Many businesses in certain industries employ individuals who receive tips as part of their compensation. These businesses include restaurants, hotels and salons.

Tip definition

Tips are optional payments that customers make to employees who perform services. They can be cash or noncash. Cash tips include those received directly from customers, electronically paid tips distributed to employees by employers and tips received from other employees under tip-sharing arrangements. Generally, workers must report cash tips to their employers. Noncash tips are items of value other than cash. They may include tickets, passes or other items that customers give employees. Workers don’t have to report noncash tips to employers.

For tax purposes, four factors determine whether a payment qualifies as a tip:

1. The customer voluntarily makes the payment,
2. The customer has the unrestricted right to determine the amount,
3. The payment isn’t negotiated with, or dictated by, employer policy, and
4. The customer generally has the right to determine who receives the payment.

Tips can also be direct or indirect. A direct tip occurs when an employee receives it directly from a customer, even as part of a tip pool. Directly tipped employees include wait staff, bartenders and hairstylists. An indirect tip occurs when an employee who normally doesn’t receive tips receives one. Indirectly tipped employees include bussers, service bartenders, cooks and salon shampooers.

Daily tip records

Tipped workers must keep daily records of the cash tips they receive. To keep track of them, they can use Form 4070A, Employee’s Daily Record of Tips. It is found in IRS Publication 1244.

Workers should also keep records of the dates and value of noncash tips. Although the IRS doesn’t require workers to report noncash tips to employers, they must report them on their tax returns.

Reporting to employers

Employees must report tips to employers by the 10th of the month following the month they were received. The IRS doesn’t require workers to use a particular form to report tips. However, a worker’s tip report generally should include:

• The employee’s name, address, Social Security number and signature,
• The employer’s name and address,
• The month or period covered, and
• Total tips received during the period.

Note: Employees whose monthly tips are less than $20 don’t need to report them to their employers but must include them as income on their tax returns.

Employer requirements

Employers should send each employee a Form W-2 that includes reported tips. Employers also must:

• Keep their employees’ tip reports.
• Withhold taxes, including income taxes and the employee’s share of Social Security tax and Medicare tax, based on employees’ wages and reported tip income.
• Pay the employer share of Social Security and Medicare taxes based on the total wages paid to tipped employees as well as reported tip income.
• Report this information to the IRS on Form 941, Employer’s Quarterly Federal Tax Return.
• Deposit withheld taxes in accordance with federal tax deposit requirements.

In addition, “large” food or beverage establishments must file an annual report disclosing receipts and tips on Form 8027, Employer’s Annual Information Return of Tip Income and Allocated Tips.

Tip tax credit

If you’re an employer with tipped workers providing food and beverages, you may qualify for a federal tax credit involving the Social Security and Medicare taxes that you pay on employees’ tip income. The tip tax credit may be valuable to you. If you have any questions about the tax implications of tips, don’t hesitate to contact us.

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Most retirement plan distributions are subject to income tax and may be subject to an additional penalty if you take an early withdrawal. What’s considered early? In general, it’s when participants take money out of a traditional IRA or other qualified retirement plan before age 59½. Such distributions are generally taxable and may be subject to a 10% penalty tax.

Note: The additional penalty tax is 25% if you take a distribution from a SIMPLE IRA in the first two years you participate in the SIMPLE IRA plan.

Fortunately, there are several ways that the penalty tax (but not the regular income tax) can be avoided. However, the rules are complex. As the taxpayer in one new court case found, if you don’t meet the requirements, you’ll be forced to pay the penalty.

Basic rules

Some exceptions to the 10% early withdrawal penalty tax are only available to taxpayers who take early distributions from traditional IRAs, while others can only be used with qualified retirement plans such as 401(k)s.

Some examples of exceptions include:

• Paying for medical costs that exceed 7.5% of your adjusted gross income,
• Taking annuity-like annual withdrawals under IRS guidelines,
• Withdrawing money from an IRA, SEP or SIMPLE plan up to the amount of qualified higher education expenses for you, your spouse, children or grandchildren, and
• Taking withdrawals of up to $10,000 from an IRA, SEP or SIMPLE plan for qualified first-time homebuyers.

Facts of the new case

Another exception is available for the total and permanent disability of the retirement plan participant or IRA owner. In one case, a taxpayer took a retirement plan distribution of $19,365 before he reached age 59½, after losing his job as a software developer. According to the U.S. Tax Court, he had been diagnosed with diabetes, which he treated with insulin shots and other medications.

The taxpayer filed a tax return for the year of the distribution but didn’t report it as income because of his medical condition. The retirement plan administrator reported the amount as an early distribution with no known exception on Form 1099-R, which was sent to the IRS and the taxpayer.

The court ruled that the taxpayer didn’t qualify for an exception due to disability. The court noted that an individual is considered disabled if, at the time of a withdrawal, he or she is “unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration.”

In this case, the taxpayer was previously diagnosed with diabetes, but he had been able work up until the year at issue. Therefore, the federal income tax deficiency of $4,899 was upheld. (TC Memo 2023–9)

Lessons learned

As the taxpayer in this case discovered, taking early distributions is one area where guidance is important. We can help you determine if you’re eligible for any exception to the 10% early withdrawal penalty tax.

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The IRS announced it opened the 2023 individual income tax return filing season on January 23. That’s when the agency began accepting and processing 2022 tax year returns. Even if you typically don’t file until much closer to the mid-April deadline (or you file for an extension), consider filing earlier this year. The reason is you can potentially protect yourself from tax identity theft.

Here are some answers to questions taxpayers may have about filing.

How can your tax identity be stolen?

In a typical tax identity theft scam, a thief uses another individual’s personal information to file a fraudulent tax return early in the filing season and claim a bogus refund.

The actual taxpayer discovers the fraud when he or she files a return and is told by the IRS that the return is being rejected because one with the same Social Security number has already been filed for the tax year. Ultimately, the taxpayer should be able to prove that his or her return is the legitimate one, but tax identity theft can be time consuming and frustrating to straighten out. It can also delay a refund.

Your best defense may be to file early. Why? If you file first, the tax return filed by a potential thief will be rejected.

What are this year’s deadlines?

This year, the filing deadline to submit 2022 returns or file an extension is Tuesday, April 18 for most taxpayers. The due date is April 18, instead of April 15, because the 15th falls on a weekend and the District of Columbia’s Emancipation Day holiday falls on Monday, April 17.

If you’re requesting an extension, you’ll have until October 16, 2023, to file. Keep in mind that an extension of time to file your return doesn’t grant you any extension of time to pay your taxes. You should estimate and pay any taxes owed by the regular deadline to help avoid penalties.

When will your W-2s and 1099s arrive?

To file your tax return, you need all of your Form W-2s and 1099s. January 31 is the deadline for employers to issue 2022 W-2s to employees and, generally, for businesses to issue Form 1099s to recipients of any 2022 interest, dividend or reportable miscellaneous income payments (including those made to independent contractors).

If you haven’t received a W-2 or 1099 by February 1, first contact the entity that should have issued it. If that doesn’t work, ask us how to proceed.

Are there any other advantages to filing early? 

In addition to protecting yourself from tax identity theft, another advantage of early filing is that, if you’re getting a refund, you’ll get it sooner. The IRS expects most refunds to be issued within 21 days. The time may be shorter if you file electronically and receive a refund by direct deposit into a bank account.

Direct deposit also avoids the possibility that a refund check could be lost, stolen, returned to the IRS as undeliverable or caught in mail delays.

Need assistance?

If you have questions or would like an appointment to prepare your return, please contact us. We can help ensure you file an accurate return and receive all of the tax breaks to which you’re entitled.

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If you have a child or grandchild in college — congratulations! To help pay for the expenses, many parents and grandparents saved for years in tax-favored accounts, such as 529 plans. But there are also a number of tax breaks that you may be able to claim once your child begins attending college or post-secondary school.

Tuition tax credits 

You can take the American Opportunity Tax Credit (AOTC) of up to $2,500 per student for the first four years of college — a 100% credit for the first $2,000 in tuition, fees, and books, and a 25% credit for the second $2,000. You can take a Lifetime Learning Credit (LLC) of up to $2,000 per family for every additional year of college or graduate school — a 20% credit for up to $10,000 in tuition and fees.

The AOTC is 40% refundable up to $1,000 (meaning you can get a refund if the credit amount is greater than your tax liability). Both credits are phased out for married couples filing jointly with modified adjusted gross income (MAGI) between $160,000 and $180,000, and for singles with MAGI between $80,000 and $90,000.

Only one credit can be claimed per eligible student in any given year. To claim the education tax credits, a taxpayer must receive a Form 1098-T statement from the school. Other rules may apply.

Scholarships 

Scholarships are exempt from income tax if certain conditions are satisfied. The most important is that the scholarship generally can’t be compensation for services, and it must be used for tuition, fees, books and supplies (not for room and board).

However, a tax-free scholarship reduces the amount of expenses that may be taken into account in computing the AOTC and LLC and may reduce or eliminate those credits.

Employer educational assistance

If your employer pays your child’s college expenses, the payment is a fringe benefit, and is taxable to you as compensation, unless it’s part of a scholarship program that’s “outside of the pattern of employment.” Then, the payment will be treated as a scholarship (if the requirements for scholarships are satisfied).

Tuition payments by grandparents and others 

If someone gives you money to pay your child’s college expenses, the person is generally subject to gift tax, to the extent the payments exceed the annual exclusion of $17,000 per recipient for 2023. Married donors who split gifts may exclude gifts of up to $34,000 for 2023.

However, if the person (say, a grandparent) pays your child’s tuition directly to an educational institution, there’s an unlimited exclusion from gift tax for the payment. This unlimited gift tax exclusion applies only to direct tuition costs (not room and board, books, supplies, etc.).

Retirement account withdrawals 

You can take money out of your IRA or Roth IRA any time to pay college costs without incurring the 10% early withdrawal penalty that usually applies to distributions before age 59½. However, the distributions are subject to tax under the usual IRA rules.

You also may be able to borrow against your employer retirement plan or take withdrawals from it to pay for college. But before you do so, make sure you understand the tax implications, including any penalties that you may incur.

Plan ahead

Not all of the above breaks may be used in the same year, and some of them reduce the amounts that qualify for other breaks. So it takes planning to determine which should be used in any given situation. Contact us if you’d like to discuss any of the above options, or other alternatives.

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