes owed, even when you pay someone to prepare your tax return. What is new are the TRAC programs (circa June 1995). Ask yourself whether your accountant is fit for the job if he’s not familiar enough with your business.

Why do I (the salon owner) have to sign the TRAC? No one has to sign the TRAC. This is a voluntary agreement to encourage workers and employers to report their tips. Anyone can start reporting her tips voluntarily and not sign the agreement. (See the sidebar “Keeping on TRAC” for advantages of signing TRAC.)

How do I force an employee to report tips? What if she refuses? As stated above, tip reporting by employees is the employee’s responsibility. As the employer, you are entitled to set working conditions and one of those conditions can be compliance with the tax laws. You probably wouldn’t allow someone to work for you who was dishonest enough to steal from your cash register — likewise, you would not want an employee who steals from the government and wants you to join in.

My accounting software is not set up for reported tips, what do I do? Paper documents can be used.

Can anyone get a TRAC agreement? Generally, anyone can participate in TRAC. (See sidebar “Keeping on TRAC” for more information on the program.)

With a TRAC agreement how does the IRS determine the percentage? TRAC does not set a tax rate. It only provides for education and a procedure to be followed to allow tips to be reported to the employer.

If I pay my employees a base wage and they now report tips, can I use the tips against their wage? Example: Mary makes $6 an hour and does a service and is tipped $3. She is now making $9 an hour. So the question is, can I pay her $3 an hour and she makes $3 in tips so then she is making $6? This is a State and Federal minimum wage question more appropriately answered by the Department of Labor.

If the IRS claims that tips are wages why couldn’t a salon owner do the example above? The Internal Revenue Code states that Social Security and Medicare tax must be paid on wages and tips. The Internal Revenue Code does not set the minimum wage.

Why is the salon owner responsible? Why can’t the employee just report tips on her tax return? The Internal Revenue Code states that the employee must report tips to the employer, and when that occurs, the employer portion of Social Security and Medicare tax must be paid by the employer. For example, the employer and employee each pay 6.2% Social Security tax on the first $80,400 of wages (for 2001) and 1.45% Medicare tax on all wages paid, without a limit. Therefore, the total paid to the government is 15.3% to Social Security and Medicare. As stated above: If employees are audited and unreported tips are discovered or if employees report tips on their own on Form 4137, the IRS can take that information and determine what the employer portion of Social Security and Medicare taxes would be due from the employer and make that assessment. There would be no penalties, generally speaking, if the amount assessed was paid with the next filed Form 941.

My workers are all booth renters so none of this applies to me, right? Booth renters record their own sales, collect their own receipts, and buy and expense their own supplies. If your workers are booth renters, then you are not their employer and the employer requirements for tip reporting do not apply to you.

I am a salon owner and most people don’t tip me. Will you take that into consideration? You are only required to report income that you receive.

As a salon owner I never take my tips. I always put them in the drawer and count it as service income. Is that OK? If you are the owner of a sole proprietorship and report the business activities on Form 1040, Schedule C, this is a proper procedure. If you are an employee of a corporation that you are a shareholder of, you should be reporting the tips as an employee so they can be included in your Form W-2 as wages. The tips are not service income to the corporation.

If my salon brings in $2,000 in a week in services, the reported tips could be as low as a $120 or as high as $500, or anywhere in between. Which makes my taxable income as low as about $2,400 or as high as $6,000 a quarter, or anywhere in between. This is a HUGE increase in payroll tax, and I think if it would happen in any other industry they would be screaming! The IRS came down on the restaurant industry for tips also. But the restaurant industry didn’t take it sitting down. They fought it and got some sort of tax break. Why can’t they do the same for us? Congress passes the tax laws that the IRS administers. Any group or industry — including yours — may lobby Congress to get tax breaks enacted. The restaurant industry was successful in getting a special credit added to the law as Section 45B. However, this credit is limited to employer social security taxes resulting from tips related to food or beverage services. Currently, organizations such as the ABA and NCA are working to obtain a tax credit for salon owners for their employees’ tips. According to Vi Nelson, a spokesperson for the ABA, the salon industry is currently facing favorable environment in Washington. “The current tax cuts that President Bush is working on are in our favor,” she says. “We hope those cuts will be granted to small businesses such as salons.” — Ed.

Keeping on TRAC

Although signing the Tip Reporting Alternative Commitment (or TRAC as it’s more commonly known) is voluntary, Don Segal says there are more advantages than disadvantages to signing the agreement.

“Generally, any salon business can participate in TRAC ,” he says. “It eliminates the employee and business owner’s concern about the consequences of not being in compliance.”

Other benefits of participating in TRAC include:

•Increased income may improve financial approval when applying for mortgage, car, and other loans

•Increased Social Security and Medicare benefits (the more you pay, the greater the benefits)

•Increased unemployment compensation benefits

•Increased employee pension, annuity, or 401(k) participation

(if applicable)

•Increased workers’ compensation benefits, should employees get hurt on the job.

For publications or information mentioned in this article contact:

IRS Internet website — www.irs.gov

IRS TaxFax service — fax phone number (703) 368-9694

IRS Forms by Mail — call (800) 829-3676

Questions for the IRS — call (800) 829-1040

TTY/TDD equipment — call (800) 829-4059

If you have attempted to deal with an IRS problem unsuccessfully, call the Taxpayer Advocate at (877) 777-4778.

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