What expense category is Tip Pooling and Tip-Out?

For restaurants, cafes, and other service-based businesses, managing employee tips is a complex but essential daily task. Tip pooling and tip-out arrangements are common practices for distributing tips among service staff, but they create significant accounting and payroll obligations for the employer.

While the tips themselves belong to the employees, the process of handling them—especially with credit card transactions—creates deductible expenses and tax credit opportunities for the business. This guide will clarify how to correctly account for tip distributions and the associated costs to ensure your business remains compliant and maximizes its tax benefits.

Tip Pooling and Tip-Out Expenses Category

Tip pools and tip-outs are not a direct expense category for a business. Tips are considered the property of the employees, not the employer. When a business collects tips on behalf of its staff (especially via credit card), it is holding that money as a liability that is owed to the employees.

The actual deductible expenses for the business that arise from this process are:

1. Bank Fees / Other Expenses: The portion of credit card processing fees that is attributable to the tip amount is a deductible business expense.
2. Taxes and Licenses: The employer's share of FICA (Social Security and Medicare) taxes paid on the reported tip income is a deductible tax expense.

Important Considerations While Classifying Tip Pooling and Tip-Out Expenses

To correctly account for these costs, it is crucial to understand the difference between tips and service charges and how to handle the associated fees.

Tips vs. Service Charges

This is a critical distinction for tax purposes.

• Tips: A discretionary payment a customer makes to an employee. Tips are the property of the employee.
• Service Charges: An automatic, mandatory fee added to a bill (e.g., an 18% gratuity for a large party). IRS Publication 535 notes that these are treated as regular revenue to the business, not tips. When you distribute this money to your employees, it is a wages expense, not a tip distribution.

Credit Card Fees on Tips

When a customer leaves a tip on a credit card, the business pays a processing fee on the total amount (meal + tip). The business can deduct the portion of the fee that applies to the tip. For example, if the processing fee is 3% and a customer leaves a $20 tip, the business incurs a $0.60 fee to process that tip. This $0.60 is a deductible business expense. Many employers also pass this cost on to the employee by deducting it from their tip payout.

Tax Implications of Tip Pooling and Tip-Out Expenses

The primary tax implications for the employer are the requirement to pay FICA taxes on tips and the opportunity to claim a valuable tax credit.

Employer's Responsibility for FICA Taxes

All tips reported to you by your employees are considered wages and are subject to the employer's share of social security and Medicare taxes. You must pay these taxes on the reported tip income.

The FICA Tax Credit

This is a significant tax benefit for restaurants and bars. As explained in IRS Publication 334, employers may be able to claim a general business credit for the employer's share of FICA taxes paid on employee tips. This credit applies to tips that are over and above the amount needed to bring the employee's wage up to the federal minimum wage. This is a dollar-for-dollar credit against your tax liability, which is more valuable than a deduction.

Taxability for the Employee

All tips an employee receives—whether directly in cash, from a credit card, or distributed from a tip pool—are taxable income to the employee and must be reported.

How to Report the Deductions

For a sole proprietor filing a Schedule C (Form 1040):

• The credit card processing fees on tips are included in the total for Line 27a, Other expenses, under a description like Merchant Processing Fees.
• The employer's share of FICA taxes paid on tips is deducted on Line 23, Taxes and licenses.

How Fyle Can Automate Expense Tracking for Tip-Related Costs

Fyle helps you capture and organize the financial data needed to correctly account for your tip-related expenses and prepare for tax time.

• Centralize Sales Reports: Forward or attach your end-of-day sales reports that detail total credit card tips directly to Fyle.
• Reconcile Processing Fees: Easily match the total processing fees on your merchant statement with the portion attributable to tips.
• Create a Clear Audit Trail: Fyle maintains a time-stamped record of your sales reports and merchant statements for easy substantiation.
• Automate Your Accounting: Sync the deductible processing fee expense directly to the correct GL account in QuickBooks, Xero, NetSuite, or Sage Intacct.