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Paying Tipped Employees: What You Need to Know

Posted Jun 13, 2018

There are many reasons why someone may want to work as an employee who receives tips as part of their compensation. Although jobs like waiting tables can be physically demanding, there are a lot of perks to the position. For people looking for flexibility in their schedules, shorter work days, and weekdays free, waiting tables can be the perfect solution.

The flip side, of course, is managing these employees.  And one of the most confusing aspects for business owners is managing the total compensation picture for waiters, waitresses, bartenders, busboys, and other employees who receive tips. The ins and outs of compensating these employees, including minimum wage requirements and tax deductions, can seem more than a little daunting.

The good news is, it’s not as complicated as it may feel when you sit in front of your computer to figure out how to pay your employees and still adhere to labor and tax laws.

Here’s a comprehensive explanation of what you need to know – including tools and tips to make the job easier.

What is a “Tipped Employee?”

The Department of Labor (DOL) defines a tipped employee as someone who regularly receives $30 or more in tips per month.  Focusing on “regularly” will help you determine how to classify your workers.

Let’s say you run a restaurant, and Anna is a college student who waits tables for you. Usually, she makes more than $30 a month in tips, but during the last month of the semester she takes some time off to study and ends up with only $20 in tips. She does this every semester, so at least two to three times a year Anna has a month where she makes less in tips.

Under the guidelines, Anna would still be considered a tipped employee. Her time off is an exception to her regular working schedule, not the norm, and so she regularly and customarily makes more than $30 a month in tips.

Let’s look at another example. Let’s say George is a doorman. George’s hours are later in the day, when his building isn’t very busy, and as a result he doesn’t get a lot of tips. However, during the holidays, George helps a lot of people with packages and receives more than $30 in tips in the month of December. Is George a tipped employee? No. George doesn’t regularly receive tip income, it only happens once a year.

Knowing who works for you who gets tipped and who doesn’t is important. As a business owner, you have a responsibility to both your employees and the IRS when it comes to tips.

How are Tipped Employees Compensated?

In 2013, Payscale did a study to find out how much of a tipped employee’s salary comes from tipping. What they found was a large range of an employee’s income could be made up from tips, from 35% to 60%!

While a sizable percentage of an employee’s salary can come from tips, employers still have a responsibility for paying wait staff and others a minimum wage. The minimum wage that you pay employees, however, varies from state to state, and even in how you handle tips with your team.

This is probably one of the most complicated aspects of employing tipped workers. Federal law sets a minimum standard for paying tipped employees, but some states have added their own laws about compensation on top of the federal standards.

Federal Minimum Wage and Tip Credit

First, let’s look at what the Fed says about paying tipped employees. According to the DOL and the Fair Labor Standards Act (FLSA), the federal minimum wage for employees who make more than $30 a month in tips is $2.13 an hour. That’s considerably less than the non-tipped employee minimum of $7.25.

The DOL allows a lower minimum wage for workers who earn tips is because of something called a “tip credit.”  The tip credit allows an employer to pay a lower minimum wage because the assumption is that employees will make up the difference with their tips. So the current federal tip credit is $5.12 an hour.

However, it’s critical that you understand this – if your tipped employee doesn’t make up the $5.12 an hour difference with tips, you have to pay them the difference so he/she reaches the  current minimum wage of $7.25. Let’s look at an example.

Back to Anna, our college student/waitress, who works 20 hours a week. If she were a non-tipped employee making minimum wage, Anna would make $145 a week (20 hours a week x $7.25/hour = $145).

Because she works in a restaurant that uses tip credit to compute pay, Anna’s base pay before tips is $42.60 (20 hours a week * $2.13 an hour = $42.60).  The difference between regular minimum wage and her tip credit salary is $102.40 ($145 – $42.60 = $102.40).

As long as Anna makes $102.40 in tips, her base pay from the restaurant remains $42.60, or $2.13 an hour. If Anna makes less than $102.40 in tips, the restaurant must make up the difference.

Not Every State Uses the Federal Minimum

Complicating matters is that many states have their own rules in regards to minimum pay for tipped employees.

For instance, several states, including California, Minnesota, and Oregon, require tipped employees to receive full state-defined minimum wage IN ADDITION to their tips. So, if Anna worked in Oregon, where the minimum wage is $10.25 an hour, she would get paid from the restaurant $205 a week for her 20 hours of work, plus tips on top of that.

Many other states, including Pennsylvania, Illinois, and Colorado, allow for tip credit but have a higher minimum wage for tipped employees. For instance, in Colorado, the minimum wage is $10.25 an hour, but employers are only allowed $3.02 for tip credit. That means tipped employees have a minimum wage in Colorado of $7.18, with the rest made up in tips or paid by the employer. So Anna’s 20 hours of work in Colorado would get her a base salary of $143.60 and she would need to get $61.40 in tips or the restaurant would need to make up the difference.

Still other states, such as Indiana, New Jersey, and Texas, follow the federal guidelines discussed above. The DOL has created a chart of tipped employee minimum wage requirements for states as well as tip credit information where you can find out the regulations for your state.

Tip Pooling Instead of Tip Credit

As of March of 2018, there is a much debated change to the FLSA and a practice called “tip pooling.” This new law allows restaurants to institute tip pooling between tipped and non-tipped – or “back of the house” – employees, as long as tipped employees make minimum wage. Although tip pooling is outside the scope of this post, it’s worth reading about and understanding how tip pooling can affects your employees, both tipped and non-tipped.

Reporting Tips

Tips are taxable income, and it’s the responsibility of the business owner to track and withhold the appropriate amount of taxes from an employee’s pay for both their base salary and their reported tips. This includes state and local income taxes as well as FICA.

Employees are required by law to report their tips to their employers and to claim tips on their taxes at the end of the year. Tipped employees are required to report their tips monthly. However, many business owners prefer workers to record their tips on a daily basis for record keeping purposes and to ensure that salaries are being met accordingly. This is especially important for states allowing tip credit.

Tips come to employees in two forms – either as cash or added on to a credit card payment. Cash tips are harder to track for the employer than credit card tips because cash tips require servers and other tipped workers to accurately record the cash they receive.

Credit card tips can be a challenge for business as well, however. Unless there is an easy way for a restaurant or other business with tipped workers to track gratuities added to a credit card, a business owner must keep track of these tips along with the cash tips so that the proper amounts are reported for tax purposes.

This is why many restaurants rely on a point-of-sale (POS) or management system that automatically keeps track of tips. Wait staff run credit cards through the POS and the tip is entered into the system, allowing owners to quickly and easily run a report. This makes payroll and quarterly taxes a breeze as compared to manual tracking of tips.

Paying Out Tips

Employers have certain responsibilities when it comes to employees who receive gratuities, including wage requirements and tax reporting. But in the end, the tips belong to the employee. A business owner cannot take money from tips.

Employees take their cash tips home at the end of their shift, but different businesses handle credit card tips in different ways. Some pay those tips out at the end of a shift like cash – something many servers prefer.

Others add credit card tips to the employee’s paycheck. Regardless how you do it, all tips (minus appropriate taxes) must go to the employee. There are stiff penalties for not doing so. Under the new March 2018 regulations, keeping tips from employees comes with a $1,000 fine per violation.

Running a business, like a restaurant or a salon, can be a rewarding and fulfilling experience. Your employees are the lifeblood of your business, and they keep your customers happy and coming back. Understanding how they are compensated, and treating your employees fairly, will help your business flourish.