In the US, tips are taxable income for the employees who receive them, and restaurant owners have real obligations around them: collecting tip reports from staff, withholding and paying payroll taxes on reported tips, and keeping records. Tip pooling is allowed in many situations, but who can share in the pool and how it is run depends on federal and state law. Get the basics right, write your policy down and have an accountant check your setup.
This guide covers tip income, tip reporting and tip pooling basics. It is general information, not tax or legal advice. Rules vary by state and city and change over time, so confirm details with a qualified accountant or attorney. For setting up sales tax in Square, see how to use Square for tax reporting in the US.
Tips are income
The IRS treats tips as income for the employee, whether they are paid in cash, by card or shared from a pool. That means:
- Employees must report tips to their employer and include them on their tax return.
- Employers generally withhold income tax and Social Security and Medicare taxes on reported tips, and pay the employer share of Social Security and Medicare.
- Reported tips appear on the employee's Form W-2.
How employees report tips
According to IRS Publication 531 (Reporting Tip Income), an employee who receives $20 or more in tips in a month while working for one employer must report those tips to that employer by the 10th of the following month. Employees can use IRS Form 4070 or another written or electronic method the employer provides. Cash, check, debit and credit card tips are all reported. In a tip pool, employees report the tips they actually keep, including tips they receive from coworkers.
Card tips are recorded automatically by your POS. Cash tips are the gap. Give staff a simple, consistent way to declare cash tips each shift so the records are complete.
Tips versus service charges
A tip is voluntary: the guest decides whether to leave one and how much. A mandatory charge, such as an automatic service charge for large parties, is generally treated by the IRS as a service charge, not a tip. Service charges paid to staff are typically treated as regular wages for payroll purposes. This distinction also matters for the federal tip deduction below, so label charges clearly on your menu and receipts.
The federal deduction for tips
Beginning with tax year 2025, federal law allows eligible workers in occupations that customarily receive tips to deduct qualified tips from their federal income, within limits set by law. Per the IRS, tips are still income, still subject to Social Security and Medicare taxes, and mandatory service charges do not count as qualified tips. Employers may also have new reporting requirements. See the IRS page "What the No Tax on Tips deduction means for you" on irs.gov and talk to your payroll provider about what changes for your business.
Tip pooling basics
A tip pool combines tips and shares them among eligible employees. Common methods:
- By hours worked: each person's share matches their share of hours in the period.
- By percentage: each role gets a set share, such as a larger share for front of house.
- Per transaction: each tip is split among everyone clocked in when the sale happened.
Under federal law, managers and supervisors generally may not keep employees' tips, and owners may not take tips from the pool. Whether back of house staff can share depends on how you pay wages (for example, whether you take a tip credit) and on state law. Some states have stricter rules than federal law, so check before setting up a pool.
Using Square to track and distribute tips
Square records card tips with each sale and can distribute them to your team. In Square Dashboard, you choose a tip distribution method (such as per recipient or pooled by hours worked, by percentage or per transaction) and mark which team members are tip eligible. Square's support center recommends turning off tip eligibility for managers who should not receive tips. If you use Square Payroll, tip importing follows the distribution method you set, so configure that first. For more detail, read the best ways to manage tips and gratuities in Square POS and using Square for payroll management.
Example: a coffee shop tip pool
A cafe with six baristas and one manager pools card and cash tips weekly by hours worked. The manager is marked not tip eligible in Square. Baristas clock in on the POS, so hours are accurate, and the closing barista enters the day's cash tips. Each week, the owner checks the tip report, runs payroll with tips imported and gives staff a summary of how the pool was split. The written policy, shared at hiring, explains all of this in one page.
A tips checklist for owners
- Write a tip policy covering who is eligible, how tips are split and when they are paid.
- Have staff clock in and out so hours based pools are fair.
- Collect cash tip declarations every shift.
- Keep managers and owners out of the pool unless your attorney confirms otherwise.
- Label any mandatory charges as service charges, not tips.
- Reconcile tips with payroll every period.
- Ask your accountant about tax credits that may apply to employer taxes paid on tips, such as the federal FICA tip credit.
Common mistakes
- Ignoring cash tips. Unreported cash tips create problems for both employees and the business.
- Calling a service charge a tip. The tax treatment is different.
- Letting managers share the pool without confirming it is allowed.
- An unwritten policy. Staff disputes are much easier to resolve with a clear policy.
Where Orda fits
Guests who order ahead can still tip. With Orda, you set tipping options for your branded app and web ordering, and those tips are recorded in Square POS with the order, so your tip distribution and payroll pick them up like any counter tip.