Any tips you receive are considered taxable income and are subject to Social Security and Medicare tax withholding, if the amount for a calendar month is $20 or more. If you receive more than $20 or more per calendar month in cash tips, you should report that income to your employer. Tip income that you tell your employer about will be reported in box 7 (Social Security tips) of your Form W-2.
The law assumes an average tip rate of 8% (or a lower agreed rate) and expects employees to report tips that total at least 8% of the gross food and drink sales. If the reported tip income is less than 8%, restaurants and bars that normally employ more than 10 employees on a typical business day are required to allocate unreported tip income among their employees. This means that the difference between what is reported and the 8% rate is distributed among the employees and reported to the IRS. This unreported tip income will also be reported in box 8 (Allocated tips) of your W-2. You must report allocated tips on your tax return unless either of the following exceptions applies.
You kept a daily tip record, or other evidence that is as credible and as reliable as a daily tip record.
Your tip record is incomplete, but it shows that your actual tips were more than the tips you reported to your employer plus the allocated tips.
If either exception applies, report your actual tips on your return, instead of the allocated tips.
Use Form 4137 to pay Social Security and Medicare taxes on unallocated tips and report any tips that you didn’t tell your employer about.
If you report less than your share, you should be prepared to answer questions about it
Even if you earn less than $20 a month in tips, you should report your tip income on Form 4137. The same holds true for employees who aren’t required to report tip income to their employers.
To learn more, see IRS Publication 531: Reporting Tip Income.