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The 8% Myth

Important Note: The following information is intended only to inform and not to be a substitute for the reader's seeking legal or accounting counsel. Any information given here should be examined by the reader's attorneys or accountants as to such information's applicability.

Overview and Background

Many restaurant employers and restaurant employees may have heard the false rumor that tip-earners only need to report tips equal to 8% (or perhaps some other number, such as 10%) of their sales. That's a widespread misconception. The law requires employees to report and pay taxes on 100% of the tips they keep after tip-outs. It's that simple.

The 8% figure is simply a threshold below which many employers must allocate tips and report certain additional information to the IRS. The IRS can use this information to flag restaurants where employees may be underreporting tips.

The $0 Paycheck Situation

When employers withhold taxes from tipped employees' paychecks, they base the amount withheld on both the tip income and cash wages employees receive. Sometimes tipped employees' paychecks may not be big enough for the employer to withhold all the required income and payroll taxes. In this "$0 paycheck" situation, here are a few tips for employers and employees:

Employers:
• Be sure you are withholding all taxes in the proper order. State and federal laws set a particular order for withholding taxes. Check with your accountant or payroll service to make sure you're doing it right.
• Let your employees know that you weren't able to withhold all the required taxes. They may want to set aside some extra money, or give you extra funds to apply toward these taxes, so they don't get socked at tax-time with a bigger tax bill because not enough taxes were withheld throughout the year.
• If you're not able to withhold the full amount of federal FICA (Social Security and Medicare) taxes due on reported tips, you are required to note this as "uncollected Social Security taxes on tips" on the employee's W-2 form.

Employees:
• If you're receiving $0 paychecks, be aware that you may owe more in taxes than you expect when you file your returns in April. Some tip-earners save a few extra dollars over the year so they don't get caught short at tax time. Better yet, many tipped employees give extra money to their employers to apply to their tax withholding. This helps avoid any estimated-tax penalties.