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Do Tips Affect Payroll Taxes? A Complete Guide for Businesses.

Jul-22-2025

Tips are a common source of income in service industries, but when it comes to payroll, things can get a bit confusing, especially when dealing with untaxed tips. Many employers and employees wonder: Do tips affect payroll taxes? And if there are no taxes on tips, what’s the payroll impact?

What Does “No Tax on Tips” Really Mean?

The idea that there are non-taxable tips can be misleading. In the eyes of the IRS and most tax authorities, tips are considered taxable income. Employees are legally required to report all tips of $20 or more per month, and employers must withhold payroll taxes accordingly.

However, there are exceptions and gray areas. For instance:

Tips under $20/month per employee do not need to be reported to the employer but are still legally taxable.
Cash gifts that are not directly tied to services may be considered non-taxable (e.g., a gift card from a friend).
Unreported tips, while still taxable, often go untracked by payroll if not disclosed by the employee.

So, while tips may seem tax-free, that status usually depends on reporting thresholds, employer systems, and compliance practices.

How Payroll Is Affected by Untaxed Tips

Untaxed or unreported tips create complications for payroll. From a legal standpoint, employers are responsible for collecting and remitting payroll taxes on reported tips, just like they are with regular wages.

When tips are reported, they are added to an employee’s gross wages. This means that employers must:

Withhold income tax from the total amount (wages + reported tips)
Deduct Social Security and Medicare (FICA) taxes
Match the employee’s FICA contribution on the employer side

When tips go unreported or fall under the taxable threshold, they’re not included in gross wages, and no payroll taxes are withheld or matched. However, this doesn’t remove the employer’s responsibility. If it becomes clear that tip reporting is not being enforced or encouraged, the IRS can still hold the employer liable for estimated payroll taxes.

Do Tips Affect Payroll Taxes?

Yes, tips directly impact payroll taxes. The IRS treats reported tip income the same as regular wages for the purpose of income tax, Social Security, and Medicare. That means more tips equal higher total earnings and increased payroll tax obligations.

Some business owners mistakenly think they can ignore tips when running payroll, especially if they’re paid in cash. But failure to report and tax those tips can lead to serious compliance issues.

How Payroll Should Handle Untaxed Tips

Managing tips in payroll requires a few clear steps to stay compliant and efficient.

First, set up a tip reporting process. Employees should be trained and encouraged to report their tips daily or weekly. This can be done manually or via point-of-sale (POS) systems that automatically track credit card tips.

Second, once tips are reported, they must be added to the employee’s gross income in payroll. The system should then calculate income tax and FICA taxes on the total amount (including tips) and withhold accordingly.

Third, employers need to match the FICA contributions and include all tip earnings in W-2 reporting at year-end.

If tips go unreported by employees, the employer still has a duty to show that they’re enforcing reporting rules. This includes keeping proper documentation and training staff on the importance of accurate tip declarations.

Lastly, use payroll software that is designed to manage tipped wages. Not all platforms are built to handle this complexity, and using the wrong system can cause major tax headaches.

Common Risks of Mishandling Non-Taxable Tips

Mismanaging tips can result in multiple problems. The IRS may audit the business, impose fines, or demand back taxes if it suspects underreported income. Employers who ignore tip tracking entirely can be held responsible for paying estimated taxes on unreported tips, even if the employees didn’t report them.

Inaccurate W-2s can also cause issues for employees when filing their personal taxes or applying for loans or benefits. If the reported income is too low due to missing tip income, it may reduce their eligibility or trigger audits on their end.

Final Thoughts: Don’t Assume Tips Are Tax-Free

So, are tips tax-free? In rare situations, yes. But in most business environments, tips are taxable income and must be processed through payroll like any other wage.

Employers need to:

Understand the true payroll implications of untaxed tips
Avoid myths about payroll tax exemptions
Use proper systems and processes to report and withhold taxes
Educate staff on why reporting tips matters

Failing to do so could cost your business in penalties, audits, and lost tax credits. Handling tips properly is not just a matter of tax compliance, it’s a matter of business responsibility.