Many small businesses have tipped workers, including restaurants, hotels, salons, and transportation services. Even though tipping spans across various industries, managing your tipped employees is not as easy as you may think. In this guide, you’ll learn how to pay employees with tips included so you can focus on growing your business.
What is the minimum wage for tipped employees?
Employees who earn tips have a different minimum wage, which is lower than the standard minimum wage in 43 states of the US. In any given pay period, a tipped employee earns:
- The tipped minimum wage
- Tips
Together, these are supposed to equal the standard minimum wage and are called “tip credits.”
What are tip credits?
Throughout any given pay period, your employees will report any cash tips earned to you. Your employees are required to keep a tip record for cash tips and hand that over to you during each pay period. At the end of each pay period, you’ll add up every employee’s cash and credit card tips and calculate their average tips per hour. This is called their “tip credit.”
Let’s use the example of a state with a $5 tipped minimum wage and a $10 standard minimum wage. An employee works 40 hours in a week and earns $250 in tips. In this case, the maximum tip credit would be:
Standard minimum wage – tipped minimum wage = $10 – $5 = $5
At the end of the week, you would first need to calculate the tips earned per hour:
Tips / hours = $250 / 40 hours = $6.25 per hour
Since the tips per hour are more than the maximum tip credit of $5 per hour, your business meets the $10 minimum wage obligation.
On the other hand, let’s say the employee earned only $150 in tips that week. The tips per hour:
Tips / hours = $150 / 40 hours = $3.75
That’s less than the tip credit, and therefore, you would need to pay your employee more for that pay period to meet the standard minimum wage. You would have to pay them:
Tip credit – tips per hour = $5.00 – $3.75 = $1.25 per hour
Can you get tax deductions from tips?
Generally speaking, when customers pay their bills – the subtotal plus taxes goes to your business, and any tips left on the bill go directly to your employees. Every state’s labor laws specify that employers cannot make any deductions from employees’ tips.
There is one small exception to that rule, and it’s for credit card processing fees. You CAN deduct credit card processing fees when tips are paid by credit card, but only the fees related to the tip itself.
For example, if your restaurant collects $120 from a sale, that sale receives $6 in credit card fees, and the sale consists of a $100 bill and $20 in tips, you can deduct credit card fees from the $20 tip—or about $1 in this case.
How does having tipped employees affect your business?
If your business has tipped employees, you have the responsibility to track the income and provide employee benefits for workers based on their wages as well as the tips they earn.
Social Security and Medicare
Your employees’ tips are considered “taxable” and “earned” income. Accordingly, tips are subject to both employer and employee payroll taxes.
- For employers: 7.65% of wages paid plus tips reported in a pay period.
- For employees: 7.65% of wages paid in a pay period.
For example, if an employee is paid $500 in wages and earns $500 in tips, their deductions would be:
Total earnings x payroll tax = $1000 x 7.65% = $76.50
Similarly, your business’s unemployment insurance and workers’ compensation insurance are based upon the total earnings of your workers—both from wages and tips.
Income taxes
Your employee’s entire income (both wages and tips) will face payroll taxes. In the case of income taxes, the amount withheld in each pay period generally depends on how your employee answered the questions on their W-4 when they were hired. However, it’s a good idea to inform your workers of their responsibility to set up their income tax withholding to account for both wages and tips so they don’t have to pay a large tax bill at the end of the year.
What are tip pools?
Sometimes, you might choose to create tip “pools” instead of each tipped worker participating in their own tips. To understand tip pools, you need to understand how tips are designed.
Tip pools were created so that those who are a part of providing a service but might not be the main contact with customers still get due compensation, such as bussers in restaurants. Only those involved in the “chain of service” can participate in a tip pool. For example, in a restaurant, hosts, servers, bartenders, and bussers can participate in the tip pool, but cooks, dishwashers, cashiers, managers, and supervisors cannot.
Your business has many options for splitting up the funds inside that pool, as long as they stay consistent in the long term – and all the workers meet the requirements of tipped minimum wages and the tip credit.
How can you simplify the process?
As you can probably tell, figuring out how to pay employees with tips included is complex, and with the math involved, mistakes can happen. There can be significant fines against employers who accidentally include the wrong people in a tip pool or incorrectly handle tip credits.
Luckily, most mainstream payroll software has modules to handle tipped employees and avoid these costly mistakes. Considering commercial payroll software’s affordable pricing and simplicity, it’s an absolute must if you have tipped workers.
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