Anything you pay to your employees is taxable wages and is subject to withholding of social security and medicare. Everything you pay to them must be on their W-2. Yes, this means that you pay extra social security and medicare on their tips. And you must withhold the employee part of social security and medicare from their tips as well as their wages. Don't issue any 1099s to your employees who receive a W-2.
Here are some IRS documents to read.
https://www.irs.gov/pub/irs-pdf/p3148.pdf
https://www.irs.gov/businesses/small-businesses-self-employed/tip-recordkeeping-and-reporting
https://www.irs.gov/publications/p531
https://www.irs.gov/pub/irs-pdf/p3144.pdf
Basically, if your employee gets $100 of cash tips during the week, they are supposed to truthfully report that to you. Then in addition to the 7.65% of social security and medicare you take from their hourly wage, you take and additional $7.65 from their wages to cover the $100 of declared tips. And you have to match that. And you may have to pay workers comp insurance and unemployment tax on the tips as well, depending on your state. Declared tips and the required taxes go on your form 941 and the W-2 like wages.
Employees and employers don't always do this honestly, especially regarding cash tips. But it becomes automatic and necessary when you process the tips through your credit card system along with the regular tab. If you don't understand these responsibilities, you should speak with a professional accountant.
