Who doesn’t love a good tip? If you have ever worked in hospitality, you know there is nothing better than a customer rewarding your service with a generous tip. For business owners on the other hand, tips can be challenging when it comes to accounting. So, allow us to share some “tips” on tips.
Accounting for Tips
First and foremost, if you are recording tips as sales revenue, that is a problem. Tips are not sales. They are earnings to the employee, paid for by the customer.
It is common for business owners to recognize all cash receipts as sales. However, the business is not entitled to the entire cash receipt. A portion of the receipt must be remitted to the government in the form of sales tax. Another portion must be paid to the employee for their daily tips. In essence, the business is acting as an agent or an intermediary.
Generally Accepted Accounting Principles (GAAP) refers to these as “agency transactions.” GAAP requires agency transactions to be recognized as a liability instead of revenue. This ensures that the business is not overstating sales.
Here’s a simple example:
Big Bear Brewery receives $1,000 in credit card receipts for the day. Of that amount, $72 must be remitted to the state to comply with the 9% alcohol tax in Maryland. Another $128 must be remitted to the employees as tips. The proper way to record this transaction is as follows:
| Cash | $1,000 | |
| Sales Revenue | $800 | |
| Sales Tax Payable | $72 | |
| Employee Tips Payable | $128 |
As shown in the journal entry above, only $800 is actually recorded as sales revenue. The “sales tax payable” and “employee tips payable” accounts are liability accounts. These accounts will be relieved once the business remits the sales tax and tips to either the government jurisdiction or employee.
Why Does It Matter?
It is necessary to appropriately account for tips for two reasons.
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The IRS requires a minimum of 8% of a hospitality business’s gross receipts to be paid out in tips. If the IRS were to audit the business and found actual tips paid were less than 8% of gross receipts, then the business would be required to pay the employees the difference out-of-pocket. In recording all cash receipts as sales, you are overstating your gross receipts, which increases your chance of falling below the 8% threshold.
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All business owners rely on accurate financial data for decision making. Sales data needs to reflect actual sales so the business owner can adequately staff the business. You don’t want your daily sales to fluctuate based on customer tips.
Let Technology Work for You
In the old days, when businesses used a basic cash register, accountants needed to manually record daily sales everyday into the accounting system. In today’s environment, this is no longer the best practice.
Most breweries and wineries capture sales through a point-of-sale (POS) system. If set up properly, the POS will automatically transmit sales, tips and tax data to your accounting system. This prevents human error and allows the business owner to access data in real-time. You have enough to worry about, so let the software do the work!
I have had experience with clients who did not set up the POS to link with their accounting system. As a result, tips were being included in sales. Make sure you properly link these systems to prevent errors and headaches on the back end. If you’re unsure how to do this, your CPA should be able to help you.
Tips & Payroll Taxes
Tips are earnings to the employee, paid for by the customer. These tips are reported on an employee’s W-2 and used to file their personal taxes. Tips are also reported to an employer so the employer can properly withhold the employee and employer’s portion of payroll taxes — Social Security and Medicare.
Business owners easily understand the need to pay employer payroll taxes on an employee’s hourly wage or salary. It is a lot tougher for business owners to grasp that they are required to pay employer payroll taxes on employees’ tips.
Let’s look at an example to illustrate the impact of having to pay payroll tax on an employee’s tips.
If Michael Jordan came into your business, purchased a beer and left an employee a $10,000 tip, the employer would be required to pay $765 in payroll taxes (Social Security tax rate is 6.2% and Medicare tax rate is 1.45%). We want our staff to be tipped well, but not at the expense of the business! Luckily, there is relief in the form of a tax credit.
Employer Tip Tax Credit
The IRS allows for the employer portion of payroll taxes paid on qualified employee tips to be taken as a tax credit on the business’s tax return.
As of January 1, 2021, the minimum wage in Maryland is $11.75 per hour. Businesses are allowed to pay below minimum wage if the employee also earns tips. If the employee earns less than $11.75 per hour after totaling the hourly wages plus tips, the employer will need to pay the difference out-of-pocket. In calculating the tax credit, the employer needs to reduce the tips paid by the difference between the state minimum wage and the actual hourly wage paid to the employee.
For example, Angel Farm Winery pays John Smith $10.00 per hour, which is $1.75 lower than the state mandated minimum wage. John works 100 hours in January 2021 and earns $1,000 in regular wages plus $500 in tips. Angel Farm Winery is required to pay employer payroll taxes on $1,500 (regular wage + tip). For the $500 in tips, the employer paid $38.25 for their portion of the payroll tax ($500 * 7.65%). Ordinarily, this would be the amount reported on the tax return as the employer tip tax credit. However, since the employee was paid below minimum wage, we need to reduce our tips. We need to reduce the tips paid by $175 (($11.75 - $10.00) * 100 hours). Therefore, for purposes of calculating the tax credit, we have qualified tips of $325, of which we can take a tax credit of $24.86.
For pass-through entities, the tax credit will flow through to the individual owners on their Form K-1, which they will use as they complete their year-end personal taxes.
Need Help?
As you can see, there are several considerations when accounting for tips. If you have questions about how to setup accounting for tips, or how to apply for the Employer Tip Tax Credit, we can help. Contact us online or call 800.899.4623.
