Leaving Change on the Table
(The Merits of the Federal Tax Tip Credit)
Danielle Hansen, Tax Senior
For New England businesses, summer is typically the busiest time of year due to an influx of tourists coming to enjoy the beautiful ocean views and delicious seafood. This sharp increase in people usually brings with it a large and sudden increase in capital to most local businesses. This is especially true for New England’s restaurant industry. New England restaurants thrive throughout the summer, but can face harsher winter months as the tourists return home and the snow begins to fall. Therefore, saving money when and where possible is incredibly important for restaurant owners if they hope to survive the winter months. Tax credits are one of the best ways for small business owners to save money, helping to relieve some of their off-season financial burdens.
This article discusses one of the most underutilized credits available to restaurant owners: The FICA Tip Credit. The goal of this article is to provide a basic understanding of the credit, including who is able to use it, how to calculate it, and how to properly report it.
General Overview, Benefits, and Applicability
Generally, employee wages represent one of the largest expenses for businesses. That expense increases for restaurants during the busiest months of the season because employers are required to pay FICA taxes on tips received by their employees as if they were regular wages paid by the employer. As is the case with regular wages, the employer is responsible for paying to the IRS not only the employee’s share of FICA taxes, but also the employer’s dollar-for-dollar “match” of those amounts. This can create a financial burden for employers, because they generally receive no benefit from the tips received by their employees. Therefore, to help relieve some of the burden businesses face because of this rule, Internal Revenue Code Section 45B was created (the FICA Tip Credit). The credit allows businesses to recover a large percentage of the employer’s share of payroll taxes paid on tip income, as long as they meet the following criteria:
- The business had employees who received tips from customers for providing, delivering, or serving food or beverages if tipping of those employees is customary, and
- The business paid or incurred employer Social Security or Medicare taxes on those tips.
Calculating the Credit
The amount of the credit equals the employer’s share of FICA taxes paid by the employer on tips received by the employee. However, employers cannot claim the credit for taxes paid on any tips that are used to meet the federal minimum wage rate in effect on January 1, 2007 ($5.15 per hour). The minimum wage amount remains frozen as of January 1, 2007 for this purpose, regardless of any increase in the federal minimum wage. The amount of tips used to calculate the credit amount must be reduced by the amount of tips used to pay each employee the base FICA minimum wage ($5.15 per hour). The total is then multiplied by the current FICA tax rate (7.65%). In essence, employers must pay FICA taxes on a base rate of $5.15 per hour per employee, but any tip income earned over that amount is eligible for the credit. This is best explained by example:
- The taxpayer is a food or beverage establishment where tipping is customary. During May 2017 an employee worked 100 hours and received $500 in tips. The employee received $400 in wages (excluding tips) at the rate of $4.00 per hour. If the employee had been paid $5.15 per hour (the frozen federal minimum wage rate as of January 1, 2007), the employee would have received wages, excluding tips, of $515. The difference between this amount and the $400 the employee actually received in wages during the month is $115. Thus, only $385 ($500-$115) of the employee tips for May 2017 are taken into account when calculating the employer’s FICA tip credit. The employer tip credit for that employee for the month of May would be $29.45 ($385 x 7.65%).
The FICA tip credit is a part of the general business tax credit, and is reported on Form 8846, Credit for Employer Social Security and Medicare Taxes on Certain Employee Tips. The credit must be elected each tax year in order to apply. An employer cannot claim both the credit and the expense deduction. If an employer claims the credit using Form 8846, it must reduce the Social Security and Medicare tax deduction accordingly. The decision regarding whether it is more beneficial to take the credit or the deduction should be discussed each tax year, as changing circumstances will affect whether one is more beneficial than the other. The credit is not refundable, meaning if the credit reduces an employer’s regular income tax to below zero, the negative amount is not available as a tax refund. However, as with the other business tax credits, the Tip Credit is subject to both carryback and carryforward provisions.
Note that employees who receive tips have reporting requirements of their own. Each month in which collected tips reach at least $20, an employee must complete, sign and date, and provide to his or her employer IRS Form 4070, Employee’s Report of Tips to Employer. This form requires very minimal information, and is used by the employer to compute the employee’s share of payroll taxes due on tips, the employer’s match of the FICA taxes, and the tip credit.
The tip credit can be utilized by restaurant owners to reduce its payroll taxes owed on tip income received by their employees. Indirectly, the credit allows restaurant owners to pay FICA tax on wages totaling only $5.15 per hour per employee, even if employee remuneration exceeds that amount. Therefore, if employers properly elect and utilize this credit, it is likely that they will benefit from large tax savings.
If you have any questions about the tip credit and how it may benefit your business, please contact Danielle Hansen or Andy Smith at 1.800.244.7444.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.