Understanding the Employee Tip Credit: A Guide for Restaurant and Hospitality Employers
If you operate a restaurant, bar, or any business where tipping is customary, the employee tip credit can be a valuable tax benefit. This federal income tax credit is designed to help offset the employer’s share of Social Security and Medicare (FICA) taxes paid on employee tips. Here’s what you need to know about how the tip credit works, who qualifies, and how to claim it.
What Is the Employee Tip Credit?
The employee tip credit, established under Internal Revenue Code § 45B, allows eligible employers to claim a credit for a portion of the FICA taxes paid on tips that employees receive from customers. Since tips are considered taxable income, employers are required to pay their share of FICA taxes on these amounts—even though the tips are paid directly by customers, not the employer.
Who Is Eligible?
The credit is available to employers in businesses where tipping is customary, such as restaurants, bars, and other food and beverage establishments. Only tips received in connection with the provision of food or beverages for consumption are eligible.
How Does the Credit Work?
The credit is based on the employer’s share of FICA taxes paid on tips that exceed the amount needed to bring an employee’s total wages (excluding tips) up to the federal minimum wage. Here’s a step-by-step overview:
Calculate Minimum Wage Requirement: For each employee, determine the minimum wage for the hours worked in a month, using the federal minimum wage rate of $5.15 per hour (the rate in effect on January 1, 2007, which is used for this calculation regardless of current rates).
Determine Cash Wages Paid: Add up the cash wages (excluding tips) paid to the employee for the month.
Apply Tips to Minimum Wage: If cash wages are less than the minimum wage, enough tips must be used to reach the minimum wage threshold.
Identify Excess Tips: Only the tips received in excess of the amount needed to reach minimum wage are eligible for the credit.
Calculate the Credit: Multiply the eligible excess tips by the employer’s FICA tax rate (currently 7.65%—6.2% for Social Security up to the wage base, plus 1.45% for Medicare).
Example:
Suppose an employee works 160 hours in a month. The minimum wage for the month is 160 x $5.15 = $824. If the employer pays $500 in cash wages, the first $324 of tips are used to reach minimum wage. If the employee reports $1,000 in tips, only $676 ($1,000 - $324) is eligible for the credit. The employer’s FICA tax rate is 7.65%, so the credit for that month would be $676 x 7.65% = $51.71.
Important Rules and Limitations
No Double Benefit: Employers must reduce their wage expense deduction by the amount of the credit claimed.
Service Charges: Mandatory service charges (such as automatic gratuities) are not considered tips for this credit; they are treated as regular wages.
Reporting: Employees must report tips to their employer by the 10th of the following month. Employers are responsible for withholding and paying FICA taxes on reported tips.
Timing: The credit is claimed in the year the employer actually pays or incurs the FICA tax on the tips. For unreported tips, the credit is available in the year the IRS issues a notice and demand for payment and the employer pays the tax.
How to Claim the Credit
Employers claim the tip credit on IRS Form 8846, "Credit for Employer Social Security and Medicare Taxes Paid on Certain Employee Tips." The amount is then included as part of the general business credit on Form 3800. If the credit exceeds the employer’s tax liability for the year, it can be carried back one year or forward up to 20 years.
Who Can Claim the Credit?
Only the employer who is legally liable for the FICA tax can claim the credit. In most cases, this is the common law employer. If you use a professional employer organization (PEO), you should confirm who is considered the employer for tax purposes.
Takeaway
The employee tip credit is a valuable tax incentive for businesses in the food and beverage industry. By understanding the rules and properly tracking employee tips and wages, employers can reduce their tax liability and improve their bottom line. If you have questions about your eligibility or how to claim the credit, consult with the leading restaurant tax team, The Kitchen CPAs. Schedule a free consultation today.