TaxBandits Knowledge Base

What are the three different methods used to allocate tips?

When the total tips reported by employees (Line 4c) are less than the calculated tip allocation amount (Line 6), the difference (excess tips) must be allocated to employees and reported on their Form W-2. There are three methods you can use to allocate these excess tips:

1. Hours-Worked Method (Line 7a)

• Qualification: The average employee hours worked per business day during a payroll period must be less than 200 hours, including both tipped and non-tipped employees.
   
• How it Works:
  • Instead of using gross receipts, tips are allocated based on the number of hours worked by tipped employees.
  • The allocation distributes tips among directly tipped employees (like waitstaff and bartenders) based on their hours worked relative to the total hours worked by all directly tipped employees.
     
• What You Need to Do: If you choose this method, you must enter the average number of employee hours worked per business day for the payroll period.

2. Gross Receipts Method (Line 7b)

• When to Use: This method is required if there’s no good-faith agreement in place for the payroll period.
   
• How it Works:

• You first calculate 8% (or a lower IRS-approved rate) of the establishment’s gross receipts (excluding non-allocable receipts).
• Subtract the tips reported by indirectly tipped employees (like bussers or cooks).
• The remaining tip amount is allocated among directly tipped employees (like waitstaff or bartenders) based on each employee’s share of the gross receipts.
• After allocating, subtract the tips already reported by each directly tipped employee from their allocated amount.
• If there is a shortfall, allocate the difference among directly tipped employees who did not report enough tips.
• Report the allocated tips on each directly tipped employee’s Form W-2.

3. Good-Faith Agreement Method (Line 7c)

• When to Use: This method is necessary when the allocation is made under a good-faith agreement for the payroll period. This agreement must be in writing and involve you and at least two-thirds of the tipped employees (such as waitstaff, bussers, and maitre d's) who will be employed at the establishment when the agreement is adopted.
   
• How it Works:
  • The agreement ensures that the tip allocation is distributed among tipped employees.
  • The agreement must be effective on the first day of a payroll period ( no later than January 1 of the following year).
  • Applies to tipped employees in each job category (e.g., waitstaff, bartenders).
  • The agreement revokes with two-thirds of affected tipped employees' written consent, effective at the start of a new payroll period.
  • Keep a copy of the agreement for your records.