Tips are in the news lately. It seems like political strategists on both sides of the aisle have concluded that excluding tips from taxable income is good for votes. One has to wonder if this political promise will go the way of Herbert Hoover’s 1928 campaign slogan, “A chicken in every pot and a car in every garage.” Herbert Hoover was elected President, but things did not work out well for his presidency or the country (The Great Depression 1929 – 1939).

To be sure, the tax treatment of tips presents challenges. Tips are income under current law.[1] Not all tips, however, constitute wages for employment tax purposes. Excluding tips from taxable income would eliminate some of these challenges and provide an indirect pay raise for workers in service industries, but it would raise new technical and fairness challenges.

A relatively new complexity is how to treat a tip received in cryptocurrency. While this would be an unusual situation in the current market, things may change as cryptocurrency becomes more common in the marketplace.

Brief Background of Tip Reporting

The historic challenge with tips was ensuring that tax was paid on tip income. With most service industry transactions now occurring on credit cards and businesses using point-of-sale software programs, unreported tip income is becoming less of an issue. The problem still remains with cash tips.

Employers are required to deduct from an employee’s wages the employee’s share of social security tax (old age, survivors, and disability insurance tax).[2] Employers also are required to withhold income tax from wages.[3]

For social security tax and income tax withholding purposes, “wages” generally means all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash.[4] Generally, the medium in which the remuneration is paid is immaterial. It may be paid in cash or in something other than cash, for example, goods, lodging, food, or clothing. Remuneration paid in items other than cash is computed on the basis of the fair market value of such items at the time of payment.[5]

Tips generally are wages, but there are some exceptions that make the definition of “wages” for tips narrower than the general definition for social security tax and income tax withholding. One exception is that tips received by an employee of $20 or less during a calendar month are not wages for social security tax or income tax withholding purposes.[6]

Another exception for purposes of social security tax and income tax withholding is that the term “wages” does not include remuneration received by an employee in the form of tips if the tips are paid in any medium other than cash (such as passes, tickets, or other goods or commodities). For this purpose, cash includes checks and other monetary media of exchange (e.g., credit card charges).[7]

Tips received by an employee are deemed paid by the employer at the time the employee reports the tips to the employer or, if no report is provided, at the time the tips are received.[8] If the employee does not provide a report, the employer’s liability for its share of social security tax is determined as if such tips were paid on the date on which the Internal Revenue Service (IRS) issues a notice and demand for such taxes.[9] Such a notice usually follows an IRS examination.[10]

In the case of tips that are wages, the employer’s requirement to withhold social security tax and income tax applies to such wages if two conditions are met. First, withholding only applies to tips that are reported to the employer by the employee in a written statement. Second, assuming tips are reported, withholding only applies to the extent that collection can be made by the employer at or after the time the employee’s report is provided and before the close of the 10th day following the calendar month (30th day in certain cases) in which the tips were deemed paid.[11]

Tips Paid in Cryptocurrency

Tips paid to an employee in cryptocurrency are income. Moreover, the IRS has taken the position that cryptocurrency constitutes wages for employment tax purposes. The IRS has issued frequently asked questions with respect to virtual currency (which includes cryptocurrency).

Q11. Does virtual currency paid by an employer as remuneration for services constitute wages for employment tax purposes?

A11. Yes. Generally, the medium in which remuneration for services is paid is immaterial to the determination of whether the remuneration constitutes wages for employment tax purposes. Consequently, the fair market value of virtual currency paid as wages, measured in U.S. dollars at the date of receipt, is subject to Federal income tax withholding, Federal Insurance Contributions Act (FICA) tax, and Federal Unemployment Tax Act (FUTA) tax and must be reported on Form W-2, Wage and Tax Statement. See Publication 15 (Circular E), Employer’s Tax Guide PDF, for information on the withholding, depositing, reporting, and paying of employment taxes.[12]

Treating remuneration paid in cryptocurrency generally as wages for employment tax purposes does not necessarily mean that tips paid in cryptocurrency are wages for employment tax purposes.

As stated earlier, for purposes of social security tax and income tax withholding, the term “wages” does not include remuneration received by an employee in the form of tips if the tips are paid in any medium other than cash (such as passes, tickets, or other goods or commodities), and for this purpose, cash includes checks and other monetary media of exchange (e.g., credit card charges).[13]

Is cryptocurrency a medium other than cash? If so, then employers are not required to withhold social security tax or income tax from tips paid in cryptocurrency. Moreover, as discussed below, the employee is not liable for the employee’s share of social security tax on such tips.

The Code generally defines a digital asset[14], for purposes of information reporting by brokers, as any digital representation of value that is recorded on a cryptographically secured distributed ledger or any similar technology as specified by the Secretary. For Federal tax purposes, cryptocurrency is treated as property. General tax principles applicable to property transactions apply to transactions using cryptocurrency.[15] Given this treatment of cryptocurrency by the IRS as property, should the phrase “monetary media of exchange” be interpreted to exclude cryptocurrency?

Some guidance can be gleaned from the Supreme Court’s decision in Wisconsin Central Ltd, et al. v. United States, 128 S. Ct. 2067 (2018), but it should be noted that this was a 5-4 decision. The issue in Wisconsin Central was whether employee nonqualified stock options were “employee compensation” under the Railroad Retirement Tax Act (RRTA), which defines “employee compensation” as “any form of money remuneration paid to an individual for services rendered.”[16] The same Congress that enacted the RRTA enacted FICA but chose a broader definition for FICA by taxing “all remuneration,” including benefits “paid in any medium other than cash.”[17] The majority was unwilling to expand the definition of “money remuneration” to include employee nonqualified stock options. The minority would have included within the meaning of “money remuneration” employee nonqualified stock options. The majority’s narrow interpretation would suggest that the Court would not include cryptocurrency in the definition of “other monetary media of exchange.”

Assuming a cryptocurrency tip is not wages for withholding purposes, is an employee who receives a cryptocurrency tip required to pay social security tax on it? If the employer cannot collect the employee’s share of social security tax from compensation paid to the employee, the employee must pay such tax.[18] This requirement only applies to tips treated as wages for social security tax purposes. Assuming cryptocurrency tips are not wages, the employee is not liable for the employee’s share of social security tax on the value of the cryptocurrency tips.

When Does an Employee Pay Income Tax on Cryptocurrency Tips?

Even though cryptocurrency tips should not be treated as wages, they still are income to the employee. When does the employee value the cryptocurrency tips for income tax purposes? FAQ 11 in Notice 2014-21 provides that the fair market value of virtual currency paid as wages is measured in U.S. dollars at the date of receipt. Following the analysis of Revenue Ruling 2023-14, which involved the taxation of cryptocurrency staking rewards, the employee would report cryptocurrency tips in income in the taxable year in which the employee obtains dominion and control over the cryptocurrency such that the employee can sell or exchange the cryptocurrency.[19] Revenue Ruling 2023-14’s timing rule for inclusion of cryptocurrency in income is the better rule and the IRS should not challenge a taxpayer who follows that rule for when to include cryptocurrency in income. Under either timing rule, the employee likely would have to include the fair market value of the cryptocurrency in income before the cryptocurrency is exchanged for cash or otherwise used in a sale or exchange transaction.

Proposed federal legislation would change the result in Revenue Ruling 2023-14 by moving the time of taxation for rewards received from staking cryptocurrency and other digital assets to the time of sale rather than the time the taxpayer obtains dominion and control over the rewards.[20] Whether Congress decides to extend this (or other proposed legislation) to transactions other than the receipt of cryptocurrency staking rewards is yet to be seen. Postponing the time for inclusion of income and valuation of the cryptocurrency to when the taxpayer receiving it sells or otherwise exchanges the cryptocurrency would go a long way toward simplifying the taxation of cryptocurrency.

[1] It is difficult to justify excluding tips from income on the basis that they are a gift. We learned long ago in the Supreme Court case of Commissioner v. Duberstein, 363 U.S. 278 (1960), that for “the value of property acquired by gift” to be excluded from income there must be a donative intent on the part of the person making the transfer; that is, gifts result from “detached and disinterested generosity” and often are given out of “affection, respect, admiration, charity or like impulses.” A tip is received for the performance of a service. “Compensation for services” is defined as income under IRC § 61(a)(1).

It also is difficult to justify excluding tips from the income of an employee in a service industry and not excluding income (or some portion) of a first responder who charges into a burning building on any notion of fairness.

Under Section 112 of the Internal Revenue Code (Code or IRC), certain active-duty military personnel may exclude combat income from taxation, but risking your life to defend your country is a far cry from being berated by a customer (although it is true that working in some restaurants seems like combat duty). Where is the fairness; where do we draw the line?

Moreover, because social security benefits are based on how much an employee earns, excluding tips from income (which presumably means excluding tips from “wages”) would reduce future social security benefits.

[2] IRC § 3102; Treas. Reg. § 31.3102-3. Of course, employers also must pay their share of social security tax.

[3] IRC § 3402(k); Treas. Reg. § 31,3401(f)-1(a).

[4] IRC § 3121(a); IRC 3401(a).

[5] Treas. Reg. § 31.3121(a)-1(e); Treas. Reg. § 31.3401(a)-1.

[6] IRC § 3121(a)(12)(B); Treas. Reg. § 31.3121(a)(12)-(1); IRC § 3401(a)(16); Treas. Reg. § 31.3401(a)(16)-1. The employee is still required to report such tips as income.

[7] IRC § 3121(a)(12);Treas. Reg. § 31.3121(a)(12)-1; IRS § 3401; Treas. Reg. § 31.3401(a)(16)-1. Similar rules apply under the Railroad Retirement Act.

[8] Treas. Reg. § 31.3401(f)-1(b).

[9] IRC § 3121(q).

[10] While it seems unfair to require an employer to pay the employer’s share of social security tax on tips never reported to it by the employee, the Supreme Court has held that the employer is liable for such taxes. See Podcast: Reporting Cash Tips to the IRS.

[11] IRC § 3102(c)(1); Treas. Reg. § 31.3102-3(a)(2); IRC § 3402(k); Treas. Reg. § 31.3402(k)-1(a)(2).

[12] Notice 2014-21, 2014-16 IRB 938; Frequently asked questions on virtual currency transactions.

[13] IRC § 3121(a)(12);Treas. Reg. § 31.3121(a)(12)-1; IRS § 3401; Treas. Reg. § 31.3401(a)(16)-1. Similar rules apply under the Railroad Retirement Tax Act.

[14] IRC § 6045(g)(3)(D). Cryptocurrency is a form of digital assets.

[15] IRS Notice 2014-21, 2014-16 I.R.B. 938.

[16] IRC § 3231(e)(1).

[17] IRC § 3121(a).

[18] IRC § 3102(c)(4); Treas. Reg. § 31.3102-3(d). The facts in Revenue Ruling 2023-14 involved a taxpayer using the cash receipts and disbursements method of account, which is the method of accounting that most individuals receiving tips would use.

[19] See When Are My Rewards for Staking Cryptocurrency Taxed? for a discussion of Revenue Ruling 2023-14.

[20] See Legislation: Cryptocurrency Staking Rewards Taxed at Time of Sale.