Fed Tax Incentives: "FICA Tip Tax Credit"
Background: Credit for Employer Social Security & Medicare Taxes Paid on Certain Employee Tips
Restaurant owners with employees who routinely receive tips may be entitled to this credit for the part of the taxes paid on their employees’ tips. In general, employee tip income is treated as employer provided wages for purposes of social security and medicare withholding under the Federal Insurance Contributions Act ("FICA"). Employees are also required to report to their employer the amount of tips received. However, to relieve the financial burden, the federal government allows eligible business owners to claim a FICA tip tax credit each year on their returns.
The Omnibus Budget Reconciation Act of 1993 ("OBRA 1993") established a business tax credit ("FICA Tip Tax Credit") under IRC 45B with respect to certain employer FICA taxes paid regarding tips treated as paid by the employer. The credit generally applies to tips received from customers in connection with the provision of food or beverages for consumption on the premises of an establishment with respect to which the tipping of employees is customary, effective for taxes paid after December 31, 1993.
Credit for Employer Share of FICA Taxes Paid
IRC § 45B(a) of the Code provides that, for purposes of the general business credit under section 38, the credit for employer social security and Medicare taxes paid on certain employee tips is an amount equal to the “excess employer social security tax” paid or incurred by the employer. The term “excess employer social security tax” means any tax paid by an employer under section 3111 (both social security tax and Medicare tax) on its employees’ tip income without regard to whether the employees reported the tips to the employer pursuant to section 6053(a). Consequently, the section 45B credit is available with respect to unreported tips in an amount equal to the “excess employer social security tax” paid or incurred by the employer. No credit, however, is allowed to the extent tips are used to meet the federal minimum wage rate.
In general, the credit applies to the tip income in excess of what is needed to bring your employee’s wages up to the federal minimum hourly rate. This credit equals the employer's portion of the FICA tax, which is currently 7.65% (Social Security tax of 6.2% plus the Medicare tax of 1.45%), multiplied by the tips in excess of the federal minimum wage ($5.15 for computational purposes).
For purposes of the IRC 45B credit, the federal minimum wage level used for the credit computation is $5.15 per hour which was the minimum wage on January 1, 2007, even though the current federal minimum wage is $7.25 per hour effective July 24, 2009. See 29 U.S. Code § 206(a); Fair Labor Standards Act of 1938 (as amended 29 U.S.C. 201, et seq. The Small Business Work Opportunity Act of 2007 effectively froze the federal minimum wage at $5.15 per hour for IRC 45B credit computational purposes. Therefore, the amount of tips for any month that are used to figure the credit must be reduced by the amount by which the wages that would have been payable during that month at $5.15 an hour exceed the wages (excluding tips) paid by the employer during that month.
Under federal law and the laws of most states, employers are allowed to pay employees who receive tips less than the minimum wage as long as their tip income makes up the difference. The Fair Labor Standards Act (FLSA) allows employers to pay workers who customarily receive tips less than the standard minimum wage as long as certain conditions are met. Under federal law, employers can take a tip credit by paying tipped workers, such as servers and bartenders, as low as $2.13 an hour if those workers earn at least the standard minimum wage of $7.25 an hour once their tips are added in.
Many states also have minimum wage laws. In cases where an employee is subject to both state and federal minimum wage laws, the employee is entitled to the higher minimum wage. As such, the FLSA rule's applicability may be diminished by state laws that set higher minimum wages or ban subminimum wages altogether. As such, employers must check the applicable state laws before claiming the tip credit provided under IRC 45B. Some states don't allow the tip tax credit to be taken at all (i.e. Alaska, California, Minnesota, Montana, Nevada, Oregon and Washington). Several other states permit a tip credit but require that workers be paid a higher cash wage than what is required under federal law. For example, in Arizona, employers must pay tipped workers at least $8.00 an hour, and workers must earn at least $11.00 an hour (the state's minimum wage) when tips are included. See U.S. Department of Labor, Wage & Hour Division - State Labor Laws, "Minimum Wages for Tipped Employees" (Jan. 1, 2019) link.
If a tip credit is taken in states with a higher minimum wage, employers must ensure that employees are receiving sufficient tips to meet both federal and state minimum wage requirements. In general, when the applicable state law provides more generous protections for employees than federal law, the state law prevails. Moreover, state law differences on this issue can pose a challenge for employers who operate in multiple jurisdictions.
Eligibility Criteria for the FICA Tip Tax Credit
In general, a restaurant business must meet both of the following two criteria to be eligible:
1. Your employees received tips from customers for providing, delivering, or serving food or beverages for consumption;
2. You paid or incurred employer Social Security and Medicare taxes on these tips.
Additionally, the IRS states that this credit only applies to taxes paid after December 31, 1993, and only applies to tips received by food and beverage employees. It is not applicable to other tipped employees.
How to Calculate the FICA Tip Tax Credit
Here's a general example below to help clarify the calculation.
An individual restaurant server works 2,080 hours in 2019 (hours worked includes all paid time including holidays, vacations, etc.) and is paid $3.13 per hour or $6,510 for the year. The server reports tip income of $15,000 to the employer. The employer withholds and “matches” FICA & Medicare taxes on the server’s combined wages and tips of $21,510. The restaurant’s FICA Tip Tax Credit for 2019 is calculated as follows for this individual server:
Section 45B “minimum wage” amount:
$10,712 (2,080 x $5.15) Server’s 2013 combined wages: $21,510 ($6,510 + $15,000)
Less server’s compensation based on $5.15 per hour: ($10,712)
Tip income above $5.15 per hour: $10,798 ($21,510 – $10,712)
FICA & Medicare tax paid: $1,646 (21,510 x 7.65%)
FICA Tip Tax Credit/Employer tax savings: $826 ($10,798 x 7.65%)
Although the example credit amount may appear immaterial for a single employee restaurant server, if you have a staffing of 20 similar employees (waiters, bartenders, etc.), assuming the same hypothetical facts and circumstances noted above, this credit for the year would grow to $16,520 in tax credits for the year to offset your income tax liability.
Lastly, it's important to note the employer’s characterization of a payment as a “tip” is not determinative for FICA tax purposes under section 3121 of the Code. See IRS Rev. Rule 2012-18. For example, an employer may characterize a payment as a tip, when in fact the payment is a service charge. The criteria of Rev. Rul. 59-252, 1959-2 C.B. 215, should be applied to determine whether a payment made in the course of employment is a tip or non-tip wages under section 3121 of the Code.
In general, the revenue ruling provides that the absence of any of the following factors creates a doubt as to whether a payment is a tip and indicates that the payment may be a service charge:
(1) the payment must be made free from compulsion;
(2) the customer must have the unrestricted right to determine the amount;
(3) the payment should not be the subject of negotiation or dictated by employer policy; and
(4) generally, the customer has the right to determine who receives the payment.
All of the surrounding facts and circumstances must be considered.
Reporting the FICA Tip Tax Credit
Restaurant owners who are incorporated as C-corporations may use the credit to directly reduce the tax liability on the face of the tax return. S-corporations and partnerships would pass the credit to its shareholders or members via their respective K-1 schedules. The shareholders or members would then claim their share of the tax credit on their personal income tax returns.
IRS Links, Notices, & Filing Requirements
Revenue Ruling 2012-18, Tips Included for Both Employee And Employer Taxes