When it comes to proper income tax reporting at salons and spas, the practice of tipping can easily be described as an accident waiting to happen.

Internal Revenue Service (IRS) tax law says:

The tip income you receive as a service provider - whether cash or included in a charge - is taxable income. As taxable income, these tips are subject to federal income tax, social security and Medicare taxes, and may be subject to state income tax as well.

There is nothing vague about the tax law. All tips are taxable income and must be reported and taxed.

IRS tax law DOES NOT say …

• “If you only report tips on credit cards … you’re covered and you can keep the cash tips.”
• “If you only report five or ten percent of your tip income … we’re good with that.”
• “Hey owners, if you don’t want to bother with reporting tip income and withholding tax on tips … just tell your employees that it’s their responsibility. We’ll never come after you.”

The reality is that too many owners, employees and independent contractors choose to make up their own rules rather than adhere to the legal requirements of tip reporting and withholding tax.

For Owners …

Reporting all employee income, both pay and tip income, is your responsibility. You cannot arbitrarily decide to opt out of this responsibility and place the responsibility of reporting tip income on your employees.

Employees must report tip income on Form 4070, Employee's Report of Tips to Employer (PDF), or on a similar statement. This report is due on the 10th day of the following month that tips are received. No report is required from an employee for months when tips are less than $20 … which means all service providers will be reporting tip income.

The IRS knows how much tip income is happening in your business. The following is from the IRS Cash Intensive Businesses Audit Techniques Guide - Chapter 10 Beauty and Barber Shops:

"Workers in the salon industry supplement their base compensation with tip income. Independent Contractors (booth renters) will report their service and sales revenue plus their tips, as gross receipts. Employees should be reporting tips to their employers."

Sample audits completed in Las Vegas, NV, showed tips as high as 22 percent of gross sales, but average tips are usually 10-15% of the bill.

Simply put … the IRS is not stupid.

It’s time to clean up your tip-reporting act. Based on the preceding statements, if your salon/spa is knowingly reporting less than 100% of the tips that occur … you are exposed to back taxes and penalties. IRS will apply their formulas to calculate the estimated tip income and compare that to the tip income you reported for employees. When IRS asks you to explain the gap … what are you going to say? It’s your company and you will be held responsible.

For Employees …

The tips you receive at work ARE income earned at work … and must be accurately reported and taxed. Tips are not gifts from clients. Tips are taxable income. Period. It’s the law.

The decision to report tip income is not optional. Reporting less than your total tip income is against the law. You are exposing yourself and the business owner to back tax liabilities and penalties.

The salons/spas you work for must follow the law. Owners are not looking to punish you by reporting and withholding tax on your tip income. It is unfair to retaliate against an owner that is following the tax laws. Adhering to tax law protects everyone.

Don't allow tips on CCs? You have an ATM! Great … IRS will just look at the ATM transactions to compare with reported tip income. If the reported cash tip income for employees is a fraction of your ATM withdrawals … you and your employees failed to accurately report tip income.

Your tip income adds up and increases your overall income. It could mean the difference between getting approved for a home mortgage or car loan. Hiding income to have a little more cash in your pocket is shortsighted thinking … and it’s illegal.

For both Owners and Employees …

“I didn’t know” is not a viable excuse for defense for failure to under-report tip income.

Tip Payouts …

• Times have changed with credit card payments. There just isn’t that much cash coming into salons and spas these days to cover daily cash tip payouts.
• Daily cash payouts may not be a big deal today with only a few employees. It can become a time-consuming chore when there are a dozen or more tip envelopes to stuff each day.
• Cash tends to be “sticky.” The more cash … the better the chance of theft. All it takes is one missing tip envelope to break trust in your culture.
• Cash tip payouts cost money to have someone run to the bank to get cash and then stuff envelops for the sake of instant gratification.
• It’s time to add tips to employee paychecks and get it over with. You're covered for tax liabilities and your employees will eventually appreciate the bigger paychecks.
• Again, tip money adds up. It’s nice to have a pocket full of cash at the end of each day … but that cash is going to evaporate on needless spending. Seeing that extra few hundred dollars, or more, of tip income in each paycheck is an eye-opener for employees. Most, if not all, will thank you.

Here are some comments from owners who ended daily tip payouts that were posted on the Strategies Salon & Spa Business Idea Exchange Facebook group. These owners now include all tip income in employee paychecks … with the appropriate withholding tax.

Dallas Maxwell: "Put it in their paychecks, make tip management easier. That’s what we did. They adjusted quickly and we didn't skip a beat. It used to take me an extra 25-35 minutes each day to do tip payouts. In my opinion, it’s a total waste of time … not to mention running back and forth to the bank to get cash. Explain why, they will understand."

Bridgett DiVohl: "We made the switch to tips on paychecks three years ago. There were some initial complaints but overall seem to like it. Now they see all their tip money as a lump sum. Make the switch."

Sarah McGee: "We switched seven years ago and it saved me so much headache. I reminded my staff that we don't get check or credit card funds immediately. The theft issue is huge as well. I keep about a third of the cash on-hand compared to daily tip payouts. I gave them three pay periods of advanced warning. They love that it's all in one check. When they got cash, they'd blow it so quickly. Now they save it and use that income for bills - not spending it shopping or at the bar. You'll be so happy when you switch."

Pamela French: "We include the tips in their paycheck. When I took over the salon one year ago, I wanted to change this practice after I realized that we carried that much cash on-hand for daily tip payouts. It could create a theft issue. With that in mind I decided to keep it added into their paychecks. Once they get used to it they will like that their checks are bigger and that money will be spent more wisely."

Here’s my challenge to you: "If your salon/spa is not reporting 100% of the tip income that’s occurring … it’s time to clean up your act and get tax compliant. Just go to www.IRS.gov and search “Tip Reporting.” You will find all the information you need to know about proper tip income reporting and tax compliance. You can also read the Audit Techniques Guide for Beauty and Barber Shops. They know how to find the money. They know."