Should I pay my tipped employees out each day or add their tips to their paycheck?
Possibly the biggest benefit to working as a waiter or waitress is the fact that you can make lots of money in cash tips. Waitstaff in popular restaurants can make multiple hundreds of dollars in one shift, and potentially take that cash home each day. While this is true of many hospitality businesses, a good portion already, or are beginning to, pay tips and gratuities to their employees via their paychecks. Hospitality business owners must ask themselves, “Should I pay my tipped employees out each day or add their tips to their paycheck?”
What is tipped income?
First, it is important to know what tipped income is. Employees of a service business often receive tips in addition to their hourly pay. A tip is considered any form of payment that is given by a customer to an employee under the customer’s own free will. Additionally, the customer must be able to determine the amount of the tip and who shall receive the tip. For example, a customer leaving additional money on a check at a restaurant is considered a tip.
Employees may receive what is known as a service charge. A service charge differs from a tip in that the service charge is not a voluntary payment by a customer. Service charges are automatically added to the check and the customer cannot determine the amount or who receives the payment. For example, an additional fee for a banquet event or hotel room is considered a service charge.
Does tipped income get taxed?
Now that we know how or why an employee would receive tips, let’s talk about taxes. Just like normal wages, tipped income is subject to payroll taxes. If an employee receives more than $20 per month in tips, employers must withhold and match certain payroll taxes like federal income tax and FICA taxes. Employees that receive more than $20 in tips per month must report those tips to their employers in order for the employer to withhold and file proper taxes to the IRS.
Employers are allowed to claim a credit against its’ business taxes for FICA taxes paid on said tipped income. This is known as the FICA Tip Credit. This credit also allows employers to pay a much lower percent of minimum wage in direct wages to its’ tipped employees. For example, employers in Maine are allowed to pay their tipped employees $6.90 per hour as opposed to $13.80 per hour in 2023. Employers must prove that the employee makes at least minimum wage when direct wages and tips are combined at the end of the week.
Paying out tips each day
Paying out tips to your employees at the end of each day has both pros and cons. In this scenario, the pros often favor the employee as opposed to the employer.
For employees, the main benefit is that they get to bring that money home each day instead of waiting until payday. This allows them to have financial flexibility. It is a reason that some businesses have begun to use what it known as on-demand pay, where an employee can access a portion of their wages before payday.
Another benefit of this for the employee is that they pay less in payroll taxes on the front end. Tipped employees are required to claim and report their tips earned to their employers. Even when reporting 100% of their tips, the employee gets to take all of their tips home that day. The drawback here is when an employee files their personal tax return. Sometimes, a tipped employee may owe taxes to the federal and state governments since they did not pay enough in taxes throughout the year.
A main benefit for employers is that the amount due out on payday will be much less than if all employee tips were paid out in paychecks. For example, a restaurant with 10 waitstaff, that each make $500 in tips in a pay period, would have an additional $5,000 due on payday. Technically, those funds are given from the customer to the company and should be put to the side to be paid to employees on payday. Many businesses may be tempted to spend that money on other bills, supplies, etc, and may not have sufficient funds to cover payroll.
Paying tips each day allows employers to see increased employee morale and retention. Many tipped employees prefer to receive their tips each day. They may even look for, and stay with, companies that pay out tips on a daily basis.
As mention before, employees may owe money when filing their taxes if they receive their tips each day. This is because many times employees do not make enough in hourly wages to cover their tax liability. Let’s look at an example.
A server works 20 hours, earns $6.90 per hour, and reports $500 in tips in one pay period. In total, this server’s reported earnings are (20 hours x $6.90 per hour) + $500 = $638. Let’s say that this employee’s tax liability is $150. Due to the fact that the server brings home the $500 in tips, their paycheck is only $138. Since their paycheck is only $138, only $138 in taxes can be withheld, not the $150 that is actually due. If this happens on a consistent basis, it could result in a tipped employee owing back taxes at year end or during a future audit.
Remember, employers are required to match the FICA taxes owed by an employee. If an employee is audited and found to owe additional taxes, the employer is also required to pay their share of these back taxes. Keep in mind, a single employee may owe $500 in back taxes, but the employer may owe a certain amount for each of their employees that have tax issues.
Another con of paying tips each day is the amount of cash on hand that is needed. Often times, employers may owe hundreds or thousands of dollars in tips each day, resulting in them needing to carry lots of extra cash. This is both a security and financial risk to the employer.
A con for both the employee and the employer, is that not putting tips into a paycheck also impacts mandatory payroll deductions and wage garnishments such as child support, retirement contributions, health insurance premiums and more. While the employee is not having these items properly withheld from the paycheck, it is a reporting and bookkeeping nightmare for employers.
Paying out tips in a paycheck
On the flip side, the pros to paying out tips in a paycheck often favor the employer as opposed to the employee. Let’s take a look.
First, employers generally protect themselves against tax issues when paying tips through a paycheck. All tips are reported and proper taxes withheld in this instance. Employers minimize their risk during potential audits because everything is reported and tracked accurately. Almost all hospitality businesses have issues with employees reporting 100% of their tips, but this problem is eliminated when paying tips through a paycheck. Further, the cash on hand that a business needs each day is greatly reduced. This lowers the potential risk of loss or theft. Finally, employers have a much easier time with reporting and bookkeeping when tips are paid through a paycheck.
For employees, back taxes and audits become less of a worry as well. In most cases, they have enough earnings in their check to cover their tax liability. This also helps employees with budgeting and keeping their finances in order. Receiving their earnings on a weekly, or biweekly, basis makes planning more efficient.
When tips are put into a paycheck, those mandatory payroll deductions and wage garnishments can be tracked, withheld and reported easily and correctly.
One con for employers is that some employees may be resistant to waiting for their tips. This could make it harder to attract and retain employees within your organization. Another con for employers would be that this method can greatly increase their payroll liability. It is important for employers to plan and side aside the tips to payout come payday.
For employees, not receiving tips each shift can be frustrating. Many employees choose to work in tipped positions due to the fact that it is “fast” money. It is nice to be able to leave each day with cash on hand and be able to use these earnings when they want.
Which is better for my business?
Neither method is a perfect fit for all businesses. Think of the pros and cons of both. Do you want to minimize the risk of tax issues? Then look into paying out tips through payroll. Are you having trouble keeping employees because you pay out tips weekly? Weigh the pros and cons of paying them out each shift.
While there is no perfect answer, paying tips through payroll has become an increasingly popular trend in the hospitality industry. In fact, the majority of our clients with tipped employees are now paying tips through employees’ paychecks for a variety of reasons. If you need assistance with your tipped employees or are looking for more information, feel free to contact us today!