Restaurants can claim a credit for part of the social security and Medicare taxes they pay on their employees’ tips, and the IRS has ruled that certain tips aren’t really tips.
Credit for employer payroll taxes
Background
Waiters, bartenders, and other restaurant workers make a large part – frequently most – of their income from tips they receive from customers. Tips aren’t tax-free. Under §3121(q) of the Internal Revenue Code, cash tips received by an employee in the course of employment are considered remuneration for that employment and are deemed to have been paid by the employer for FICA tax purposes. So, both the employee and employer are required to pay social security and Medicare taxes (generally 7.65% each) on tips received.
Tip (no pun intended): Tips totaling less than $20 per month are excluded from these rules.
Employees are required to report tips received to their employer on a written statement by the 10th day of the month following the month in which the tips are received – i.e., May tips must be reported to the employer by June 10th. The employer than withholds the employee’s portion of FICA taxes from the employee’s wages, and pays both portions of FICA taxes in the usual manner under the Form 941 deposit and reporting procedures.
The big problem is that people don’t like to pay taxes, and many tips are paid in cash. The idea behind the credit is that, if employers don’t have to pay their share of FICA taxes on tip income, they’ll be more likely to report tips, and collection of employee FICA taxes and income taxes on tips will increase. Before the credit was enacted, the IRS estimated that only 15% of tip income was reported. Even with the credit, the IRS estimates that well less than half of all tips are reported as income.
Who can claim the credit
The credit can only be claimed by food and beverage establishments. Other industries in which employees receive tips are not eligible.
Amount of the credit
As usual, Congress and the IRS take a simple concept and make it somewhat complex. Many workers who receive tips are allowed to be paid less than the minimum wage. If their tips do not get them to the minimum wage level, the employer generally must make up the difference with wages. Employers therefore have an interest in ensuring that sufficient tips are reported to get employees to minimum wage, and would question an employee’s reported tips if they were extremely low. Accordingly, the credit does not apply to FICA taxes on the amount of tips needed to get an employee to minimum wage. But, it’s not the current minimum wage that counts. The federal minimum wage before 2007 – $5.15 per hour – is the number used for purposes of the credit.
The current federal minimum wage for tipped employees is $2.13. This minimum is applicable in nineteen states. Twenty-four states and DC have minimum wages for tipped employees that is higher than the federal, but still lower than the regular minimum wage. In Pennsylvania where I am, it’s $2.83. The remaining seven states require employers to pay the full state minimum wage before tips.
The amount of the credit is equal to the amount of FICA taxes paid on each employee’s tips in excess of the amount of tips needed to get them to a $5.15 hourly rate. This calculation must be done monthly for each tipped employee.
Example
Yummy Burgers has two tipped employees, Janice and Steve. Janice has worked for Yummy for over a year and earns an hourly rate of $3.15. Steve just recently started at the state (PA) minimum wage of $2.83. In May 2014, Janice works 100 hours and reports tips of $600. Steve works 80 hours and reports tips of $400. Neither employee is over the FICA ceiling of $117,000.
The total FICA tax paid by Yummy Burgers for the two employees under the Form 941 deposit procedures is:
| Janice wages |
$315.00 |
| Steve wages |
$226.40 |
| Janice tips |
$600.00 |
| Steve tips |
$400.00 |
| Total taxable compensation |
$1,541.40 |
| Employer social security at 6.2% |
$95.57 |
| Employer Medicare at 1.45% |
$22.35 |
| Total employer FICA taxes |
$117.92 |
An equal amount is withheld from the employees’ wages.
The amount of excess tips and credit is calculated as follows:
|
Janice |
Steve |
Total |
|
| A. Actual wages and tips |
$915.00 |
$626.40 |
$1,541.40 |
| B. Hours worked |
100 |
80 |
180 |
| C. Wages at $5.15/hour |
$515.00 |
$412.00 |
$927.00 |
| D. Excess tips (A – C) |
$400.00 |
$214.40 |
$614.40 |
| E. Employer social security on excess |
$24.80 |
$13.29 |
$38.09 |
| F. Employer Medicare on excess |
$5.80 |
$3.11 |
$8.91 |
| G. Amount of credit |
$30.60 |
$16.40 |
$47.00 |
Tip: You’ll need to give your tax preparer monthly payroll reports showing wages, tips, and hours worked to properly claim the credit.
How to claim the credit
The credit is claimed by completing and attaching Form 8846 to your income tax return. The form is deceptively simple, and only has 6 lines. However, calculations like those in the example above need to be done apart from the form, and need to be done by month and by employee.
Other considerations
You can’t take both a deduction and a credit for the excess tips. If you take the credit, the amount of the credit must be added back to income. Credits are generally better than deductions because credits reduce your tax dollar-for-dollar. However, you may not be able to use credits in a particular year. You can elect not to take the credit in any tax year. Your tax advisor can determine which approach is better for your particular circumstances.
When is a tip a tip
The fine print at the bottom of a menu sometimes says that a gratuity will be automatically added to the check for parties of a certain size. You may have wondered how a mandatory charge could be termed a “gratuity.” So did the IRS.
In order for a tip to be a tip, it must be (among other things) a voluntary payment from a customer. An automatic gratuity clearly isn’t voluntary. The IRS has issued guidance stating that effective Jan. 1, 2014, such automatic gratuities will be considered as service charges collected by the restaurant, rather than tips collected by the employees. Instead of employees taking them home at the end of their shift, automatic tips should be treated as part of the employees’ regular wages and paid with their next regular paycheck.
Some restaurants find this to be an administrative hassle and have done away with automatic tips. Instead, they’re putting suggested tip amounts (e.g. 15%, 18%, and 20%) on the bills, but leaving the customer free to enter any tip they like, or no tip at all.
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