Taxing Tips: A Historical Overview Of Legal Changes

The taxation of tips has been a topic of debate in the US for several decades. While tips are considered income and are subject to federal income taxes, there have been various proposals and bills put forward to exclude tipped income from taxation. The No Tax on Tips Act, introduced by Republican senators in 2024, is one such example. This act aims to exclude tipped income from federal income taxes, but not from federal payroll taxes. The issue of taxing tips is complex and has implications for workers, businesses, and government revenue.

History of taxing tips

The history of taxing tips in the United States is a complex and evolving issue. While tipping has been a common practice in the service industry for decades, the taxation of tips has been a subject of debate and legislative changes. Here is a brief history of the key moments in the evolution of taxing tips:

Early History: For many years, the taxation of tips was not strictly enforced, and it was common for tipped workers, such as waitstaff and bartenders, to underreport their tip income. This led to a sense of entitlement among taxpayers, as they believed that tax-free tips were a right.

1982: A pivotal moment occurred in 1982 when Senator Bob Dole successfully convinced his congressional colleagues to take action on taxing tipped workers. As part of the 1982 Tax Equity and Fiscal Responsibility Act, large restaurants were required to report taxable tips for their employees, regardless of whether those tips had actually been received by servers. This change aimed to ensure that tipped workers were taxed on their actual income.

2012: The issue of taxing tips resurfaced during the 2012 presidential election, with Representative Ron Paul proposing to exclude tipped income from federal income taxes. However, this idea did not gain traction and disappeared along with his candidacy.

2024: In the 2024 election cycle, both major presidential candidates, Donald Trump and Kamala Harris, proposed exempting income from tips for service and hospitality workers from federal taxes. This rare moment of bipartisan agreement brought the issue of taxing tips back into the spotlight. The "No Tax on Tips Act" was introduced by Republican Senators, excluding tips from income tax. However, experts warned of potential drawbacks, including a federal revenue deficit and unintended consequences on overall wages and worker contributions to Social Security.

The debate around taxing tips continues, with supporters arguing for tax relief for tipped workers, while opponents raise concerns about the impact on tax revenue and fairness to non-tipped workers. The history of taxing tips in the United States demonstrates the ongoing challenge of effectively taxing tip income and the need for careful policy considerations to ensure equitable treatment for all workers.

Pros and cons of taxing tips

The debate over taxing tips in the United States has been a heated topic, with both major political parties reviving the discussion on how to support service industry workers. While the idea of untaxing tips has gained traction, it also has its advantages and disadvantages. Here are some pros and cons of taxing tips:

Pros:

• Increased take-home pay for some workers: Not taxing tips could provide financial relief to workers in industries such as restaurants and hospitality, where base wages are often low.
• Improved financial stability: By reducing the income subject to tax, workers who rely heavily on tip income might have more disposable income to cover living expenses and essentials, improving their financial stability.
• Popularity among voters: A recent Ipsos survey found that roughly three-quarters of Americans like the idea of untaxing tips, with support from across the political spectrum.

Cons:

• Loss of federal revenue: Some economists have raised concerns about the potential loss of federal revenue. The Committee for a Responsible Federal Budget estimates that exempting tips from income and payroll taxes could result in a revenue shortfall of $150 billion to $250 billion over the next decade.
• Ineffective targeting: Critics argue that untaxing tips may not effectively help those who need it the most. A Yale University analysis found that only a small fraction of the workforce would benefit from the tax exemption as many low-income workers already pay minimal or no federal income tax due to their earnings level.
• Abuse and unfair advantage: Eliminating taxes on tips could lead to employers reclassifying wages as tips to exploit tax benefits, and higher earners could take unfair advantage of the policy without proper safeguards like income limits.
• Negative impact on minimum wage efforts: Focusing on tips could hurt efforts to raise the minimum wage, and employers should instead raise base pay to support workers relying on tips.
• Legislative hurdles: Implementing this policy would require legislative action, and it is unclear if the proposal would gain enough bipartisan support in Congress to become law.

Who is affected by taxing tips

In the United States, taxing tips became law in 1982 when Kansas senator Bob Dole convinced Congress to get serious about taxing tipped workers.

According to the Fair Labor and Standards Act, a "tipped worker" is defined as someone who "customarily and regularly" receives $30 or more in tips per month. This definition encompasses millions of Americans, including waiters and waitresses, bartenders, barbers, and hairdressers.

Tipped workers tend to be younger than non-tipped workers, with a median age of 31 compared to 41 for non-tipped workers. They also tend to earn lower wages, with a median weekly wage of $538 in 2023, compared to $1,000 for non-tipped workers.

As a result of their lower incomes, a significant portion of tipped workers already pay zero federal income tax. In 2022, 37% of tipped workers had incomes low enough that they faced no federal income tax, even before accounting for tax credits. This means that any changes to the taxation of tips would primarily affect middle- and high-earning service workers, rather than lower-wage workers.

It is worth noting that, in addition to federal income taxes, tipped workers and their employers are also subject to federal payroll taxes, Social Security taxes, and Medicare taxes. Any changes to the taxation of tips could impact these additional taxes as well.

Overall, the group most affected by the taxation of tips are middle- and high-earning service workers in industries such as hospitality and entertainment, where tipping is customary.

How to report tips

Tips are taxable and must be reported to the IRS. Here is a step-by-step guide on how to report tips:

Keep a Daily Tip Record:

Use Form 4070A, Employee's Daily Record of Tips, to record all tips received, including cash tips and tips received through electronic payments or other means. Keep track of the date and value of any non-cash tips, such as tickets or passes.

Report Tips to Your Employer:

If your total tips for the month are $20 or more, you must report them to your employer using Form 4070, Employee's Report of Tips to Employer. This form must be submitted by the 10th of the month following the month you received the tips. The report should include your name, address, Social Security number, employer's name and address, the period the report covers, and the total amount of tips received.

Report Tips on Your Individual Income Tax Return:

When filing your taxes, you must report all tips on your individual income tax return, even if they were less than $20 per month. Use Form 4137, Social Security and Medicare Tax on Unreported Tip Income, to report any unreported tip income and include it as additional wages on your tax return.

Understand the Difference Between Tips and Service Charges:

Service charges, such as automatic gratuities or surcharges added to a customer's bill, are not considered tips by the IRS. These charges are included in your regular wages and are subject to income, Social Security, and Medicare tax withholding.

Know the Consequences of Not Reporting Tips:

Failing to report tips can result in penalties. If you are audited and have unreported tips, you may be subject to additional taxes and penalties. Additionally, not reporting tips can affect your Social Security benefits when you retire.

By following these steps, you can ensure that you are properly reporting your tip income and complying with tax laws.

Legislation and bills related to taxing tips

In the United States, cash and non-cash tips received by an employee are subject to federal income taxes and must be reported to the Internal Revenue Service (IRS). This includes cash tips received directly from customers, as well as tips received through electronic payments such as credit and debit cards. While there is no specific legislation or bill mentioned that directly addresses the taxation of tips, there are some related points worth noting:

Firstly, the Internal Revenue Code requires employees to report cash tips to their employer, excluding months where the total tips received are less than $20. Employers are responsible for withholding taxes on these reported tips and paying the employer's share of Social Security and Medicare taxes.

Secondly, in 1982, the Tax Equity and Fiscal Responsibility Act included a provision that required large restaurants to report taxable tips for their employees, addressing the issue of underreported tips. This provision set an 8% threshold for reported tips and allocated any deficiency among the tipped employees, reporting it to the IRS.

More recently, there have been legislative efforts to exempt tip income from taxation. The "No Tax on Tips Act", introduced by Senator Ted Cruz and Representative Byron Donalds, proposes exempting tips from federal income taxes (but not federal payroll taxes). A separate bill, the "Tax-Free Tips Act of 2024", introduced by Representatives Thomas Massie and Matt Gaetz, goes further by suggesting exempting tips from both income and payroll taxes. These proposals are aimed at providing tax relief to tipped workers, but critics argue that they are poorly targeted and may have unintended consequences.

It is worth noting that the discussion around taxing tips is ongoing, and while there have been proposals to exempt tips from taxation, no specific legislation or bill has been mentioned as being enacted into law. The information provided gives an overview of the legislative and political discussions related to taxing tips.

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